Is There Hope For Credit Rating Agencies?

ATTORNEY: Anna Karin F. Manalaysay
POMERANTZ MONITOR, MARCH/APRIL 2015

Anyone compiling a list of culprits in the U.S. subprime residential mortgage debacle of 2007-2008 would have to include the credit rating agencies at or near the top. Meant to provide investors with reliable information on the riskiness of various kinds of debt, the agencies have instead been accused of defrauding investors by giving triple-A ratings to mortgage-related securities so risky they were even considered doomed to fail by the banks that created them.

Why did this happen? Probably because the financial incentives for the ratings agencies have changed dramatically. In the past, credit rating agencies charged a subscription fee to subscribers to cover their rating activity. Then the practice changed, and the company or issuer being rated pays the fee. By switching to this business model, the ratings agencies assumed a crippling conflict of interest; for if they did not deliver high ratings regardless of the circumstances, issuers would shop around for a more compliant ratings agency the next time around.

The best-known credit rating agencies in the United States are Moody’s Investor Services, Standard and Poor’s, and Fitch. S&P issues nearly half of all credit ratings and together with Moody’s and Fitch, the so-called “Big Three” issue ninety-eight percent of the total ratings. On February 3, 2015, S&P agreed to pay $1.375 billion to settle lawsuits brought by the U.S. Department of Justice and 20 attorneys general concerning ratings S&P gave to certain mortgage securities just before the 2008 financial meltdown. So far, this has been the largest settlement involving a credit rating agency.

The press release issued by the Justice Department said the ratings at issue were given to residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) during the period 2004 to 2007. RMBS are created when a bank or other financial institution pools together mortgage loans. CDOs pool together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors.

The lawsuit filed by the Justice Department in 2013 alleged that S&P had engaged in a scheme to defraud investors by knowingly inflating the credit ratings it gave to RMBS and CDOs which resulted in substantial losses to investors and ultimately contributed to the worst financial crisis since the Great Depression. The Justice Department claimed that S&P’s rating decisions were not independent and objective as they were required to be but, rather, based in part, on its business concerns.

As a part of the settlement, S&P agreed to a statement of facts that contained an admission that its ratings for CDOs were partially made based on the effect they would have on S&P’s business relationship with issuers. It also admitted that, despite knowledge within the S&P organization in 2007 that many loans in RMBS transactions it was rating were delinquent and losses were probable, it continued to issue and confirm positive ratings.

As credit rating agencies were being blamed for feeding a subprime mortgage frenzy, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July 2010. Among its various provisions, Dodd-Frank outlined a series of broad reforms to the credit rating agencies market. Despite Dodd-Frank, however, some signs of trouble have re-emerged. In January 2015, for example, S&P paid nearly $80 million to settle accusations of the SEC that it orchestrated similar fraud in 2011, years after the financial crisis took place. S&P also agreed to take a one-year “timeout” from rating certain commercial mortgage investments at the heart of the case, an embarrassing blow to the rating agency. The pact is the SEC’s first-ever action against a major ratings firm.

The SEC has since issued new rules aimed to enhance governance, protect against conflicts of interest, and increase transparency. These rules, which went into effect January 1, 2015, require rating agencies such as S&P to: 

• provide records of their internal control policies and rating methodology;
•  prohibit their sales teams from participating in the rating process;
• review, and revise if needed, ratings for companies that later hire one of the agency’s employees; and
• file annual reports showing how the agencies monitor ratings, how ratings changed over time and whether evaluated companies eventually defaulted.

If a credit rating agency violates these rules, the SEC will suspend or revoke the agency’s registration — disciplinary action that may be effective in preventing further violations. However, while the regulations do attempt to keep rating activity under strict surveillance, they do not restructure the way rating agencies solicit business or receive payment. Thus, the inherent conflict of interest still exists since the agencies are paid by the same banks and companies they rate.

The SEC has thus far failed to maintain control and ensure rating agencies follow proper rating methodologies — the multiple accusations against S&P attest to these failures — but only the health of the future financial market will tell whether the recent regulations, coupled with the hefty consequences credit rating agencies such as S&P have had to face, will have a long-term stabilizing impact.

Pomerantz Wins Important Motion, Post-Halliburton

ATTORNEY: Joshua B. Silverman
POMERANTZ MONITOR, MARCH/APRIL 2015

When the Supreme Court issued its landmark decision in Halliburton v. Erica P. John Fund last summer, it did not give either side a total victory. Critically for investors, the Supreme Court reaffirmed the fraud-on-the-market presumption, which is necessary for class certification in most securities fraud actions. The presumption allows classwide proof of reliance, an element of Exchange Act claims, by demonstrating that the stock traded in an efficient market. In efficient markets, publicly-available information is incorporated into the stock price and traded on by all investors, so plaintiffs need not show that each class member actually heard or read the misrepresentations giving rise to the lawsuit. By reaffirming these principles, the Court ensured the continued viability of securities fraud class actions. However, at the same time, the decision offered defendants the ability to rebut the fraud-on-the-market presumption at the class certification stage by demonstrating that the alleged fraud did not affect the stock price.

Halliburton did not specify precisely how lower courts should determine market efficiency or lack of price impact. As lower courts begin to grapple with these issues, the early results are promising for investors. Thus far, district courts (and in one case, an intermediate court of appeals) have applied rational tests for both market efficiency and price impact, consistent with the principles set forth in Halliburton. 

The most important consequence of Halliburton may be to stabilize the law over what constitutes an efficient  market. In 1988, when the Supreme Court first recognized the fraud-on-the-market presumption, it declined to adopt any particular test for market efficiency. In the years that followed, most courts used the so-called “Cammer test,” which assessed, among other factors, trading volume, analyst coverage, and price movement following release
of important company-specific news. 

However, more recently defendants and their experts have urged courts to stack on top of the Cammer factors a litany of additional requirements lifted from the extreme end of academic debates about market efficiency. A significant minority of courts accepted these arguments, resulting in a patchwork of inconsistent standards. For example, some courts refused to certify cases involving stocks that moved in trends, theorizing that such trending—or serial correlation—was inconsistent with the belief of some academicians that efficient markets must be wholly unpredictable. Other courts looked to related options markets, holding that a lack of parity input and call options demonstrated constraints on arbitrage activity, and therefore showed market inefficiency. A few other courts suggested that impairments to arbitrage could also be found if the stock was difficult or expensive to sell short. 

Halliburton should put an end to these fringe academic tests. In its opinion, the Supreme Court emphasized that for purposes of the fraud-on-the-market presumption, market efficiency refers only to “the fairly modest premise that market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.” As one law professor explained, Halliburton demonstrates that “the efficiency question is not meant to be particularly rigorous.” District courts appear to get the message. Since Halliburton, no district court has cited serial correlation, lack of put-call parity, or short-lending costs as a basis for denying class certification in a securities fraud class action. 

Recently, Pomerantz won an important motion addressing the continued relevance of fringe academic market efficiency tests. In the Groupon securities litigation, where Pomerantz serves as lead counsel, defendants had argued that plaintiffs’ class certification expert was unreliable because he failed to conduct put-call parity and short lending fee analyses. After an extensive evidentiary hearing, the court sided with Pomerantz, holding that such tests were unnecessary because they addressed an extreme variation of market efficiency that “was squarely rejected by the Halliburton court.”

District courts have also applied reasonable, consistent tests when assessing the price impact defense recognized in Halliburton. They have thus far uniformly rejected defendants’ attempts to show lack of price impact by demonstrating that some or all of the misrepresentations did not move the stock at the time they were made. Instead, recognizing that misrepresentations are used to artificially maintain as well as boost share prices, courts in the Regions Financial, IntraLinks, and Best Buy litigations have all held that price impact can be found where the share price declines when the truth is revealed, even if the stock did not move at the time the false statements were issued. Best Buy has been appealed, so the Eighth Circuit will soon weigh in on the issue.

Defendants have been equally unsuccessful in attempts to persuade courts to disregard price movement, where it does occur, by claiming it was caused by something other than the alleged fraud. For example, in Catalyst Pharmaceuticals, the court rejected expert testimony that the truth was already known to the market. Such evidence, the court held, did not disprove price impact but instead addressed whether the omitted information was material, an issue reserved for the trier of fact. By strictly enforcing the Supreme Court’s requirement that defendants prove the absence of price impact instead of just proffering different explanations for price moves, lower courts have ensured that the exception to the fraud-on-the-market presumption did not swallow the rule.

Courts will continue to construe Halliburton in the coming months, particularly in the Best Buy appeal and Halliburton itself (where the issue of price impact was remanded to the district court). If they apply the measured reasoning seen in early cases, it will bring much-needed consistency and predictability to the class certification process.

Delaware Court Refuses to Apply Fee-Shifting Bylaw

ATTORNEY: Alla Zayenckik
POMERANTZ MONITOR, MARCH/APRIL 2015

Pomerantz achieved an important corporate governance victory for stockholders in March when Chancellor Bouchard of the Delaware Court of Chancery refused to apply a fee-shifting bylaw to plaintiff and the class in Strougo v. Hollander. Fee shifting bylaws impose on plaintiff shareholders and their counsel the defendants’ entire litigation costs, unless the action achieves a complete victory, including an award of the entire remedy sought in the action. Such bylaws, if widely adopted, would foreclose virtually all shareholder litigation, regardless of the merits. Last year, in a case called ATP, the Delaware Supreme Court held that such bylaws can be legally enforceable, at least in some circumstances.

In Strougo v. Hollander, a closely-watched test case, Chancellor Bouchard issued the first Delaware opinion to address fee-shifting bylaws since the Supreme Court’s ATP decision last year. The Chancellor found that defendants cannot bind plaintiff and the class to a fee-shifting bylaw adopted after plaintiff had been forcibly cashed out through a reverse stock split.

Accepting the arguments proffered by Pomerantz partner Gustavo F. Bruckner, head of Pomerantz’s corporate governance practice, the Court found the bylaw inapplicable as to plaintiff and the Class under both Delaware contract and corporate law. Chancellor Bouchard explained that the Bylaw does not apply for two related reasons: (i) the Board adopted the bylaw after plaintiff’s interest in the company was eliminated by the reverse stock split; and (ii) Delaware law does not authorize a bylaw that regulates the rights or powers of former stockholders who were no longer stockholders when the bylaw was adopted.

The Chancellor found that “[A] stockholder whose equity interest in the corporation is eliminated in a cash-out transaction is, after the effective time of that transaction, no longer a party to [the] flexible [corporate] contract. Instead, a stockholder whose equity is eliminated is equivalent to a non-party to the corporate contract, meaning that former stockholder is not subject to, or bound by, any bylaw amendments adopted after one’s interest in the corporation has been eliminated.”

The Chancellor also commented on the underlying merits of the case and the effect of fee-shifting bylaws. He wrote “the Bylaw in this case would have the effect of immunizing the Reverse Stock Split from judicial review because, in my view, no rational stockholder—and no rational plaintiff’s lawyer—would risk having to pay the Defendants’ uncapped attorneys’ fees to vindicate the rights of the Company’s minority stockholders, even though the Reverse Stock Split appears to be precisely the type of transaction that should be subject to Delaware’s most exacting standard of review to protect against fiduciary misconduct.”

Prior to the Chancellor’s ruling, on March 6, 2015, the Council of the Corporation Law Section of Delaware State Bar Association issued proposed amendments to the Delaware General Corporation Law that would ban fee-shifting provisions from a company’s bylaws or charter. If enacted, the amendments will become effective on August 1, 2015.

Pomerantz Appointed Lead Counsel in Historic Petrobras Securities Class Action

ATTORNEY: Francis P. McConville
POMERANTZ MONITOR, MARCH/APRIL 2015

Pomerantz will take the helm on a consolidated group of securities class actions over revelations of rampant corruption at Petroleo Brasileiro SA (“Petrobras”), according to an order issued March 4, 2015 by New York U.S. District Judge Jed S. Rakoff. We were selected as lead counsel by lead plaintiff Universities Superannuation Scheme Ltd. (“USS”).

USS was chosen over three other candidates for lead plaintiff: the SKAGEN-Danske group, made up of three European asset managers; a group of three State Retirement Systems; and an individual investor.

The class action against Petrobras, brought on behalf of all purchasers of common and preferred American Depositary Shares (“ADSs”) on the New York Stock Exchange, as well as purchasers of certain Petrobras debt, principally alleges that Petrobras and its senior executives engaged in a multi-year, multi-billion dollar money-laundering and bribery scheme, which was, of course, concealed from investors. Senior management has openly admitted its culpability. In testimony released by a Brazilian federal court, the executive in charge of Petrobras’ refining division confessed that Petrobras accepted bribes “from companies to whom Petrobras awarded inflated construction contracts” and “then used the money to bribe politicians through intermediaries to guarantee they would vote in line with the ruling party while enriching themselves.” These illegal acts caused the company to overstate assets on its balance sheet, because the overstated amounts paid on inflated third party contracts were carried as assets on the balance sheet.

As of November 2014, the Brazilian Federal Police had arrested at least 24 suspects in connection with Petrobras’ money laundering and bribery schemes; and Brazil’s president, who was a senior Petrobras executive during the relevant period, has also been engulfed in this scandal. As a result of the fraudulent scheme, Petrobras may be forced to book a $30 billion asset writedown in order to reduce the carrying value of some of its assets. That impairment would equal approximately 42% of the company’s market value.

USS was not the lead plaintiff applicant with the largest losses from the fraud. Indeed, the SKAGEN-Danske group, with purported losses exceeding $222 million, asserted by far the largest losses of all the competing lead plaintiff applicants. However, although the securities laws establish a rebuttable presumption in favor of the appointment as lead plaintiff of the movant with the “largest financial interest” in the litigation, that movant must also “otherwise sastisf[y] the requirements of Rule 23 of the Federal Rules of Civil Procedure” under the Private Securities Law Reform Act (“PSLRA”).

In particular, USS and Pomerantz argued that the SKAGENDanske and State Retirement Systems were artificial groupings put together by counsel trying to win the lead counsel position, and were plagued by numerous deficiencies rendering them inadequate to represent the Class. Although the PSLRA states that a lead plaintiff may be a “group of persons,” to allow an aggregation of unrelated plaintiffs (asset managers and pension funds, in this instance) to serve as lead plaintiffs defeats the purpose of preventing lawyer-driven litigation. In stark contrast, USS, the largest pension fund as measured by assets in London, opted to move for appointment as sole lead plaintiff, in order to allow it full and independent control of its counsel and the prosecution of the litigation. In fact, prior to engaging the Pomerantz firm, USS spent over 50 hours of in-house attorney time determining whether to step forward as lead plaintiff. To assist its decision making process, USS retained outside counsel at its own expense to assist it in deciding whether to enter the action.

Moreover, the record in this case demonstrated that the SKAGEN-Danske Group – with SKAGEN showing a net gain on Petrobras common ADSs – had interests that could be deemed antagonistic to purchasers of Petrobras common ADSs. In this case, the large losers in Petrobras preferred ADSs, such as the SKAGEN-Danske Group, potentially have interests antagonistic to common ADS purchasers because of the unique qualities of each security and the potential threats facing the capital structure of Petrobras. USS, with the single largest losses of PBR common ADSs among the various lead plaintiff movants, thus presented the court with an attractive and safe option for potential lead plaintiff.

At bottom, USS argued that it was the ideal plaintiff envisioned by Congress when it enacted the PSLRA. No other movant had demonstrated the willingness and ability to adequately oversee counsel and vigorously prosecute the claims against Petrobras on behalf of the Class. Critically, USS was the only movant not overwhelmed by various inadequacies and unique defenses. Nor did USS have any ties to potentially relevant political contributions or curious arrangements with counsel, which have heretofore afflicted the alternative lead plaintiff groupings.

Accordingly, the independence and diligence evidenced by USS and Pomerantz during the lead plaintiff process ultimately paid off. As articulated during the briefing process, USS’s conduct represented the “gold standard” for institutional oversight of proposed lead counsel, and represents the model for institutional investors seeking to file future applications for appointment as lead plaintiff in securities class actions.

SEC Reverses Its Own Whole Foods Ruling

ATTORNEY: H. Adam Prussin
POMERANTZ MONITOR, JANUARY/FEBRUARY 2015

As we have been reporting for years, corporate America has been at war with activist investors who want the right of “proxy access,” which would allow them to propose nominees for director that can appear on the companies’ own proxy statements. Not too long ago, the SEC backpedaled from a proposed rule that would have granted automatic proxy access to investors who had held a certain percentage of the company’s outstanding shares for an extended period of time. This proposal is now in seemingly eternal limbo.

Instead, investors have sought to put the issue of proxy access to a shareholder vote on a company by company basis. For example, Scott M. Stringer, the New York City comptroller and overseer of five city pension funds with $160 billion in assets, recently put forward proposals at 75 companies that would allow shareholders to nominate directors. In response to these and other similar efforts, some companies have tried to pre-empt those requests by proposing, instead, their own watered-down version of similar proposals – typically with much higher threshold requirements the shareholder would have to meet. An SEC rule states that a shareholder proposal can be excluded if it “directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.”

Whole Foods is a case in point. A Whole Foods investor proposed that investors holding 3 percent of the grocer’s shares for at least three years be allowed to nominate directors at the company. Whole Foods asked for permission to exclude the proposal last fall, saying that it planned to put its own proposal on director elections to a shareholder vote. Under management’s proposal, an investor interested in nominating directors had to own a far larger stake and to have held it for much longer than in the investor’s proposal.

In its original ruling, issued December 1, the SEC staff granted a no action letter to Whole Foods, allowing it to exclude the shareholder proxy access proposal. Shortly afterwards, 18 other companies asked for no action letters permitting them to do the same. This caused a backlash from institutional investors who viewed this tactic as a too-convenient way for companies to avoid putting more aggressive proxy access proposals to a shareholder vote, and who began asking the SEC to revisit its Whole Foods decision.

On January 16, the SEC announced that it had reversed its Whole Foods decision. In a public statement, SEC Commissioner Mary Jo White said that questions had arisen about “the proper scope and application” of the SEC rule on which its staff had relied when making the decision. She also said she had directed the staff to review the rule and report its findings to the full commission. While its review is underway, the SEC said it would make no rulings on requests for no action letters involving shareholder proposals that are similar to those made by management.

Many view this development as handwriting on the wall, predicting that this preemption tactic is going to be prohibited or at least severely curtailed. Still, without a ruling one way or the other just yet, companies will have to decide for themselves whether to include such proposals in their upcoming proxy statements this spring.

Agencies Shifting Many Enforcement Actions to In-House Administrative Courts

ATTORNEY: Emma Gilmore
POMERANTZ MONITOR, JANUARY/FEBRUARY 2015

The Securities and Exchange Commission and the Commodity Futures Trading Commission have recently signaled that they intend to bring many future enforcement actions in administrative courts rather than federal courts. Kara Brockmeyer, the chief of the Division’s Foreign Corrupt Practices Act Unit, said at a legal conference in Washington held in October that bringing cases as administrative proceedings “is the new normal.”

While both venues have always been available for such actions, the Dodd-Frank Act expanded the powers of administrative courts, allowing them to impose remedies similar to those available in federal court, including the imposition of monetary penalties. The shift has stirred a flurry of public debates on the fairness of the administrative procedures.

Critics argue that the administrative procedure mechanism deprives defendants of constitutional and procedurals advantages, as discovery is limited (essentially precluding depositions, except to preserve evidence); the Federal Rules of Evidence do not apply (even hearsay is admissible); and there is no right to a jury. Those critics also point out that the initial factfinder is an SEC employee, and is therefore presumably biased in the SEC’s favor. They argue that while a defendant can appeal the administrative decision to a federal court of appeals, the court is likely to defer to the administrative agency. Among the fierce critics of such administrative proceedings is Southern District of New York Judge Jed S. Rakoff, who, in a speech last November, argued that “the law in such cases would effectively be made, not by neutral federal courts, but by SEC administrative judges,” saying that administrative proceedings are compromised by “informality” and “arguable unfairness.”

Another federal judge, Lewis A. Kaplan of the Southern District of New York, takes a decidedly different view. He recently held that a defendant’s right to appeal to a federal court at the end of the procedure would suffice to address any injustice or due process violations committed in the administrative proceeding. He concluded that “Congress has provided the SEC with two tracks on which it may litigate certain cases. Which of those paths to choose is a matter of enforcement policy squarely within the SEC’s province,” and the SEC is “especially competent…to determin[e] which…cases are appropriately brought in a district court and which in an administrative proceeding.” (emphasis in original).

In similar vein, the SEC’s Enforcement Division Director Andrew Ceresney defended the agency’s recent shift. “It’s not the case there is no more activity in district court; there is. Having said that, it is certainly the case we’re going to use [administrative] proceedings more often. Why is that? Because Congress gave us the authority under Dodd-Frank to obtain the same remedies in administrative proceedings as we can obtain in district courts,” Ceresney said. He argued at a November 7 conference sponsored by the Practicing Law Institute (“PLI”) that the administrative proceedings process is not only fair to defendants, but also constitutes a more efficient means to reach a resolution. dministrative proceedings are relatively fast, with rulings usually handed down within 300 days of the case being filed, as opposed to years for the typical federal-court case. Ceresney insisted that cases are heard by judges who are seasoned, sophisticated fact finders in the securities field.

At that same PLI conference, CFTC’s Enforcement Division Director Aitan Goelman said a streamlined enforcement proceeding is necessary because his agency is financially constrained and does not have the money to engage in lengthy litigations. The CFTC is mulling a “best-offer” settlement agreement very early in the proceeding in hopes of streamlining the resolution of enforcement disputes.

Another likely reason for the forum shift may be, as the Wall Street Journal recently reported, that the SEC’s win rate in recent years is “considerably higher” in administrative forums than in federal courts. In the 12 months through September 2014, the SEC won all six contested administrative hearings where verdicts were issued, but only 61%—11 out of 18—federal-court trials. Previous years showed the same pattern: the agency won nine of 10 contested administrative proceedings in the 12-month period through September 2013 and seven out of seven in the 12 months through September 2012, according to SEC data. The SEC won 75% and 67%, respectively, of its trials in federal court in those years.

Given the SEC’s success rate in such forum, this shift can prove beneficial to private litigants. Assuming the administrative procedures are fair and do not violate a defendant’s due process rights (and given the administrative law judges’ specialized knowledge of securities laws), appeals courts are likely to affirm the administrative law decisions. SEC-favorable decisions can in turn be employed as highly persuasive authority by private plaintiffs in actions brought against distinct defendants but under analogous fact patterns.

Court Upholds Our Claims Challenging Going Private Transactions

ATTORNEY: Gustavo F. Bruckner
POMERANTZ MONITOR, JANUARY/FEBRUARY 2015

When a controlling shareholder, who also happens to be the CEO of the company, proposes to take the company private, the situation is ripe for abuse. That’s exactly what we believe occurred in the case of Zhongpin Inc., a Delaware company headquartered in China.

In 2013 Xianfu Zhu, Zhongpin’s CEO, who owned 17.3% of the company’s shares, offered to acquire all shares of the company that he did not own for $13.50 per share. Even though there was another, higher offer for the company on the table, Zhu refused to raise his price, stating that he would not remain as CEO if an alternate bidder acquired a majority stake, would not engage in discussions with third-party investors interested in acquiring the company and would withdraw his proposal if the special committee of the Board formed to consider his offer did not approve it within several days.

The special committee retained Barclay’s Bank to act as financial advisor on the transaction, but it later resigned without ever rendering a fairness opinion. Nonetheless, the special committee approved the deal, and a tiny majority of unaffiliated shareholders ratified it.

Pomerantz is co-lead counsel representing shareholders in a class action in Delaware that seeks damages for investors injured by this self-dealing transaction. Defendants moved to dismiss our action, arguing that Zhu was not a controlling shareholder of Zhongpin because he owned only 17.3% of its shares, and that he therefore did not owe fiduciary duties to other shareholders.

Late last year, in a victory for shareholders, Pomerantz successfully argued that even a 17.3% shareholding stake could be sufficient to assert control, and that the transaction therefore had to be evaluated under the “entire fairness” standard. The Chancery Court rejected the motion to dismiss and the case will proceed to trial.

Because they manage the business for the benefit of the shareholders, corporate directors and officers occupy a fiduciary relationship to both the corporation and its shareholders; but shareholders do not normally owe fiduciary duties to other shareholders. However, when a shareholder “controls” the company, courts have found that he or she owes similar duties as directors to the other shareholders. That is because a controlling shareholder can dominate and control the conduct of the Board and will be held to have indirectly acted in a managerial capacity and thus to have assumed the burden of fiduciary responsibility.

The issue of whether Zhu had control was therefore at the heart of defendants’ motion to dismiss. Under Delaware law, clearly a shareholder owning a majority of a corporation’s stock would be considered a controlling shareholder since with one share more than 50%, such a shareholder could place its own designees on the Board and assure every corporate decision is decided in its favor. Courts have found that some large holders, albeit less than majority holders, may still be considered controlling shareholders if they exert actual control over the Board. That is, they have the power to elect their slate of directors, to adopt or reject fundamental transactions proposed by directors or exercise control over the corporation’s business affairs.

The fact that Zhu was CEO and owned a 17.3% stake was not enough to give him control over the board. In fact, Delaware courts had previously dismissed similar claims of control in other cases where the allegedly controlling shareholder held such a small stake.

In our case, the court held that “Plaintiffs do not need to prove that Zhu was a controlling stockholder in order to withstand the motions to dismiss. Rather, Plaintiffs must plead facts raising the inference that Zhu could control Zhongpin.” The court also held that “while most owners of 17% of a corporation’s stock are not controllers, a plaintiff may argue that given the circumstances of a particular case, such a sizeable stockholder actually exercises control.”

Here the court held that the circumstances supported just such an inference. During the sales process, the company filed its annual report which stated that Zhu “has significant influence over our management and affairs and could exercise his influence against” the best interests of shareholders. The annual report referred to him as the “controlling shareholder” and also stated that as a result of his alliances, and pursuant to the company’s By-Laws, he could “exercise significant influence” over the company, including election of directors, selection of senior management, amount of dividend payments, the annual budget, changes in share capital and preventing a change of control. The court concluded that “Zhu exercised significantly more power than would be expected of a CEO and 17% stockholder” and that “one can reasonably conceive that Zhu could ‘control the corporation, if he so wishe[d].”  Under the circumstances, the court held, Zhu’s dominance “left the company with no practical alternatives other than to accept his proposal.”

This has implications for challenges to buy-out proposals submitted by controlling shareholders. Courts seek to protect minority shareholders from the whims and self-interest of controlling shareholders just as they do from the self-interest of corporate directors.

Typically when a shareholder, unhappy over the sale of the company, brings an action against the company’s board of directors to challenge the transaction, a court will defer to the business judgment of the company’s board of directors. The “business judgment rule,” as this protection is known, affords corporate officers and directors who are not subject to self-dealing conflicts of interest immunity from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence. In such a situation, the shareholder-plaintiff has the high burden of proving that the directors’ actions were not made in good faith in order to successfully challenge the transaction.

However, if the directors should have self-interests in the transaction, the burden shifts to the director-defendants to prove the “entire-fairness” of the transaction. The court will also impose the heightened scrutiny of the entire fairness standard of judicial review over the transaction.

Similarly, when a controlling shareholder engages in a self-dealing transaction with its controlled corporation, entire fairness review will apply. That is the standard the court applied here.

Second Circuit Rains on Preet Bhahara’s Insider Trading Parade

ATTORNEY: Jennifer Sobers
POMERANTZ MONITOR, JANUARY/FEBRUARY 2015

Manhattan U.S. Attorney Preet Bharara has dedicated the last five years to cracking down on insider trading, putting dozens of Wall Street traders behind bars. He has had a nearly undefeated record, with over 80 convictions. But then, in December, came U.S. v. Newman, which reversed two convictions directly, led to the dismissal of four guilty pleas, and threatens to make future insider trading convictions far more difficult to obtain.

It seems inconceivable that in 2015 there is still no statute expressly prohibiting insider trading. Instead, courts have analyzed insider trading as a species of securities fraud. 

The Supreme Court has espoused two theories of insider trading – the classical and misappropriation theories. The classical theory applies when a corporate insider trades on, or discloses, confidential company information, in violation of his fiduciary duty to the company and its shareholders. This rule prevents corporate insiders from taking unfair advantage of uninformed shareholders.

The misappropriation theory applies when outsiders, who do not have any fiduciary duty or other relationship to a corporation or its shareholders, gain access to confidential corporate information and trade on it or leak it to others. If, for example, an employee of Company A learns that it intends to acquire company B, and misappropriates that information to trade in shares of Company B, he is culpable even though he owed no duty to shareholders of Company B. That is because he breached his fiduciary duty to his own company, the source of the information, by misusing it for his own purposes.

Courts have expanded insider trading liability to reach situations where the insider or misappropriator in possession of material nonpublic information (“tipper”) discloses the information to another person (“tippee”) who then trades on the basis of the information before it is publicly disclosed. Courts have held that the elements of tipping liability are the same regardless of whether the tipper’s duty arises under the classical or the misappropriation theory. A tipper must have breached a fiduciary duty and must have received an improper benefit in exchange for leaking the information. Tippees, who are often Wall Street brokers, traders, and hedge fund executives, can also be liable for trading on leaked material non-public information if they knew that the leak was a breach of fiduciary duty. Some question remained, however, as to whether they also had to know that the tipper had received an improper benefit.

In Newman, decided in December, the Second Circuit rocked the insider trading legal landscape. The case involves tippees who were several layers removed from the original leak. The three-judge panel held that in order for a tippee in a “classic” insider trading case to be convicted she must have known not only that an insider disclosed the confidential information, but also that she received, in exchange, a significant personal benefit. In finding that evidence lacking here, the Court reversed the convictions of former Level Global Investors L.P. manager Anthony Chiasson and former Diamondback Capital Management, LLC manager Todd Newman, finding that there was no evidence they knew they were trading on information from insiders, or that those insiders received any benefit in exchange for such disclosures. And in a fairly bold step, the Second Circuit instructed the district court on remand to dismiss the Newman and Chiasson indictments with prejudice, as oppose to conducting a new trial.

The case turned on the fact that Newman and Chiasson were three or four levels removed from the corporate insiders who improperly leaked Dell and NVIDIA’s earnings numbers, and claimed that they had no idea that the information came from insiders, much less that those insiders had breached any duty by disclosing the information, or that they had received an improper benefit for disclosing it.

The district court did not instruct the jury that Newman and Chiasson, to be convicted, had to have known about a personal benefit received by the insider. The jury returned a verdict of guilty on all counts. The Second Circuit held that this was error, holding that the tippee had to know that the tipper disclosed confidential information in exchange for personal benefit. In rejecting the government’s position as a “doctrinal novelty,” the court concluded that disclosing confidential information, even if in breach of a fiduciary duty, is not enough, because “although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.”

Newman will be a significant obstacle in many future prosecutions, particularly where, as in these cases, the tip was passed along by the original tippee to others both inside and outside the tippee’s organization. These recipients may have no idea who the original source of the information is, much less his motivations for leaking that information.

Compounding this difficulty is the court’s analysis of what does, and does not, constitute a “personal benefit” that triggers insider trading liability. In the past, some courts have been satisfied with de minimus showing of benefits, including such things as “friendship” as a culpable motivation. The Second Circuit obviously now requires more. The personal benefits received in exchange for the Dell tips were such intangible things as: the tipper giving career advice and assistance to the tippee, a fellow business school alumnus, which included discussing the qualifying examination in order to become a financial analyst, and editing the tipper’s resume and sending it to a Wall Street recruiter. The Second Circuit found that the evidence of personal benefit was even more scant in the NVIDIA chain, where the tipper and tippee were merely casual acquaintances who met through church and occasionally socialized together, and the tippee even testified during cross examination that he did not provide anything of value to the tipper in exchange for the information.

The Second Circuit decided that these facts do not evidence a tangible quid pro quo between tipper and tippee. That is, an inference of personal benefit based on the personal relationship between the tipper and tippee is not permissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature. The government may not prove the receipt of personal benefit by the mere fact of a friendship, or that individuals were alumni of the same school or attended the same church. To hold otherwise, the court reasoned would render the personal benefit requirement a nullity.

Moreover, the Second Circuit found it inconceivable to conclude, beyond a reasonable doubt, that Newman and Chiasson were aware of a personal benefit, when tippees higher up in the tipping chains disavowed any such knowledge. The Court appeared even more skeptical about the liability of the tippees when the tippers themselves had not been criminally charged (and in the case of the Dell tipper, neither administratively nor civilly charged).

This Second Circuit decision may well lead to fewer insider trading prosecutions of remote tippees such as Newman and Chiasson. Already, a number of high-profile district court cases were put on hold awaiting this decision from the Second Circuit. For example, the sentencing of Danny Kuo, a former research analyst at Whittier Trust Co. who pleaded guilty to also trading on illegal tips and sharing information about Dell and NVIDIA, was adjourned on July 1 and rescheduled to within 48 hours of this Second Circuit decision. Kuo was two levels removed from the inside tipper in the NVIDIA chain, which although not as far down the chain as Newman and Chiasson, nevertheless, is remote enough to beg the question of whether Kuo knew the original tipper received a personal benefit from disclosing the insider information. To date, the parties are still considering the effects of the decision on Kuo’s case and have asked the judge for additional time to provide the court with a proposed course of action.

Most recently in January, a federal judge in Manhattan vacated the guilty pleas of four remote tippees charged with trading on inside information involving shares of IBM, and delayed the trial of a fifth man who pleaded not guilty, citing the Second Circuit opinion. Prosecutors in the case argued that because the confidential information came from an outside lawyer, the claim relied on the misappropriation theory of insider trading, to which the Newman decision did not apply. The judge disagreed, finding that the elements of tipping liability are the same, regardless of whether the tipper’s duty arises under the classical or the misappropriation theory. The district judge further stated that the Second Circuit’s unequivocal statement on the point is part of a “meticulous and conscientious effort by the Second Circuit to clarify the state of insider-trading in this Circuit” and as such, the opinion “must be given the utmost consideration.” Bharara, perhaps confident that the district judge would not apply what he called “Newman’s novel holding” to this misappropriation case, conceded in an earlier letter to the judge that if the court found that Newman applies, then the court should dismiss the indictments because the government’s otherwise-sufficient proof would no longer suffice under the Newman definition of a personal benefit. The district judge has yet to decide whether the charges in that case should be dismissed.

The ripple effects of the Second Circuit decision are being felt outside of New York, as defendants in insider trading cases in Boston and California have already tried to take advantage of the ruling. Courts around the country may increasingly have to grapple with Newman, as they often look to the Second Circuit for guidance on insider trading.

Undoubtedly, this turn of events is what led Bharara to recently challenge the Second Circuit ruling. He requested both that the same panel of judges that issued the ruling revisit its decision and, as an alternative, for every judge on the United States Court of Appeals for the Second Circuit to hear the case, a process known as en banc review; and the SEC has also filed a brief supporting a reversal of Newman. In his petition, Bharara contended that the Court’s ruling “threatens the effective enforcement of the securities laws.” Specifically, he argued that the “panel’s erroneous definition of the personal benefit requirement will dramatically limit the government’s ability to prosecute some of the most common culpable and market threatening forms of insider trading.”

Some scholars are of the view that the insider trading landscape may be well-served by concrete laws. Courts very rarely grant en banc review, particularly where the panel’s decision was unanimous. It seems Bharara may welcome the Congressional support in his quest to prosecute inside traders at all levels.

Pom Shorts

ATTORNEY: H. Adam Prussin
Pomerantz Monitor, November/December 2014   

PENSION PLANS SEEK RIGHT TO NOMINATE DIRECTORS. 
A band of institutional shareholders is mounting the first push ever at 75 United States companies to allow investors to hire and fire directors directly. Leading the drive is Scott M. Stringer, the New York City comptroller, who oversees five municipal public pension funds with $160 billion in assets. He announced that his office will submit a proposal to each of the 75 companies, asking the company to adopt a bylaw allowing shareholders who have owned at least 3% of its stock for three years or more to nominate directors for election to the board. Among those 75 companies are eBay, Exxon Mobil, Monster Beverage and Priceline. State pension plans in California, Connecticut, Illinois and North Carolina are reportedly also supportive of these efforts. 

So far this year, shareholder activists had a success rate of 72 percent in proxy fights, up from 60 percent in 2013, according to FactSet SharkRepellent, a research firm. Notably: 

STARBOARD VALUE LP WON ALL 12 DIRECTOR SEATS AT OLIVE GARDEN. 
In our last issue we discussed the proxy battle launched by Starboard to win control over the board of Darden Restaurants, which owns the Olive Garden chain. Both of the top proxy advisory firms, Institutional Shareholder Services and Glass Lewis, recommended that investors vote for all 12 of Starboard’s nominees -- and that’s exactly what they did, ousting the entire incumbent board. Rest assured, Olive Garden will be salting its pasta from here on out. 

BIG BANKS PAY BILLIONS MORE IN FINES, AS NEW INVESTIGATIONS ARE LAUNCHED INTO OTHER MISCONDUCT. 
So what else is new? It seems like every issue of the Monitor contains news of another multi-billion-dollar settlement of government claims of wrongdoing by our ne’er-do-well banks, and this issue is no exception. This time Citibank, JPMorgan Chase Bank, Royal Bank of Scotland, HSBC Bank and UBS have agreed to pay $4.3 billion to settle claims involving foreign currency transactions. Their currency traders allegedly attempted to manipulate benchmark rates known as the World Markets/Reuters Closing Spot Rates, the most widely referenced benchmark, which is used to establish relative values of different foreign currencies. Often they used information about imminent trades by their own customers to trade ahead of them and reap profits at their expense. The government is reportedly also considering criminal prosecutions against individual traders. 

No sooner were the settlements announced than we heard news that government agencies are investigating various banks, once again including JPMorgan Chase, for trying to collect on loans that have been discharged in bankruptcy. The banks allegedly tried to coerce borrowers to pay those discharged loans by continuing to report the loans to credit reporting agencies as if they were still in default.

Delaware Court Cleans RBC’s Clock

ATTORNEY: Ofer Ganot
POMERANTZ MONITOR, NOVEMBER/DECEMBER 2014

The Delaware Chancery Court is extremely unhappy, to say the least, with financial advisors, hired to advise a company on a potential going-private transaction, who have hidden conflicts of interest that taint their advice to the detriment of the company’s public stockholders. We saw this in the In Re Del Monte Foods Company Shareholder Litig. decided by the Delaware Supreme Court in 2011. Now we see it again, in spades, in the In Re Rural Metro Corporation Stockholders Litig. 

There, Vice Chancellor Laster has come down hard on RBC Capital Markets (“RBC”), which advised Rural Metro that its acquisition by Warburg was fair to its stockholders when, in fact, the offering price undervalued the company by over $91 million. 

Warburg’s acquisition of Rural Metro was announced in March 2011. The total value of the acquisition was approximately $438 million. Two stockholders filed lawsuits challenging the merger, contending that the members of the Rural Metro board breached their fiduciary duties in connection with the merger, and that the company’s financial advisors, RBC (which acted as Rural Metro’s lead financial advisor) and Moelis & Company (which acted as Rural Metro’s secondary financial advisor) aided and abetted the directors in breaching their fiduciary duties. 

The court held two trials – one on the question of liability, decided last March, and the other, decided in October, on apportioning responsibility among the various defendants, including the directors of Rural Metro. At the end of the day, the court held that RBC was almost completely to blame, and accordingly ordered it to pay Rural Metro stock-holders 83% of their total damages, about $76 million. 

What did RBC do wrong? In the court’s view, RBC created a conflict for itself by trying to earn multiple fees, from multiple parties, in the same deal. It offered to provide financing to Warburg to help finance its acquisition of Rural Metro, while at the same time advising the company that the acquisition was fair and should be approved. 

Making matters worse, it also offered to finance an acquisition of Rural Metro’s lone national competitor -- AMR (and its parent company EMS) -- and scheduled the two bidding processes to occur simultaneously. While this was designed to maximize the fees RBC could potentially earn, this was a disastrous strategy for Rural Metro, because bidders could not make offers or even get involved in merger talks and discovery for both companies at the same time, and as a result fewer potential buyers for Rural Metro came forward to bid. The last straw was RBC providing a fundamentally misleading analysis of the fairness of Warburg’s offer, which Rural Metro’s directors then included in the proxy statement seeking stockholder approval. 

The court decided that RBC was 100% responsible for the disclosure violations, which concerned its own financial analyses of Rural Metro’s acquisition. The court also decided that with respect to some of the other breaches of fiduciary duties, RBC had “unclean hands” because it committed “fraud on the board” of Rural Metro, misleading it about its financial analyses, talking it into a disastrous sale strategy, and concealing its conflicts of interest. In such cases, the court held, the advisers may not be entitled to contribution from the other de-fendants. This holding may have the most far-reaching consequences for financial advisors, because it ratchets up their exposure in cases where they mislead the directors.

The court’s analysis resolved several legal issues of first impression under Delaware law, resulting in a 95- page opinion dealing with questions of relative fault, and relative liability, of multiple defendants in a breach of fiduciary duty case. Complicating matters was that other defendants, including the Rural Metro directors, had settled the claims against them prior to trial, triggering complex issues relating to settlements involving some, but not all, “joint tortfeasors.” When such partial settlements happen, the non-settling defendants have the difficult job of proving that it was really the other guys -- those who settled -- who were primarily to blame for what happened and paid less than their fair share in their settlement. In this case, RBC failed at that job and will suffer the consequences.

Investigations As Loss Causations

ATTORNEY: Louis C. Ludwig
POMERANTZ MONITOR, NOVEMBER/DECEMBER 2014

The announcement that government agencies have commenced investigations of possible wrongdoing, particularly SEC and FCPA inquiries, has long played an important role in kicking off securities fraud litigation. Recently, however, the universe of these triggering investigations has expanded to include alleged violations of the Lacey Act involving the importation of illegally logged wood from Russia and China; alleged violations of payday lending rules by the U.K.’s Office of Trading; alleged violations of the International Traffic in Arms Regulation; civil investigative demands regarding Medicare fraud; FTC, DOJ, and Senate Finance Committee investigations; and even Chinese governmental investigations of possible corruption. It has been estimated that such cases triggered nearly 10% of securities class action lawsuits filed in 2013. 

This rise in the filing of these “investigation follow-on” actions has drawn increased judicial scrutiny, specifically in regard to loss causation. To state a claim under Section 10(b) of the Exchange Act, a plaintiff must demonstrate, among other things, that the public disclosure of a misrepresentation caused plaintiff’s complained-of financial loss (or “loss causation”). To satisfy this requirement, there usually has to be a “corrective disclosure” of the true facts which, in turn, causes the losses. The question, then, is whether the announcement that an investigation has begun amounts to a “corrective disclosure.” 

In August, the Ninth Circuit issued Loos v. Immersion Corp., which holds that the “announcement of an investigation, standing alone, does not give rise to a viable loss causation allegation[,]” even though the announcement was accompanied by a drop in share price. To reach this outcome, the Ninth Circuit reasoned that the announcement of investigation disclosed only the “risk” or “potential” for widespread fraudulent conduct, and did not “reveal” fraudulent practices to the market. As stated in Meyer v. Greene, a 2013 Eleventh Circuit opinion followed by the Immersion court, “the announcement of an investigation reveals just that-an investigation-and nothing more.” 

In September, the Ninth Circuit amended its opinion in Immersion to clarify that the court did “not mean to suggest that the announcement of an investigation can never form the basis of a viable loss causation theory.” The court added that “[t]o the extent an announcement contains an express disclosure of actual wrongdoing, the announce-ment alone might suffice” to support loss causation by itself. But what happens if the fraud hinted at by an investigation isn’t confirmed for months, or even years? 

The optimistic take is that if an investigation ultimately bears fruit, loss causation may be shown in hindsight. Interestingly, the Immersion plaintiff argued this exact point, claiming vindication by way of post-class period disclosures that Immersion’s financial statements were unreliable and would have to be restated. Unfortunately, the Ninth Circuit deemed that argument waived because plaintiff failed to raise it before the district court or in his complaint, so it’s uncertain how it would play out on the merits. We do know that the amended Immersion opinion states that its holding doesn’t affect investigatory announcements bolstered by a “subsequent disclosure of actual wrongdoing[,]” implying that such fact patterns are actionable. This appears to validate the Immersion plaintiff’s claim that later revelations “‘solidif[ied] the causative link’ between the fraud and his loss.” He simply failed to plead that link in time. 

If this reading is correct, it raises an additional question: with a two-year statute of limitations governing Exchange Act claims, and with investigations notoriously slow to resolve, should a potential 10(b) plaintiff faced with an investigatory announcement, but no definitive “corrective disclosure” or admission of wrongdoing, file anyway? On one hand, the claim would be preserved – a plaintiff could “wait-and-see,” then, provided that the fraud was ultimately confirmed, argue that the investigation heralded a later “materialization of the risk.” On the other hand, the court could run out of patience prior to the needed corrective disclosure and dismiss the complaint. The difficulty here is that statutes of limitations typically do not start to run until the cause of action “accrues,” which means that enough facts are disclosed to allow investors to file a claim. If there is uncertainty as to whether disclosure of an investigation is sufficient to support a claim, a plaintiff who does not file a case right away risks falling afoul of the statute of l imitations, resulting in the claim being time-barred. 

Practically, the best advice for plaintiffs is to take Immersion at its word and avoid pleading an announcement of investigation as a stand-alone basis for loss causation. Multiple disclosures are often simply unavailable, but as Immersion shows, they should be ferreted out in the pre-filing in-vestigation and pleaded whenever possible. This is demonstrated by Public Employees Retirement System of Mississippi et al. v. Amedisys, Inc., issued by the Fifth Circuit in October as the first decision to grapple with Immersion. In contrast to Immersion, the Fifth Circuit upheld the complaint in Amedisys, which alleged, as corrective disclosures, the announcement of investigations by the DOJ, SEC, and Senate Finance Committee, along with the following additional disclosures: a report published by Citron Research raising questions about Amedisys’s billing; executive resignations; and a number-crunching WSJ article con-cluding that Amedisys was “taking advantage of the Medicare reimbursement system.” While opining that some of these allegations, standing alone, would be insufficient to show loss causation, the court held that the multi-ple partial disclosures “collectively constitute and culminate in a corrective disclosure that adequately pleads loss causation...” In sum, Immersion and Amedisys teach that there is strength in numbers. 

As a postscript, a Pomerantz case, In re LifeLock Sec. Litig. (D. Ariz.), will be the first test of Immersion at the district court level nationwide. Plaintiff alleges that LifeLock de-liberately turned off “identity theft prevention” alerts to elderly customers in violation of a 2010 settlement with the FTC that required ongoing compliance (and honesty with consumers). After a whistleblower came forward, the FTC re-opened its inquiry into LifeLock, causing shares to drop. In their pending motion to dismiss, defendants argue for a broad reading of Immersion, in which investigatory announcements are presumptively ill-suited to support an allegation of loss causation. Plaintiff contends that the renewed investigation didn’t merely portend a “risk” of fraud, but was instead a materialization of LifeLock’s noncompliance with the FTC settlement. Most importantly, the complaint also pleads additional disclosures, making the upcoming ruling not only a test of Immersion, but of the countervailing approach on display in Amedisys as well.

Pomerantz Achieves Additional Victories for BP Investors

ATTORNEY: H. Adam Prussin
POMERANTZ MONITOR, NOVEMBER/DECEMBER 2014

BP p.l.c. is a U.K. corporation with substantial U.S. operations. Its common stock trades on the London Stock Exchange (LSE), while its American Depository Shares (ADS) trade on the New York Stock Exchange (NYSE). In April 2010, the Deepwater Horizon offshore drilling rig chartered to BP exploded and sank, killing 11 people and spilling roughly five million barrels of crude oil into the Gulf of Mexico before the blown well was capped. 

Since 2012, Pomerantz has been pursuing ground-breaking claims on behalf of nearly three dozen institutional investors to recover losses in both BP securities stemming from allegedly fraudulent pre-spill statements about BP’s safety reforms and post-spill statements about the scope of the spill. 

The challenge has been to craft a legal strategy that would permit our clients to pursue claims for their LSE-traded BP shares in U.S. courts, notwithstanding the U.S. Supreme Court’s 2010 decision in Morrison v. Nat’l Australia Bank Ltd., which foreclosed use of the U.S. federal securities laws to pursue claims over foreign-traded securities. Throughout the litigation, BP has sought to get the cases dismissed, for litigation in foreign courts with disadvantageous rules, relying on Morrison and a litany of factual and legal arguments. As the Monitor reported last year, Pomerantz already defeated BP’s motion to dismiss claims brought by our first tranche of clients, three U.S. public pension funds. 

This time, in a series of landmark rulings by U.S. District Judge Keith P. Ellison of the Southern District of Texas in October 2014, Pomerantz defeated BP’s motion to dismiss claims brought by our second tranche of clients. Specifically, the court rejected BP’s attempts to: (i) dismiss foreign investors’ lawsuits so as to require them to be litigated abroad; (ii) extend the reach of a U.S. federal law so as to require dismissal of both foreign and domestic investors’ English common law claims, and (iii) shorten the time periods within which a U.S. federal securities claim (for our clients’ ADS losses) could be filed. Each of these cutting-edge victories preserved claims for our clients. 

Pomerantz Secures Rights of Foreign Investors to Sue in U.S. Courts

In the most significant October 2014 ruling, Pomerantz has now established the right of foreign investors who  purchased foreign-traded shares of a foreign corporation to pursue foreign-law claims for securities fraud losses in a U.S. court. This hard-fought outcome represents the first time after the Supreme Court’s Morrison decision that such claims have been permitted to proceed in a U.S. court. 

A year ago, Pomerantz defeated BP’s motion to dismiss similar claims by U.S.-based pension funds, when Judge Ellison held that their claims had sufficient ties to the U.S. to warrant adjudication here – rather than in England – even after he decided to apply English common law. At that time, facing only U.S. plaintiffs, he also did not credit BP’s arguments that Morrison or the U.S. Constitution prohibited such an outcome as impermissible regulation of foreign commerce. 

This time, BP, once again invoking the Morrison holding, sought to dismiss the cases of Pomerantz’s foreign clients under the same forum non conveniens doctrine, so that they would have to litigate their cases in English courts. Given the English system’s restrictions on contingent fee litigation and its imposition of a “loser pays” approach on legal fees, this argument posed a serious threat to the viability of our clients’ cases. BP’s argument, boiled down, was that because these clients were “foreign,” their cases necessarily had a stronger nexus to England – even though many of our “foreign” clients hailed from nations outside the U.K. (and indeed outside of Europe). 

After extensive briefing, Pomerantz Partner Matthew Tuccillo argued against dismissal in a multi-hour hearing in July 2014. He successfully argued that Pomerantz’s foreign clients deserved the same deference on their choice of forum as our U.S. clients. Drawing upon extensive advance due diligence that he and Pomerantz Associate Jessica Dell had conducted with the outside investment management firms that serviced our clients, Mr. Tuccillo then persuaded Judge Ellison that our foreign plaintiffs’ cases had considerable ties to the U.S., such that BP had not met its burden to disrupt their forum choice.

Pomerantz Defeats BP’s Attempt To Extend SLUSA Dismissal to Foreign Law Claims 

BP also argued that the Securities Litigation Uniform Standards Act (or “SLUSA”), which in certain instances requires dismissal of securities claims brought under U.S. state law, should be extended to apply to foreign-law claims. Under BP’s interpretation, SLUSA would have mandated dismissal of the English common law claims of all of Pomerantz’s foreign clients and U.S. non-public clients. 

Here, Pomerantz forcefully argued that the Exchange Act of 1934 expressly defined the “State” law claims to which SLUSA applies as those brought under the laws of “any State of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, or any other possession of the United States.” As Mr. Tuccillo argued to Judge Ellison in July, “Defendants ask this Court to do nothing less than to rewrite, selectively, an unambiguous statute that was duly elected by Congress to suit their purposes, and the Court should decline to do so.” Judge Ellison agreed. 

Judge Ellison also rejected BP’s argument that the original pleading of Texas law claims (later amended to be English law claims) and/or the use of Texas choice of law rules to identify English law as the governing substantive law served to trigger SLUSA’s dismissal provisions. In doing so, he validated our read of the existing split in the national case law on SLUSA’s application. 

These rulings were significant, as they preserved the lawsuits of dozens of BP plaintiffs, including both foreign and domestic institutions represented by Pomerantz and other firms. 

Pomerantz Establishes a Broader Time Period for Exchange Act Claims

The court also ruled in Pomerantz’s favor as regards the U.S. federal securities claims being pursued by some of our foreign and domestic clients who purchased BP’s ADS on the NYSE. Normally, the pendency of a class action will serve to toll the applicable statute of limitations for individual plaintiffs who may later pursue the same claim. Here, a parallel class action has sought to pursue, on a class-wide basis, a claim under Section 10(b) of the Exchange Act for losses in BP’s NYSE-traded ADS (although, notably, the court has more recently failed to certify most of the proposed class). 

BP had argued that Pomerantz’s clients waived this tolling by filing their individual lawsuits prior to the adverse decision on class certification in the class action. BP also argued that in any event, the statute of repose for our clients’ Exchange Act Claims, which is normally intended to be the “outside” date by which a claim must be filed, was never tolled. These arguments, if credited, would have served to bar as untimely our clients’ Exchange Act claims. 

Judge Ellison sided with us on both arguments, thereby preserving tolling of both the statute of limitations and the statute of repose. The repose ruling in particular was significant, because there is a deep divide in the case law nationally, and the Supreme Court had been poised to hear the issue this term (before the case raising it was settled). These rulings permit our clients to continue to file Exchange Act claims regarding their BP ADS losses, a very valuable right in the wake of Judge Ellison’s decisions denying class certification for most of the time period at issue in the parallel class action.

The Path Ahead

Together, these landmark rulings have highlighted a new path toward recovery in U.S. courts for foreign investors pursuing foreign law claims regarding their losses in foreign-traded securities. Ever since Morrison was decided in 2010, no other case like this has survived. 

Pomerantz serves on a court-appointed Steering Committee overseeing all individual actions against BP by institutional investors and serves as the sole liaison with the court and BP. Our third tranche of plaintiffs’ cases is already on file, and discovery is anticipated to commence in all cases in the near future. 

Pomerantz currently represents nearly three dozen institutional plaintiffs in the BP litigation, including U.S. public and private pension funds, U.S. limited partner-ships and ERISA trusts, and pension funds from Canada, the U.K., France, the Netherlands, and Australia. The BP litigation is overseen by Partners Marc Gross, Jeremy Lieberman, and Matthew Tuccillo. 

To Salt or Not to Salt, That Is the Question

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014

Starboard Value LP, a hedge fund, is trying to take over Darden Restaurants, the parent company of Olive Garden restaurants. Recently it made history, of a sort, when it sent out a 300 page proxy statement asking shareholders to vote for its 12 nominees to the Darden board. Its solicitation was a soup to nuts critique of everything it believes is wrong with Olive Garden and its recipe for fixing it all. What makes it noteworthy is its scathing attack on the restaurants themselves. Most notable: it expresses outrage that Olive Garden does not add salt to the water it uses for cooking its pasta, a practice it believes to be universal everywhere else. Starboard characterized this non-salting as an “appalling decision [that] shows just how little regard management has for delivering a quality experience to guests.” This generated a lot of buzz from casual observers who could care less about Starboard’s takeover efforts. Most people apparently agree that failing to salt the water is a serious faux pas.

Not content with pouring salt on this open wound, Starboard also criticized Olive Garden for oversupplying guests with unlimited breadsticks and salad. While not saying much about the salting issue, Darden did vigorous¬ly debate the issue of the endless breadsticks. Starboard had contended that Olive Garden was wasting millions of dollars by delivering more breadsticks to each table than customers normally eat, though it has said it doesn’t want to get rid of unlimited breadsticks. Darden’s rejoinder: its breadstick generosity “an icon of brand equity since 1982″ and claims that it “conveys Italian generosity.” 

Institutional Shareholder Services and Glass Lewis, the two leading proxy advisory firms, have both rec-ommended that their institutional clients vote in favor of all 12 Starboard nominees. The vote is next month. 

We’ve been to Olive Garden. Salt and breadsticks are the least of their problems.

Is Da Fix In?

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR: SEPTEMBER/OCTOBER 2014

About two years ago, the Commodities Futures Trading Commission started an investigation into whether the world’s largest banks had conspired to manipulate ISDA¬fix, a benchmark similar to LIBOR, which in this case is used to set rates for trillions of dollars of complex financial products, such as interest-rate swaps. Much of the evidence collected by the CFTC seems to have been provided as a byproduct of the LIBOR rate-fixing investigation. Pomerantz currently represents a number of banks and financial institutions in a class action on behalf of lenders arising out of the LIBOR rate-rigging scandal.

A few weeks ago, the press reported that the CFTC reported to the Justice Department that it had found evidence of criminal collusion in manipulating ISDAfix rates. 

Here we go again. 

Until this year, the dollar-denominated version of the ISDAfix rate was set daily by ICAP, a brokerage firm, based on price quote data submitted by banks. Once the CFTC started investigating, ICAP lost that central role.

Bloomberg News reported last year that the CFTC had found evidence that traders at Wall Street banks had instructed brokers to buy or sell as many interest-rate swaps as necessary to rig ISDAfix, by moving it to a predetermined level. Doing so helped banks reap millions of dollars in trading profits, at the expense of companies and pension funds.

Since then, the Alaska Electrical Pension Fund has filed a civil action accusing 13 banks, including Barclays, Bank of America and Citigroup, of conspiring to fix ISDAfix. The Fund claimed the banks did this in order to manipulate payments to investors on the derivatives. The banks’ alleged actions affected trillions of dollars of financial instruments tied to ISDAfix, including so-called “swap¬tions,” which enable institutions to hedge against moves in interest rates. By fixing the rate, the banks apparent¬ly hoped to profit on transactions in these instruments.

The Alaska Fund further alleges that the banks coordi¬nated their scheme through electronic chat rooms and other private communications channels, and the result was that, as far back as 2009, they often submitted identical rate quotes to ICAP, down to the thousandth of a ratings point. The Fund alleges that “even if reporting banks always responded similarly to market conditions, the odds against contributors unilaterally submitting the exact same quotes down to the thousandth of a basis point are astronomical. Yet, this happened almost every single day between at least 2009 and December 2012.” 

The Feds want to throw some people in jail to show that they are tough on Wall Street after all. Maybe they have found some ripe targets.

Pomerantz Defeats Motion to Dismiss in Accounting Row

POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014

Pomerantz recently scored a significant win for investors in a securities class action involving Avid Technology, a software company. Our complaint alleges that Avid, certain of its officers and directors and its long-time outside auditors Ernst & Young committed accounting fraud. On June 27, 2014, U.S District Judge William Young of the District of Massachusetts denied motions to dismiss filed by all the defendants.

This case presents a rare victory for investors on a motion to dismiss where a company has announced that it will have to file restated financial results but, over a year later, had still failed to file them when the complaint in the action was filed (well after the filing of the complaint). In such cases it is often much harder to plead the fraud in sufficient detail, because it is not until the restatements are issued that the company spells out in detail what was wrong with those original results, and why. Even more importantly, the court refused to let Avid’s auditors off the hook for restatements that, when they come, will affect three years’ worth of software contract revenues.

In 2013, Avid announced that it would restate three years’ worth of financial results because it had improperly recognized revenue from post-contract customer support (“PCS”). Avid revealed that it improperly recognized PCS up front, rather than ratably over the life of the contracts, as accepted accounting standards require. Delayed recognition of PCS in this manner is a fundamental accounting rule for software companies such as Avid. Its announcement said that it would conduct a comprehensive review of the accounting treatment for five years’ worth of software contracts.

Avid had not restated its financial results as of the filing of the complaint. The company tried to take advantage of its own delays, claiming that the allegations were not specific enough because they did not identify specific PCS contracts that were mishandled. We were forced to rely on Avid’s disclosures when it originally announced the need to restate its financials, which were not very specific. However, Judge Young was persuaded that Avid’s repeat¬ed statements about proper revenue recognition practic¬es with respect to PCS sufficiently alleged that material misstatements had been made.

With respect to scienter, the court highlighted statements found in con¬ference call transcripts in which Avid’s CEO demonstrated his knowledge of PCS accounting requirements, as well as allegations from a confidential witness who claimed that the CEO himself decided to recognize PCS up front, rather than ratably. The Court also found persuasive our argument that a compelling inference of scienter was bolstered by the magnitude of the restatement—especially considering that, even though a year had passed since announcing the restatement, the restatements was not complete at the time of the motion to dismiss.

Finally, the Court did not let Ernst & Young, Avid’s long-time outside auditors, escape responsibility. The court was persuaded that the length and magnitude of the errors, the systematic lack of internal controls, and the long-standing relationship between the auditors and Avid sufficiently alleged recklessness as to the auditors. 

Avid recently filed the restated financial results, and the changes were massive. Before 2011, Avid’s net accu-mulated losses were $495.3 million; after the restatement, Avid’s pre-2011 net losses total $1.246 billion, reflecting a previously-reported understatement of net losses of 60%. Avid made public, only last week, the fact that the restate¬ment dates back to 2005, restates almost $900 million of previously-reported revenues, and involves a whopping 5 million transactions—apparently all, or nearly all, of Avid’s software contracts since 2005. Because Avid’s restate¬ment and on-going internal control failures are broader and deeper (and have come to light later in time) than we could have anticipated, we likely will amend the complaint to encompass the massive fraud revealed by the restatement. 

Pomerantz currently is engaged in discovery with the company and its auditors. Depositions are set to begin shortly.

Fifth Circuit Revives Our Houston American Case

ATTORNEY: MURIELLE STEVEN WALSH
POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014 

Pomerantz recently prevailed in an appeal before the Fifth Circuit In re Houston American Sec. Lit. The court reversed and remanded district Judge Harmon’s order dismissing the complaint.

The case involves misrepresentations by Houston American, a Texan oil drilling company, about the amount of its recoverable oil reserves, as well as the success of the company’s oil drilling efforts in a particular region, the so-called “CPO4 Block.” In November 2009, the company made the extraordinary claim that the CPO4 Block contained 1-4 billion barrels of recoverable oil reserves. Later, after it began drilling in the block, Houston American represented to investors that the drilling was producing significant “hydrocarbon shows,” which generally indicate the presence of oil.

The case alleges that, in fact, the company had never conducted any of the necessary tests to substantiate its estimate of recoverable oil, and that company executives were aware of significant problems concerning the drilling operations which conflicted with positive statements they made about the drilling. Houston American eventually admitted that it had abandoned drilling efforts in CPO4, and that the SEC was investigating what had happened.

The district court dismissed the complaint, holding that it failed to substantiate either of the required elements of scienter or loss causation. With respect to scienter, it accepted allegations by our confidential witnesses that the individual defendants were aware of serious problems with their drilling operations when they made positive statements about them to investors; and it also accepted the allegation that the defendants had no reasonable basis for their assertion that the CPO4 block had billions of barrels in recoverable oil reserves.

The court nonetheless found that defendants’ decision to invest additional money into the drilling ($5 million of corporate funds, not their own), somehow negated any inference of scienter as a matter of law. The district court reasoned that it would make no sense for the defendants to invest additional money in a venture if they didn’t believe it would ultimately be successful. In reversing, the Fifth Circuit emphasized that defendants’ personal beliefs about the ultimate success of their operations are irrelevant because they were aware of, but concealed, negative information that was inconsistent with those professed beliefs.

The district court had also held that plaintiffs had not sufficiently pleaded that their losses were directly caused by the misrepresentations, as opposed to “other economic factors.” The Fifth Circuit found that this too, was an error, because it imposed a heightened pleading requirement for loss causation that is not required under the Supreme Court’s decision in Dura.

A few weeks after the Fifth Circuit decision came down, the SEC filed a formal complaint against Houston American and its executives, alleging securities fraud.

Pomerantz Defeats Motion to Dismiss Delcath

Attorney: Tamar A. Weinrib
Pomerantz Monitor September/October 2014

On June 27, 2014 Judge Schofield of the U.S. District Court for the Southern District of New York denied defendants' motion to dismiss our case against Delcath Systems, Inc., in whichPomerantz is sole lead counsel.

Delcath is a specialty pharmaceutical and medical device company focused on oncology. The case concerns the company’s development of the "Melblez Kit," a device designed to deliver targeted high doses of melphalan (a chemotherapeutic agent) to treat certain types of liver cancer. A key part of the kit is a filter, the purpose of which is to remove the toxic byproducts of the melphalan before they reenter the bloodstream from the liver, thus preventing exposure to toxic levels of melphalan which can lead to severe and often fatal side effects. 

The FDA ultimately refused to approve the Melblez Kit, causing the market price of Delcath’s stock to plummet. Our complaint alleges that the company knowingly failed to disclose to investors that the filter it had used during the clinical trial had not sufficiently removed the toxicities from the blood, resulting in far more deaths and other serious adverse events than those caused by other available treatment methods.

Specifically, during of the clinical trial the company used a filter (the “Clark” filter) that had only been tested “in vitro,” and not on live subjects, prior to its inclusion in Phase III oftesting on humans. Those in vitro tests, however, failed to detect flaws in the Clark filter. After receiving a Refusal to File letter from the FDA in response to its first New Drug Application (“NDA”) for the Melblez Kit, which cited major deficiencies in the NDA including incomplete information regarding serious adverse reactions, as well as manufacturing and quality control issues, Delcath filed a second NDA purporting to correct these major flaws.

The second NDA, however, sought approval of the Melblez Kit with yet another new filter, the Generation 2 filter, which the Company had, once again, tested in vitro, even though it knew those same in vitro tests had failed to detect critical deficiencies in the Clark filter. The company never tested the Generation 2 filter on humans. Defendants did not disclose to investors that they developed the Generation 2 filter, and included it in the second NDA, because of the unprecedented toxicities caused by the Clark filter.  

The FDA convened an advisory panel to review the new NDA, and that panel unanimously recommended that the agency not approve the Melblez Kit, because the risk of harm outweighed the Kit's potential benefit. The FDA relied on this recommendation and ultimately rejected the second NDA.

The court found that defendants should have informed investors that the severity and frequency of the serious adverse events far surpassed those resulting from other available treatments and that no patients in the control group died during the Phase III trial. The court held that the omitted facts about the relative toxicity of defendants’ product caused the FDA to reject the Melblez Kit. The court also found that the Complaint sufficiently pled scienter by alleging that defendants "knew facts or had access to information suggesting that their public statements were not accurate." 

Specifically, the court held that the following factors created a compelling inference of scienter: 1) Delcath is a small company focused on one product; 2) FDA approval of the Melblez Kit hinged on the Phase III trial results; 3) confidential witnesses all corroborated that Delcath's CEO, defendant Hobbs, made all the company's decisions, including those relevant to the Melblez Kit; 4) Hobbs' public statements indicated that he was familiar with the trial data; 5) the company proposed a new and relatively untested filter, the Generation 2 filter, in its revised NDA, rather than the Clark filter used in the Phase III trials, suggesting that defendants knew that the results of its Phase III trials were not as strong as they represented in public statements; and 6) the FDA, and the Advisory Panel it convened, both made scathing comments about the Phase III trial results, and ultimately rejected the Melblez Kit NDA as a result.

With regard to loss causation, the court found that defendants' argument that the drop in stock price was caused by the FDA's rejection of the NDA rather than the revelation of a fraud "is a factual argument for a later day and does not diminish the sufficiency of the Complaint."

The decision is notable as it requires pharmaceutical companies going through the FDA approval process for clinically tested drugs or devices to give investors a complete picture of specific known risks that may impact approvability, and not hide behind generalized risk warnings, particularly where the company opts to speak about the trial results.

The discovery process has begun and Lead Plaintiff will file its motion for class certification in October.
 

Supremes to Police: Keep Your Hand off that Cell Phone

Attorney: JAYNE A. GOLDSTEIN
Pomerantz Monitor, July/August 2014

In an unanimous decision issued on June 25, the Supreme Court held that in most cases the police must obtain a search warrant prior to searching an arrestee’s cell phone. This opinion will affect many of our police organization clients, by hampering the ability of their members to obtain evidence when making an arrest. 

The “search incident to arrest” doctrine allows police to search, without a warrant, the area within the arrested person’s immediate control, to protect officer safety or to prevent escape or the destruction of evidence. The question here was whether an officer is also routinely allowed to rummage through all the files on the arrested person’s cell phone without a search warrant. The Court said no, recognizing that “modern cell phones, as a category, implicate privacy concerns far beyond those implicated by the search of a cigarette pack, a wallet or a purse.” 

The Court recognized that cell phones are repositories of huge amounts of personal information, such as personal messages, bank statements, photographs, notes, mail, lists of contacts and/or prescriptions. “The sum of an individual’s private life can be reconstructed through a thousand photographs labeled with dates, locations, and descriptions; the same cannot be said of a photograph or two of loved ones tucked into a wallet.” In short, “more or two of loved ones tucked into a wallet.” In short, “more than 90% of American adults who own a cell phone keep on their person a digital record of nearly every aspect of their lives…” In order to address safety concerns of the police during an arrest, the police remain free to examine “the physical aspects of a phone to ensure that it will not be used as a weapon,” but once secured, “data on the phone can endanger no one.” To prevent the suspect from destroying evidence on the phone, the Court said that police could remove the phone’s battery or could place the phone in an enclosure that would prevent it from receiving radio waves. The Court also left open the possibility that in exigent circumstances the police could search the phone immediately. 

However, our police officer clients tell us that, at times, immediate access to information contained on a cell phone could be crucial, leading, e.g., to the rapid capture of an accomplice through the reading of text messages, and waiting for a search warrant could permit the accomplice to get away. This ruling will surely lead to more cell phones being seized, to preserve them for possible future searches after a warrant is obtained.

Data Breach: A 21st Century Consumer Problem

ATTORNEY: Mark B. Goldstein
Pomerantz Monitor, July/August 2014

Pomerantz is representing a class of Target customers who were victimized by a widely-publicized hacking incident late last year. Thieves were able to sneak into customer data files maintained by the company and steal 40 million credit and debit cards numbers and 70 million customer records. Target announced the breach last December and said that consumers who shopped at Target between November 27 and December 15, 2013 were victimized. 

Since then there have been many similar breaches at other companies, including Sally Beauty, Michaels Crafts, and the popular Chinese restaurant chain P.F. Chang’s. Typically, thieves steal card data by hacking into cash registers at retail locations and installing malware that covertly records data when consumers swipe credit and debit cards through the machines. Often, the perpetrators re-encode the data onto new counterfeit cards and use them to buy expensive goods that can be resold for cash. Since last year, the cost of data breaches have risen on average 15%, to $3.5 billion. 

In response, consumers have filed class actions against the companies whose data bases were breached. Consumers and banks have filed more than 90 cases against Target, most of which allege that Target negligent¬ly failed to implement and maintain reasonable security procedures to protect customer data and that it knew, or should have known, about the security vulnerabilities when dealing with sensitive personal information. The cases also allege that Target did not alert customers quickly enough after learning of the security issue. Target did not disclose the data breach until weeks after it was announced by a security blogger. Then, Target revealed weeks later that even more customers were affected than originally announced. 

More recently, consumers sued P.F. Chang’s, alleging that it “failed to comply with security standards and allowed their customers’ financial information to be compromised, all in an effort to save money by cutting corners on security measures that could have prevented or mitigated the security breach that occurred.” The complaint claims that P.F. Chang’s failed to disclose the extent of the security breach and notify its affected customers in a timely manner. 

Data breach lawsuits are a relatively new phenomenon, so there is new law to be made here. There are practices that can cut down on these breaches. Most notably, since the Target breach, there has been much discussion of adopting the European-style “chip and pin” credit cards, whose information is more difficult to hack. These cards use a computer chip embedded in the smartcard, and a personal identification number that must be supplied by the customer. The benefit of the chip and pin system is that cloning of the chip (i.e. reproducing it on a counterfeit card) is not feasible. Only the magnetic stripe can be copied, and a copied card cannot be used on a PIN terminal. The switch to chip and pin credit cards in Europe has cut down theft dramatically. France has cut card fraud by more than 80% since its introduction in 1992. Chip and pin cards are yet to be adopted universally by American vendors. 

In the meantime, consumers should be vigilant with their credit card use, and frequently check their credit card statements. Additionally, consumers subject to data breach should act immediately and cancel their credit cards to limit their vulnerability.

BNP Paribas Joins the Bank Perp Walk

Attorney: MICHELE S. CARINO
Pomerantz Monitor, July/August 2014

On June 30, BNP Paribas, France’s biggest bank and one of the five largest banks in the world, pled guilty to charges that it conspired to violate the International Economic Powers Act and the Trading with the Enemy Act. It agreed to forfeit approximately $8.9 billion traceable to its misconduct. This is the largest amount paid by any bank to settle allegations brought by the U.S. government and bank regulators. 

According to the Statement of Facts the Justice Department filed in the U.S . District Court in the Southern District of New York, from at least 2004 through 2012, BNP processed thousands of transactions through the U.S. financial system on behalf of banks and entities located in countries subject to U.S. sanctions, including Sudan, Iran, and Cuba. BNP structured the transactions to help clients move money through U.S. financial institutions while avoiding detection by U.S. authorities and evading sanctions. The practices were deliberate and pervasive, involving, for example, intentionally deleting references to sanctioned countries in order to prevent the transactions from being blocked, and using non-embargoed, non-U.S. “satellite banks” and complicated, multistep transfers to disguise the origin of the transactions. 

To make matters worse, U.S. authorities uncovered substantial evidence that senior executives knew what was happening and did nothing about it. In fact, in 2006, BNP issued a policy for all its subsidiaries and branches that “if a transaction is denominated in USD, financial institutions outside the United States must take American sanctions into account when processing their transac¬tions.” Then, in 2009 and 2010, when the U.S. DOJ and New York County District Attorney’s Office contacted BNP to express concern, the bank was less than cooperative in responding to requests for documents from BNP’s offices in Geneva. Overall, BNP allegedly processed 2,663 wire transfers totaling approximately $8.3 billion involving Sudan; 318 wire transfers totaling approximately $1.2 billion involving Iran; 909 wire transfers totaling approximately $700 million involving Cuba; and 7 wire transfers totaling approximately $1.5 million involving Burma. The New York Department of Financial Services places the estimates much higher, contending that a total of $190 billion of dollar-based transactions were concealed between 2002 and 2012. 

BNP potentially faced criminal, civil, and regulatory actions by various U.S. authorities involving potential penalties of about $19 billion. The $8.9 agreed-upon fine resolves all these related actions and ensures that BNP will not be subject to further prosecution for violations of U.S economic sanctions laws and regulations. While BNP may temporarily suspend payment of dividends to shareholders and may have to take steps to shore-up its capital ratio, the fine is not expected to have any long-term financial repercussions. Notably, BNP’s stock rose 3.6% the day the settlement was announced. 

But the plea agreement contains significant non-financial provisions. Specifically, BNP faces a five-year probationary period and is required to enhance it compliance policies and procedures. An independent monitor will be installed to review BNP’s compliance with the Bank Secrecy Act, Anti-Money Laundering Statute, and economic sanctions laws. In addition, BNP is banned from U.S. dollar-clearing operations through its New York Branch and other U.S. affiliates for one year for certain lines of business for certain BNP offices implicated in the conspiracy. BNP is not permitted to shuffle clients to other BNP branches or affiliates to circumvent this ban. This means that client relationships may be damaged, as clients take their business elsewhere. Furthermore, although there have not been any individual criminal prosecutions to date, 13 individuals were terminated and 32 others were disciplined as a result of the investigations and Plea Agreement. 

These measures are more likely to prompt reform, because they are implemented over a longer time period, require replacement of personnel, and change the way the business operates. They also signal to the industry what is required in this new regulatory environment. The fact that Deutsche Bank, itself a target of investigators, recently announced that it would be hiring 500 new employees in the U.S. in compliance, risk, and technology is not a coincidence. Other banks likely will follow suit. If that occurs, it may be the most positive result to come out of the BNP settlement for all investors.

Lawsuits Against GM are Mounting

Pomerantz Monitor, JULY/AUGUST 2014

Last February, General Motors decided to recall certain models due to defects in the ignition switches that can cause the engine and electrical system to shut down while the vehicle is in motion. If that happens, essential safety features such as airbags, power brakes, and pow¬er steering are all cut off. Since then, GM has recalled approximately 6 million cars due to the faulty ignition switch and nearly 29 million worldwide for a range of defects. 

Similar to the cases filed in the wake of the Toyota recalls, at least 85 lawsuits have been filed against GM seeking recovery of the declines in resale value on the recalled vehicles caused by revelation of the ignition-switch defect. With such lawsuits pending all over the country, in May a court in Chicago sent all of them to New York for consolidated pretrial proceedings. 

But many of these cases may not go forward at all. GM has claimed that economic loss cases are barred by a “discharge” order entered in its bankruptcy case in 2009 that, it argues, insulates the company from depreciation-related liability claims for automobiles sold before 2009. Plaintiffs’ lawyers claim this violates constitutional due-process rights, since GM allegedly knew about the ignition-switch problems at the time of the bankruptcy but kept them secret for years. A ruling on this issue is expected by the end of the summer. 

 GM also has to contend with its own shareholders, some of whom have sued the company and its top executives and board members. On March 21, 2014, Pomerantz filed the first and (so far) only securities class action in the Eastern District of Michigan on behalf of shareholders who purchased GM stock between November 17, 2010—the date of GM’s $20.1 billion initial public offering—and March 10, 2014. According to the complaint, GM’s misstatements and omissions about the ignition-switch defect resulted in “significant reputational and legal exposure” and caused the share price to tank “wiping out billions in shareholder value” when the true extent of the defect was disclosed. Four movants filed motions seeking appointment as lead plaintiff in the securities class action, including clients represented by Pomerantz. 

Oral argument is scheduled in August 2014.

Supremes Finally Weigh in on Crucial Securities Law Issues

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, JULY/AUGUST 2014

At the end of its term in June, the Supreme Court issued two significant rulings relating to securities laws issues. 

 The main event was the decision in Halliburton, which addressed the continued viability of the “fraud on the market” presumption in securities fraud cases. Without the benefit of that presumption, most securities cases could not be certified as class actions. 

After the oral argument in Halliburton in March, we pre­dicted that the Court would not throw out the fraud on the market presumption, but would probably allow defendants to try to rebut that presumption at the class certification stage, if they could show that the fraud did not actually distort the market price of the company’s stock. Our pre­diction was right. In June, the Court issued its ruling, and now “price impact” will be a potential issue on class certification motions. If the company made significant misrepre­sentations about its business or financial results, it will be strange indeed if that had no effect on the price of its stock. 

Typically, when allegedly false statements are released by the company, they do not have any immediate effect on the stock price, because they do not deviate much from previously disclosed information. It is the bad information, which is covered up or falsified, that has the impact, and that impact can be measured when the truth finally does come out, in the so-called “corrective disclosure.” We be­lieve that defendants, in order to rebut the fraud on the market presumption, are going to have a heavy burden to prove that the corrective disclosures had no significant effect on the market price of the company’s stock, and that any price movements that did occur at that time were caused completely by market-wide fluctuations in share prices, by general market conditions, or by some other “bad news” unrelated to the fraud. 

The Court’s other decision came in Fifth Third Bancorp, which concerns the requirements for pleading a breach of fiduciary duty claim under ERISA against retirement plan trustees who continued to invest assets into stock of the employer company despite warning signs of impending catastrophe. 

Under ERISA, trustees of retirement plans have an obligation to act with prudence in investing plan assets or in making investment recommendation to plan participants. In one sense, such claims are easier to win than run of the mill securities fraud claims because there is no scienter requirement. 

But what level of knowledge actually is needed to trigger culpability for trustees? In the past, the courts gave the trustees of an employee stock ownership plan (“ESOP”) a “presumption of prudence” when they decided to invest, or continue to invest, in company stock. To overcome that presumption, they previously required that plaintiff plead, with particularity, that the trustees ignored facts showing that the company was on the brink of financial collapse. The only open question, we thought, was whether the presumption of prudence applied at the motion to dismiss stage, or only later, at trial. 

We thought wrong. To everyone’s surprise, the Court has now thrown the presumption of prudence out the window not only at the pleading stage of the case, but at every stage of the case. 

Instead, the Court set forth a new set of considerations. It held that ERISA claims cannot be based on the theory that the trustees ignored publicly available information about the company or its line of business. But where, as in most cases, the trustees (who are typically company executives) had adverse non-public information about the company, courts must balance the requirements of prudence with the laws against trading on inside information, and with the possible adverse consequences to the company if its ESOP suddenly stops buying company shares. 

In other words, it is going to take years to figure this out.

Fannie Mae and Freddie Mac Secure $9.3 Billion Settlement With B of A

ATTORNEY: JESSICA N. DELL
Pomerantz Monitor, May/June 2014

In March, Bank of America (“BofA”) agreed to pay $9.3 billion to settle four settle lawsuits filed by the Federal Housing Finance Agency (“FHFA”). The lawsuits alleged that the bank misrepresented risks inherent in billions of dollars in mortgage-backed securities that it sold to Fannie Mae and Freddie Mac. Under the terms of the settlement, BofA subsidiaries Countrywide Financial Corp and Merrill Lynch will pay $5.83 billion and repurchase another $3.2 billion in mortgage-backed securities, FHFA said. 

As many will recall, FHFA filed these lawsuits among seventeen similar cases in its capacity as conservator for Fannie Mae and Freddie Mac, after it was reported that Fannie and Freddie lost up to $30 billion in the subprime mortgage market. Cases were brought against all the big banks: JPMorgan, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, and UBS. To date, the lawsuits have recovered more than $20 billion. Seven of those cases are still pending. The recovery is impressive, but brings renewed scrutiny to the whole fiasco, including the unclean hands of some Fannie and Freddie executives, who had long insisted that Fannie and Freddie’s involvement with subprime loans was minimal. We now know that Daniel Mudd and Richard Syron, chief executives of Fannie and Freddie, were aware of the exposure and the risks. Internal documents released at Congressional hearings showed that both ignored repeated warnings from internal risk officers. In March 2006, Enrico Dallavecchia, Fannie Mae’s chief risk officer, wrote to CEO Daniel Mudd to say, “Dan, I have a serious problem with the control process around subprime limits.” 

Fannie’s role goes back to the beginning of the subprime phenomenon. The New York Times journalist Gretchen Morgenson reported that Fannie had actually recruited Countrywide to make the loans to help fulfill Fannie’s own “affordable housing” goals. In return, Countrywide was given a discount on fees. By 2004, Countrywide was Fannie’s top mortgage supplier, accounting for 26 percent of the loans purchased by Fannie. Fannie executives were also among the dozens of employees who enjoyed steeply discounted mortgage rates from Countrywide. The House Oversight and Government Reform Committee found that 153 “VIP loans” had been issued to 27 employees. 

When the government took over and ousted the executives, Fannie and Freddie appeared to be winding down and out. But wait. Mel Watt, head of FHFA, just signaled that Fannie and Freddie may not be exiting the mortgage industry, but instead might be enjoying something of a renaissance. As the Times reported, in a quote attributed to Jim Parrott of the Urban Institute, “(Watt’s) message was he will turn from focusing on the enterprises as institutions in intentional decline to institutions that should be better prepared to form the core of our system for years to come… this shift in focus ripples through the many decisions announced in the speech and signals a watershed moment in the brief history of the agency.” 

The BofA settlement plays a significant role in the appearance of renewal: of the $5.7 billion Fannie Mae reported as comprehensive income for the first quarter, $4.1 billion was revenue from legal settlements, nearly double the $2.2 billion that Fannie had garnered in 2013. Freddie Mac also reported $4.9 billion in benefits from legal settlements. 

This is only the latest in a seemingly endless cycle of banking industry misdeeds. In addition to misrepresentations about mortgage backed securities, we have money laundering, manipulations of LIBOR, aiding and abetting tax evasion, circumventing the sanctions on Iran, the London Whale fiasco, and a host of other high crimes and misdemeanors. That public outrage has somewhat waned on the matter might be attributed to sheer exhaustion. We have not seen the last of it. Not by a long shot.

The Struggle Over the Use of Confidential Witnesses

ATTORNEY: LEIGH H. SMOLLAR
Pomerantz Monitor, May/June 2014

In 1995, Congress passed the PSLRA to eliminate what it considered to be abusive practices in federal securities litigation. Among other things, it raised plaintiffs' burden in pleading federal securities fraud actions. It heightened the standard to plead scienter, requiring that the complaint plead facts "giving rise to a strong inference that the defendants acted with the required state of mind." At the same time, it instituted an automatic discovery stay until resolution of the defendant's motion to dismiss. In combination, these requirements can pose a significant hurdle to securities plaintiffs in making sufficiently specific allegations of wrongdoing. 

Plaintiffs often attempt to meet this burden by relying on statements from former company insiders. Because they often are wary of the possibility of retaliation from their former employers, or because they are still employed, or hope to be employed, in the same line of business, they typically demand that their names be kept confidential, and complaints usually refer to them as “CWs,” or confidential witnesses. Ultimately, their names must be disclosed to defendants, which must be relayed to the CW at the time of the interview. In ruling on motions to dismiss, some federal judges have expressed discomfort in relying on statements of anonymous CWs, worrying that they may not be in a position to know what they are talking about, or that they may be disgruntled former employees looking for revenge while hiding behind a smokescreen of anonymity. Other federal judges believe that CWs are reliable where there is strength in the number of confidential witnesses, their corroborative aspects, and the specific descriptions of each of them. Many cases have required that allegations based on information from CWs must disclose enough about them to substantiate that they were in a position to know what they are talking about. This requirement, of course, makes it easier for the former employers to figure out their identity. Once that happens, defendants have often tried to discredit their allegations or even to contact them to pressure them to “recant.” Southern District of New York Judge Jed Rakoff, a leading jurist in securities litigation, has noted that heightened pleading standards in securities class actions have left confidential plaintiffs' witnesses in a tough spot—sometimes lured by plaintiffs lawyers to exaggerate wrongdoing, and/or unfairly pressured by defendants to recant truthful allegations. 

Defense attorneys have different theories on what can be done to alleviate these concerns; however, many of these “theories” are not practical, such as, for example, requiring plaintiffs’ lawyers to include a sworn declaration from a confidential witness verifying the allegations in the complaint. Such disclosures would reveal the name of the signatory, defeating the protection of confidentiality. As Judge Rakoff noted, once the identities of confidential witnesses are known, they can then be “pressured into denying outright the statements they had actually made.” In fact, fear of retaliation by the former employer accounts for most of witness recantation. Moreover, any requirement that former employees sign a formal legal document, especially under oath, would have a chilling effect on their willingness to reveal what they know. 

Defense attorneys have also suggested that plaintiffs’ lawyers themselves, and not just investigators, participate in the witness interviews. While this might help ensure that the complaint’s summary of CW allegations is accurate, it would be impractical. The involvement of a lawyer, rather than an investigator alone, would be a deterrent for some CWs. Investigators would have to coordinate meetings among counsel and the witnesses, making information collection much more burdensome and time-consuming. 

There are, however, some steps that plaintiffs’ counsel can take to make the CW process more reliable. Investigators should be required to state clearly that they work for a law firm adverse to the former employer, and that they do not represent the witness. They should also be required to ensure that the witness is not currently employed with the defendants and that there is no confidentiality agreement that precludes disclosure. Counsel should also make sure that the information from the CW is consistent with all of the other evidence gathered in the case. The court’s decision in Tellabs III provides that corroborating evidence is the key to CW allegations. Because the Reform Act requires plaintiffs to plead the details of the CW’s position and ability to know the facts alleged, the defendants often can figure out who the CWs are, and “reach out” to them. As Judge Rakoff has stated, the witness often feels pressure to recant or water down what s/he has said. If defendants succeed in this effort and the complaint is dismissed, defendants often file a Rule 11 motion seeking sanctions against plaintiff’s counsel. Such “recantation” should not be the basis for a Rule 11 motion. Plaintiffs’ attorneys should not be deterred by defendants’ latest attempt to dismiss valid securities fraud cases through Rule 11 motions. However, plaintiffs’ counsel should take care to ensure that the allegations in any complaint are accurate, and move for cross-sanctions where appropriate.

Lululemon Ordered to Produce Records of Its Stock Trading Plan

ATTORNEY: SAMUEL J. ADAMS
Pomerantz Monitor, May/June 2014

In a dishearteningly familiar scenario, a couple of years ago the chairman of lululemon athletica dumped a large number of company shares he owned, a few hours before the company announced that its CEO was resigning. By trading ahead of the news, the Chairman saved about $10 million. In defending himself from the charge that he traded the shares on inside information, the company’s chairman had publicly claimed that he had sold a big block of his company stock pursuant to his 10b5-1 stock trading plan, and not because he had inside information about impending bad news. 

Pomerantz represents a shareholder of lululemon, and we and our client were interested in finding out whether the chairman’s assertions were true. So we brought a “books and records” action, asking to inspect the company’s records relating to the plan and to this particular transaction. 

Deciding an issue of first impression in Delaware, the Chancery Court recently granted our request, holding that the circumstances of this transaction raised enough suspicion to warrant inspection. The importance of the inside information was beyond dispute. The company, which is known for its yoga apparel, had recently announced a highly embarrassing recall of approximately 17 percent of its women’s workout pants. News of the recall caused the price of lululemon common stock to drop almost 7% within two days, which, in turn, led to the resignations of several key executives and the termination of the company’s Chief Product Officer.

Then came the big blow: soon afterwards, the company’s Chief Executive Officer announced his resignation. That news caused lululemon’s stock to drop almost 22% in the span of a few days. The same day that the lululemon Board of Directors learned of the CEO’s imminent departure, but prior to any public announcement of it, lululemon’s chairman sold over 600,000 shares of company stock for more than $49.50 million. Had he waited to sell until after the public announcement, he would have received a little more than $39 million—approximately $10 million less. This looks a lot like insider trading.

Delaware law allows stockholders of public companies to inspect certain corporate documents, if the stockholder can assert a proper purpose and satisfy other technical requirements. After lululemon refused our requests, Pomerantz filed a complaint, known as a Section 220 action, to compel lululemon to produce certain documents relating to the stock trading plan. Delaware courts have encouraged stockholders to file Section 220 actions as investigatory tools before commencing other forms of litigation, such as derivative actions. 

In response to the Section 220 action, lululemon argued that stockholders had no basis to question the chairman’s stock sales because the trades were executed by the chairman’s broker, who was granted sole discretion under a trading plan to sell shares on behalf of the chairman over a period of time. The plan, known as a 10b5-1 stock trading plan, is implemented by corporate insiders in an attempt to insulate themselves from allegations of insider trading.

Pomerantz, on the other hand, pointed to the fact that the stock sale at issue here was the single largest stock sale conducted on the chairman’s behalf since the establishment of his pre-arranged stock trading plan in late 2012, raising suspicions as to both the timing and the size of the sale.

The Court found that the 10b5-1 stock trading plan did not preclude potential liability for insider trading. The Court also found that there were “legitimate questions as to the propriety” of the sale and ordered the production of certain related documents. In addition to acknowledging that the chairman’s sale was the single largest he had made under the 10b5-1 stock trading plan, the Court also inferred that the number of shares sold was the maximum amount that the chairman could have sold in any one month under the terms of the 10b5-1 plan. These facts allowed the Court to infer a “credible basis” that wrongdoing may have taken place in connection with the June 7, 2013 stock sale. Accordingly, the Court ordered lululemon to produce the 10b5-1 trading plan, as well as certain other documents relating to the stock sale.

The Court’s holding that the mere existence of a 10b5-1 trading plan will not serve as an absolute defense for defendants and will not preclude a finding of a credible basis for an inference of wrongdoing, was an important victory for stockholders of public companies.

Delaware Court Raises the Bar in Controlling Shareholder Transactions

Pomerantz Monitor, May/June 2014

It is long-established law that where a transaction involving self-dealing by a controlling shareholder is challenged, the transaction will be reviewed under a standard referred to as “entire fairness.” That standard places the burden on the defendant to prove that the transaction with the controlling shareholder was entirely fair to the minority stockholders, including not only a fair price but a fair process for negotiating the transaction. 

Twenty years ago, the Delaware Supreme Court was presented with the question of whether the business judgment rule might apply to transactions with a controlling shareholder if the transaction was approved either by a special committee of independent directors, or by an informed vote of the majority of the minority shareholders. The Court said no, but that in such cases the burden of proof on the issue of the entire fairness of the transaction would be shifted to the plaintiff shareholders. While this may sound like splitting hairs, in fact the question of which standard — entire fairness or business judgment — will be applied usually determines the outcome of the case.

Now, in Kahn v. M&F Worldwide Corp., the Delaware Supreme Court was presented with a case where the controlling shareholder had used both protective devices: the transaction had to be approved both by an independent special committee and by the minority shareholders. The question was: What is the appropriate standard of review now? 

The Court concluded that those provisions, taken together, neutralized the influence of the controlling shareholder and the highly deferential business judgment standard of review should apply. This creates a much higher barrier for plaintiffs to overcome. They will now have the burden of proving that the challenged transaction was so egregious that it could not have been a result of sound business judgment. 

To demonstrate that the business judgment rule should apply, the controlling shareholder will have to agree at the outset that the completion of the merger will be contingent on the approval of a special committee and approval of the majority of the minority shareholders. Then, defendant must show that: 

• The special committee was composed of independent directors;
• The special committee was empowered to reject the controlling shareholder’s proposal, and is free to engage its own legal and financial advisors to evaluate the proposal;
• The special committee met its duty of care in negotiating a fair price; •    The majority of the minority shareholders was informed; and
• There was no coercion of the minority. 

The Court reasoned that the dual protections of the special committee and the majority of the minority “optimally protects the minority stockholders in controller buyouts.” It concluded that the controlling shareholder knows from the inception of the deal that s/he will not be able to circumvent the special committee’s ability to say no, and that s/he will not be able to dangle a majority of the minority provision in front of the special committee in order to close the deal late in the process, but will have to make a price move instead. 

While this ruling may serve as a setback to plaintiffs in certain cases, the business judgment standard of review will only apply when all of the above criteria are met. Defendants may be unwilling to condition the completion of the transaction at the outset on the approval of a special committee and a majority of the minority shareholders, as this might create too much uncertainty and risk around the proposed transaction.

Court Strikes Down “Cross-Listed Shares” Theory

ATTORNEY: C. DOV BERGER
Pomerantz Monitor, May/June 2014

In 2010, the United States Supreme Court handed down its landmark decision in Morrison v. National Australia Bank, which held that United States federal securities laws only apply to transactions in securities listed on U.S. exchanges, or to securities transactions that take place in the U.S. The ruling has been interpreted to bar recovery under the U.S. federal securities laws by investors who bought shares on foreign exchanges. As previously reported in the Monitor (Volume 10, Issue 6, November/December 2013), Pomerantz has led the effort to seek alternative paths to recovery in the U.S. courts, including via pursuit of common law claims against issuers like British Petroleum and corporate executives charged with securities fraud. 

But what about instances where a security is listed both in the U.S. and on a foreign exchange, and the investor bought his shares overseas? A case in point is City of Pontiac Policemen's & Firemen's Ret. Sys. v. UBS AG, No. 12-4355-cv (2d. Cir.), a securities class action against Swiss Investment Bank UBS AG by foreign and domestic institutional investors that bought shares of UBS stock on the SIX Swiss Exchange. 

The complaint alleged that UBS failed to disclose that its balance sheet had inflated the value of billions of dollars in residential mortgage-backed securities and collateralized debt obligations. It alleged that when the market for those securities dried up, UBS eventually had to recognize a loss of $48 billion. The complaint also alleged that the bank made misleading statements claiming that it was in compliance with U.S. tax laws, only to be forced to settle tax fraud claims with federal authorities for a penalty of $780 million.

Although the plaintiffs had bought UBS shares on a foreign exchange, they invoked the so-called “Listing Theory,” which posits that since shares of UBS are traded on both the Swiss Exchange and in the U.S. on the New York Stock Exchange, all purchasers of UBS shares should be protected by the U.S. federal securities laws, regardless of which exchange they used to purchase their shares. The plaintiffs also invoked the “Foreign-Squared Claims Theory,” which posits that the place where the buy order was placed should control, rather than the location of the exchange where the trade was ultimately executed. The buy orders for some of the purchases of UBS shares at issue had been placed in the U.S. Under this theory’s rationale, such transactions should satisfy the second prong in Morrison, which applies the U.S. federal securities laws to “transactions” that take place in the U.S.

However, the District Court rejected both theories, holding that (1) reading Morrison as a whole, the limitation precluding U.S. securities laws from applying on foreign transactions should apply even when the foreign issuer also lists shares on a U.S. Exchange, and (2) the mere placement of a buy order in the U.S. is too tenuous a connection for the U.S. securities laws to apply to claims for losses related to a securities trade. The Second Circuit affirmed that ruling on appeal on May 6, 2014, in an opinion that aligns with the dominant interpretations of Morrison, whereby investors that had purchased UBS securities on the NYSE could have sought remedies under the U.S. federal securities laws, while those who had purchased UBS securities on the Swiss Exchange could not do so. The decision, a victory for dual-listed issuers, further curtails investor rights and remedies under the U.S. federal securities laws barring an appeal to the U.S. Supreme Court. 

As their rights to seek recovery under U.S. law for foreign-listed securities evaporate in the wake of Morrison, investors can only try to convince Congress to revise the federal securities laws so as to restore, in whole or in part, the protections they once offered. Otherwise, under certain circumstances, they may seek to pursue common law claims such as those pursued by Pomerantz against BP. Until then, investors will have to further weigh the benefits of buying shares of dual-listed companies on foreign exchanges, which may include better prices or lower transaction costs, against the possibility of losing the protection of U.S. federal securities laws in the U.S. courts. The UBS ruling could have added significance if it is followed in other U.S. federal Circuits.

Rise in “Dissenting Shareholder” Merger Conditions

ATTORNEY: ANNA KARIN F. MANALAYSAY
Pomerantz Monitor, March/April 2014 

The increasing frequency of appraisal proceedings has led directly to a significant change in Delaware law and practice, most notably to the increasing use of dissenting-shareholder conditions in merger agreements. These provisions allow an acquirer to back away from the merger if holders of more than a specified percentage of outstanding shares exercise their appraisal rights. Without this condition, the acquirer would have to go through with the merger even if there are a large number of dissenting shares, thereby running the risk of having to pay a lot more than what it had bargained for. In Delaware, valuation of the target company’s stock in an appraisal proceeding requires a court to “determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger” but taking into account “all relevant factors.” 

Historically, the appraisal remedy has been pursued infrequently because the appraisal process is complex and potentially risky for the dissenting shareholder. Shareholders seeking appraisal must be prepared to invest considerable time and expense in pursuing their rights. Even when the process goes quickly, dissenters face the risk that the court will undervalue the company and their shares. Dissenters must initially bear all their litigation expenses and do not receive payment until finally ordered by the court, and then only receive reimbursement depending on the number of other dissenters, each of whom must pay his or her share of the costs. Absent a group of dissenters who can share costs and (most importantly) legal and expert witness fees, the cost of an appraisal is prohibitively expensive except for holders with large stakes. 

Despite these obstacles, the appraisal remedy is becoming more and more popular, at least in Delaware. One reason is that appraisal valuations have exceeded the merger price in approximately 85% of cases litigated to decision. Another is that even if the court’s valuation is lower than the merger price, dissenters can still come out ahead because these awards include interest at a rate of 5% above the Federal Reserve discount rate. According to recent academic studies, last year the value of appraisal claims was $1.5 billion, a ten-fold increase in the past ten years; and more than 15 percent of takeovers in 2003 led to appraisal actions by dissenters.Recent changes to Delaware law encourage the appraisal remedy by allowing shareholders to exercise their appraisal rights even prior to the consummation of the merger, at the conclusion of the first step in the transaction. Mergers often are completed in two steps. In step one, the acquirer launches a tender or exchange offer for any and all outstanding shares. Upon the close of that transaction, the acquirer then scoops up any shares not tendered in the offer by way of a second-step merger. 

A “short-form” merger does not require stockholder approval of the second-step merger, but can be used only if the acquirer buys at least 90 percent of the target’s stock after the step one. If the acquirer gets less than 90 percent, it has to use a “long-form” merger, which requires it to mail a proxy statement to all remaining shareholders and hold a stockholder meeting to approve the merger. Delaware recently enacted a new law that permits parties entering merger agreements after August 1, 2013, to agree to eliminate the need for a stockholder vote for a second-step merger if certain conditions are met, including receiving tenders of at least 50% of the shares. At the same time, Delaware amended its appraisal statute to provide that in connection with a merger under the new law a corporation can send the required notice of the availability of appraisal rights to its stockholders prior to the closing of the offer, and can require them to decide immediately whether to exercise their appraisal rights. In response to these changes, Delaware corporations have begun notifying their stockholders that all demands for appraisal must be made no later than when the first-step offer is consummated. 

The significance of these changes is that acquirers will now know, before they buy a single share of the target, how many shareholders are going to exercise their appraisal rights. This development, in turn, makes it possible for an acquirer to include a dissenting-shareholders condition to its obligation to consummate even step one of the deal, which, is, effectively, a condition to doing the entire deal. 

With the rising popularity of appraisal litigation and recent changes to the DGCL, a dissenting-shareholders condition will likely become a common feature in merger agreements.

Appraisal is the New Black

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, March/April 2014 

For decades, appraisal has been viewed as an antiquated, seldom-used procedure that “dissenting” shareholders can use if they believe that their company is being sold for an inadequate price. Instead of accepting the merger price, dissenters can ask a court to determine the “fair value” of their shares. But they rarely do. 

Until now. As highlighted in a recent New York Times Dealbook article, the “new, new thing on Wall Street is appraisal rights,” particularly in the hands of hedge fund investors who can easily afford the costs. 

The Dell management buyout may have been the start of this trend. There were months of wrangling between the buyout group and a “special committee” of disinterested directors, who were unable to scare up any legitimate competing offers from any third parties, despite intensive efforts to shop the company and lots of noise from Carl Icahn. Then, the deal finally went through, at a total cost of $24.9 billion. About 2.7 percent of shareholders exercised appraisal rights, including institutional investor T. Rowe Price. A much bigger percentage of dissenters appeared in the wake of the Dole Food management buyout of last fall. According to Dealbook, most investors were underwhelmed by the merger price, and in the end, only 50.9 percent of the shares voted to approve the merger. Four hedge funds reportedly bought about 14 million shares when the buyout proposal was first announced, and they have now exercised their appraisal rights. In all, about 25 percent of Dole’s public shareholders have sought appraisal -- an astonishing number. These four dissenting hedge funds have engaged in this same tactic several times in the past, and a nascent cottage industry in appraisal rights is developing. As discussed in the following article, this has led to significant changes in Delaware law and practice, to help acquirers back away from a merger agreement if too many shareholders choose to dissent. Acquirers are going to think twice if they can’t predict how much they are actually going to have to pay to buy a company. 

The threat of appraisal actions is probably a good thing, especially in the context of management buyouts, where the odds are heavily stacked against the public shareholders. It is useful for these insiders to know that, if they try to cut too good a deal for themselves, savvy financial institutions can take them to the cleaners in appraisal proceedings.

When Corporate Internal Investigations Become Part of the Problem

ATTORNEY: JOSHUA B. SILVERMAN
Pomerantz Monitor, March/April 2014 

When a company uncovers evidence of accounting improprieties or executive misconduct, or when the government does it for them, a common step is for the company to conduct an “independent” internal investigation. The American Institute of Certified Public Accountants has gone so far as to say that an audit committee must initiate an internal investigation when fraud is detected. A proper investigation, followed by a candid report of findings to investors, can play a critical role in rebuilding investor confidence. However, all too frequently internal investigations are used to hide the truth and protect those responsible. For example, the Office of the Comptroller of Currency (OCC) recently charged that a JP Morgan internal investigation into the bank’s handling of Madoff funds was designed to conceal the knowledge of key witnesses. After spending time with JP Morgan’s lawyers, the government said that the witnesses demonstrated “a pattern of forgetfulness.” 

Even worse, because the investigation had been conducted by lawyers, JP Morgan claimed that the details of the investigation were protected by attorney-client privilege. On that basis, JP Morgan refused to produce the notes from interviews of 90 bank employees following Madoff’s arrest. OCC lawyers argued that the privilege did not apply because it was being used to perpetuate a fraud. However, the argument failed because the OCC could not establish what the newly-forgetful witnesses told their lawyers, or what the lawyers told them to say to investigators. 

In December, 2013, the OCC dropped its attempt to discover details regarding JP Morgan’s internal investigation. A month later, JP Morgan agreed to pay a civil penalty of $350 million to the OCC. The deal represented the largest fine ever paid to the OCC, but it also ensured that the facts surrounding the internal investigation would forever remain private. Where the investigators’ report cannot be manipulated from the outset, companies sometimes contrive to conceal the results. In the AgFeed Industries, Inc. securities litigation, for example, Pomerantz uncovered evidence of an attempt to bury the findings of an internal investigation. In that case, the chairman of the committee investigating rampant fraud at the company testified that investigative committee lawyers and other committee members refused to produce a report to investors because the lawyers – who also represented management at the time – believed that the findings would expose management to litigation. As a result, the full breadth of the fraud was concealed for years. 

In a recent editorial in the Financial Times, short seller Carson Block questioned why these independent investigations so routinely failed to identify even blatant cases of fraud: “Time and again, investigators report that they have found no evidence to support claims of wrongdoing. The question that investors need to ask themselves is: how hard did these investigators look for clues that might have revealed something was amiss?” On his website, Block named names. Concentrating on U.S.-listed Chinese firms, Block identified seven independent investigations that purported to clear management despite obvious signs of fraud that caused investors to lose most of their investment: China Agritech, ChinaCast Education, China Integrated Energy, China Medical Technologies, Duoyuan Global Water, Sino Clean Energy, and Silvercorp. 

The OCC’s charges in the JP Morgan case and the list of improper independent investigations published by Carson Block both confirm a disturbing trend. One possible reason for the trend: outside law firms, which often turn internal investigations into a lucrative practice area. Shielding management is the safe play for the investigating law firms. If they candidly exposed wrongdoing to investors, what company is going to hire them the next time around?

Supreme Court Upholds Claims Arising From Stanford Ponzi Scheme

ATTORNEY: EMMA GILMORE
Pomerantz Monitor, March/April 2014 

In a 7-2 decision issued on February 26, 2014, the United States Supreme Court resolved a circuit split over the application of the Federal Securities Uniform Standards Act of 1998 (“SLUSA”). This act bars class actions alleging state law claims of common law fraud “in connection with” the sale of a SLUSA-defined ”covered security”. The decision clears the way for investors to seek recovery under state law from the law firms of Proskauer Rose and Chadbourne and Parke, and other secondary actors, of just under $5 billion they paid for certificates of deposit administered by Stanford International Bank Ltd. The decision marked a win for the plaintiffs’ bar. The plaintiffs alleged that convicted swindler Allen Stanford ran a multibillion dollar Ponzi scheme, selling investors bogus certificates of deposit issued by the bank. These certificates are not “covered securities” as defined by SLUSA. However, the proceeds of the offer were supposed to be invested in “covered securities” that were conservative investments. Stanford never bought the covered securities. Instead he used the investors’ money to repay old investors, maintain a lavish lifestyle, and to finance highly-speculative real estate ventures. 

The Court defined the crux of the claim as “whether SLUSA applies to a class action in which the plaintiffs allege (1) that they ‘purchase[d]’ uncovered securities (certificates of deposit that are not traded on any national exchange), but (2) that the defendants falsely told the victims that the uncovered securities were backed by covered securities.” The key phrase in SLUSA, according to the majority opinion, was its prohibition of state law class actions arising “in connection with” the purchase of a covered security. The majority interpreted that phrase narrowly, holding that an actual sale of a covered security has to occur for SLUSA to apply, and not just a promised sale. The majority observed that a broader interpretation would directly conflict with matters primarily of state concern the fact that the certificates were allegedly backed by covered securities was an insufficient connection to covered securities to bring the case within SLUSA’s reach. 

In a dissention opinion, Justices Anthony Kennedy and Samuel Alito warned that the majority’s ruling could hamper SEC’s enforcement efforts, because Section 10(b) of the Securities Exchange Act, under which the SEC brings enforcement actions, also uses the phrase “in connection with the purchase or sale of any security.” The majority found that concern unfounded, however, saying the SEC failed to identify any enforcement action filed in the past 80 years that would be foreclosed by the ruling. Indeed, the SEC had already successfully sued Stanford and his accomplices over the certificates of deposit. “The only difference between our approach and that of the dissent,” Justice Breyer added, “is that we also preserve the ability for investors to obtain relief under state laws when the fraud bears so remote a connection to the national securities market that no person actually believed he was taking an ownership position in that market.” 

Securities law experts are backing the majority’s limited ruling. “The opinion is imminently correct as a matter of common sense and legal policy,” said Donald Langevoort, a professor of law at Georgetown University. Langevoort said he was “very surprised” the SEC tried to argue that a ruling for the plaintiffs may curtail the government’s enforcement powers.

Supreme Court Has a Full Plate of Securities Cases

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, March/April 2014 

Halliburton.
In our last issue, we devoted much space to discussion of Halliburton, which presents the issue of whether the “fraud on the market” theory, which underpins much of securities class action practice, is still the law of the land. As we said, since the Court’s decision in Basic v. Levinson about 25 years ago, securities class action plaintiffs have relied on this theory to obtain class certification. The theory helps investors establish the essential element of reliance on a class wide basis. It presumes that all investors rely on the market price of a security as reflecting all available material information about the security, including defendants’ alleged misrepresentations. By agreeing to reconsider this question, the Court threw the securities bar, on both sides, into a frenzy. 

On March 5, the Supremes held oral argument in Halliburton, and most observers thought that the Justices seemed unwilling to throw out Basic altogether. Instead, it seems likely that they intend to tweak it a bit, by allowing defendants to rebut the fraud on the market presumption at the class certification stage, with evidence that the false or misleading statements issued by the company did not actually distort the market price of its stock. If this prediction is accurate, investors will be able to live with the new Halliburton rule, and corporations will have to. 

Indymac.
Another venerable Supreme Court precedent in the class certification arena is American Pipe, a 1974 decision concerning the statute of limitations. In that case, plaintiffs filed a class action, but after the statute of limitations had expired the court refused to certify the class, and various would-be class members then tried to file individual claims. The Court held that for those people the statute of limitations was “tolled” – stopped running– while the class certification motion was still pending. That ruling made it unnecessary for potential plaintiffs to start filing individual lawsuits to protect themselves while the class certification motion was still undecided. Under American Pipe, only if class certification is denied would individual actions be necessary in order to protect a plaintiff’s rights from expiring. 

American Pipe talks about limitations periods which start to run when plaintiffs knew, or should have discovered, facts establishing their claim. The new case, Indymac, involves a so-called statute of repose, which in this case says that, under §11 of the Securities Act, the action must be brought within three years after the initial public offering that is the subject of the action, regardless of when investors knew or should have known of their claim. 

Class certification motions are usually not decided within three years, so the same problem that caused the Court to create the American Pipe tolling rule would arise with statutes of repose: as the three year limitation approaches, if the class certification motion is still not decided, individual investors would have no choice but to file individual actions in order to protect themselves from expiration of the “repose” period. A multitude of separate, duplicative lawsuits is not something investors or the courts want to see. 

All appeals courts that have considered the question until last summer had concluded that the three year statute of repose for §11 is tolled by the pendency of a class action motion; but then, in Indymac, the Second Circuit disagreed, setting up this Supreme Court appeal. 

Fifth Third Bancorp.
This case, to be argued in April, concerns the duties of fiduciaries of employee benefit plans governed by ERISA. Many of those plans invest participants’ contributions in stock of the employer corporation, or provide employer stock as an investment option. If the corporation then makes a “corrective” disclosure of negative information, plan participants who invested in company stock can suffer big losses. Sometimes they bring class actions against plan fiduciaries for ignoring warning signs that something was amiss. 

The issue the Court will consider in Fifth Third Bancorp is what plaintiffs in these cases must plead in order to survive a motion to dismiss. ERISA imposes on plan fiduciaries the obligation to act prudently and reasonably. Under one line of cases, plaintiffs must plead facts sufficient to rebut a presumption that the fiduciaries acted reasonably. In cases involving allegedly imprudent investments in company stock, the facts alleged have to show that the company was in dire straits for that presumption to be rebutted. In Fifth Third Bancorp, however, the Sixth Circuit held that this presumption of prudence does not apply at the motion to dismiss stage, but only later, when there is a fully developed evidentiary record. According to the Sixth Circuit, a plaintiff need only allege that “a prudent fiduciary acting under similar circumstances would have made a different decision”. Class actions against plan fiduciaries are a regular accompaniment to securities fraud litigations. Whatever the Court holds will have a major impact in the industry.

JPMorgan Chase Admits that it Covered Up the Madoff Ponzi Scheme

Pomerantz Monitor, January/February 2014 

This January, Federal District Judge Jed Rakoff published an essay in The New York Review of Books that reverberated in the financial community. He noted that, five years after the market crash of 2008 that caused millions of people to lose their jobs, “there are still millions of Americans leading lives of quiet desperation: without jobs, without resources, without hope.” Yet the Wall Street malefactors who caused this catastrophe have never been called to account. “Why,” he asked, “have no high-level executives been prosecuted?” Many of us have asked the same question. After all, after previous periods of financial scandal, several big time honchos spent years staring at the inside of a jail cell. Just ask Dennis Koslowski and Jeffrey Skilling, to name only two. The JPMorgan Chase case shows how much things have changed. The bank has confessed to a litany of misconduct, including fraud in connection with its sale of mortgage-backed securities, and allowing its “London Whale” trader to run amok, causing the company to lose billions of dollars, and then covering it up. Now, on almost the same day as Judge Rakoff’s essay was published, JPMorgan Chase has fessed up again, admitting that it committed two criminal violations when it covered up its knowledge of Bernard Madoff’s $65 billion Ponzi scheme, which was run through Madoff’s bank accounts at the bank. According to prosecutors, JPMorgan’s actions amount to “programmatic violation” of the Bank Secrecy Act, which requires banks to maintain internal controls against money laundering and to report suspicious transactions to the authorities. According to Preet Bharara, the U.S. Attorney for the Southern District of New York, JPMorgan’s “miserable” institutional failures enabled Madoff “to launder billions of dollars in Ponzi proceeds.” To resolve these Madoff cases, JPMorgan agreed to pay more than $2.6 billion in various settlements with federal authorities. At the same time, it also filed two settlements in private actions totaling more than $500 million – one for $325 million with the trustee liquidating the Madoff estate, and the other for $218 million to settle a class action. 

Interestingly, the federal prosecutors credited the trustee’s team with discovering many of the unsavory facts of the bank’s involvement. 

These payouts bring to nearly $32 billion the total that JPMorgan has reportedly paid in penalties to federal and state authorities since 2009 to settle a litany of charges of misconduct. Most notably it came to a record $13 billion settlement just months ago with federal and state law enforcement officials and financial regulators, over its underwriting of questionable mortgage securities before the financial crisis. 

And yet, no one at the bank has been criminally prosecuted for any of this. The deal reached by JPMorgan with prosecutors in the Madoff case stopped short of a guilty plea, and no individual prosecutions were announced. Instead, the bank entered into a deferred prosecution agreement, which suspends a criminal indictment for two years on condition that the “too big to fail” and “too big to jail” bank overhauls its money laundering controls. Even so, this is reportedly the first time that a big Wall Street bank has ever been forced to consent to a non-prosecution agreement. 

Given what JPMorgan Chase admits happened here, it is amazing that there were no prosecutions of individuals. According to documents released by the U.S. Attorney’s office, the megabank’s relationship with Madoff stretched back more than two decades, long before Madoff was arrested in 2008. One document released by prosecutors outlining the megabank’s wrongdoing observed that “The Madoff Ponzi scheme was conducted almost exclusively through” various accounts “held at JPMorgan.” 

By the mid-nineties, according to an agreed statement of facts released by prosecutors, bank employees raised concerns about how Madoff was able to claim remarkably consistent market-beating returns. Indeed, one arm of the bank considered entering into a deal with Madoff’s firm in 1998 but balked after an employee remarked that Madoff’s returns were “possibly too good to be true” and raised “too many red flags” to proceed. Then, in the fall of 2008, the bank withdrew its own $200 million investment from Madoff’s firm, without notifying either its clients or the authorities. 

Twice, in January 2007 and July 2008, transfers from Madoff's accounts triggered alerts on JPMorgan's anti-money-laundering software, but the bank failed to file suspicious activity reports. In October 2008, a U.K.-based unit of JPMorgan filed a report with the U.K. Serious Organised Crime Agency, saying that "the investment performance achieved by [the Madoff Securities] funds ... is so consistently and significantly ahead of its peers year-on-year, even in the prevailing market conditions, as to appear too good to be true — meaning that it probably is." But that information was not relayed to U.S. officials, as required by the Bank Secrecy Act. On the day of Mr. Madoff’s arrest in December 2008, a JPMorgan employee wrote to a colleague: “Can’t say I’m surprised, can you?” The colleague replied: “No.” 

In commenting on this latest settlement by the bank, Dennis M. Kelleher, the head of Better Markets, an advocacy group, observed that “banks do not commit crimes; bankers do.” Jailing people is the best way to deter future misconduct. If anyone thinks that huge fines are enough to deter misconduct by huge financial institutions, they should think again. Despite its huge penalties, JPMorgan just reported another multi-billion dollar quarterly profit, and announced that Chairman Jamie Dimon will receive a hefty raise. Obviously, it can afford to keep treating penalties as just another cost of doing business.

"Go-Shop" Provisions – Too Little, Too Late

ATTORNEY: OFER GANOT
Pomerantz Monitor, January/February 2014 

In a previous issue of the Monitor, we discussed potential problems the combination of certain “deal protection devices” may cause for shareholders wanting to receive the most they can get for their stock when their corporation receives an acquisition offer. 

In most merger transactions, the party making the offer wants to lock up the transaction as tightly as possible. The offeror, after all, has just finished negotiating the deal, usually after a long and expensive process of due diligence, and does not want its offer to be just the opening of an all-out bidding war with competing bidders. Offerors therefore typically condition their offer on the target agreeing to limit its ability to consider other offers. 

On the other side of the table sits the target company’s board of directors, which has fiduciary duties to the target company and its public shareholders. Among those is the duty to maximize shareholder value if the company is sold, and, to that end, to keep itself as free as possible to consider (or even to seek out) superior offers, should they be made (through what are known as “fiduciary out” provisions). 

This conflict is usually resolved through the adoption of multiple deal protection devices which are incorporated into the merger agreement between the target company and buyer. These devices can include, among other things, “no solicitation” provisions which restrict the target’s board of directors from soliciting and negotiating potentially superior offers; “matching rights” which essentially give the buyer a leg-up over any potential bidder, allowing it to match any superior offer made for the target company; and termination fees which require the target company to pay a significant amount (usually ranging between 3% and 4% of the total value of the transaction) to the buyer in the event the target’s board decides to pursue a superior offer. 

Sometimes the target’s board will negotiate what is known as a “go-shop period,” which is a period of time, usually between 30-45 days, during which the target’s board of directors is allowed to actively solicit superior offers from potential bidders without breaching the “no solicitation” mechanism. 

But there is an inherent flaw in this mechanism, which in most cases does not turn up any superior bids. More often than not, go-shop provisions are negotiated in lieu of a pre-signing market check. This usually happens when the buyer pressures the target’s board to accept its bid in a short period of time. The board, afraid that any delay may thwart this opportunity, may choose to skip a market check – a process that takes time – and instead enter into a merger agreement with the buyer, leaving itself the theoretical possibility of potentially securing a better offer after the deal with the buyer is already agreed upon and publicly announced. 

However, at that point, the target’s board has already approved the deal with the buyer, including the consideration to be paid for the target’s common stock. This acceptance by the target’s board sometimes leads to a number of insiders (including board members) entering into voting and support agreements pursuant to which they agree to vote their shares in favor of the deal with the buyer, and against any other deal. 

Moreover, the go-shop mechanism doesn’t necessarily neutralize the other deal protection devices in place including, without limitation, the termination fees and matching rights. This means that any potential bidder who is now interested in making an offer for the target company must assume significant time and expense just to be able to make a superior offer, knowing that the buyer can always simply match the bidder’s offer. Such potential bidder will also have to work harder to secure a majority supporting its offer, in light of any voting or support agreements entered into by target insiders. Even if the buyer chooses not to match, the new bidder must, directly or indirectly, incur the termination fees, thereby increasing even further the cost of such a transaction. 

It is no surprise, then, that the go-shop process usually produces zero competitive bids for the company. The hoops potential bidders must jump through are usually just too many, and they usually go on to search other opportunities, potentially leaving money on the table instead of in the target’s shareholders’ pockets. As a result, go-shop provisions are often dismissed as “too little, too late.” 

It should therefore be shareholders’ preference that a company undergo a significant and meaningful pre-signing market check, or outright auction, rather than negotiate a post-signing go-shop. Bidders are far more likely to materialize if the target hasn’t already signed a deal with someone else. Target boards have to weigh the risk that the offeror will walk away, with the risk that they will be foregoing possibly better offers. In other words, directors have to decide whether a bird in the hand is really better than two in the bush.

Threat to Shareholder Protections in Transactions with Controlling Parties

ATTORNEY: GUSTAVO F. BRUCKNER
Pomerantz Monitor, January/February 2014 

A recent Delaware Chancery Court decision, now on appeal before the Delaware Supreme Court, may dramatically lessen the customary safeguards for minority shareholders in controlling party transactions, such as going private mergers. 

In M&F Worldwide(“MFW”), Chairman Ronald Perelman offered to acquire the remaining 57% of MFW common stock he did not already own. As part of his proposal, Perelman indicated that he expected that the “board of Directors will appoint a special committee of independent directors to consider [the] proposal and make a recommendation to the Board of Directors,” and also noted that the “transaction will be subject to a non-waivable condition requiring the approval of a majority of the shares of the Company not owned by M&F or its affiliates.” 

Controlling shareholder transactions normally trigger the enhanced “entire fairness” standard of judicial review. This enhanced standard places a burden on the corporate board, and the controlling shareholder, to demonstrate that the transaction is inherently fair to the shareholders, by both demonstrating fair dealing and fair price. This is a very difficult standard for the company to meet. 

However, Delaware courts have held that the burden of proof on the issue of “entire fairness” can be shifted to the plaintiff challenger if the transaction has been approved either by an independent special committee of directors or by a positive vote of a majority of the minority shareholders. Independent committee and “majority of the minority” provisions are an attempt to assure that the company and its shareholders can exercise independent judgment in deciding to accept or reject the transaction. Although shifting of the burden of proof creates a higher hurdle for minority shareholders to surmount, it is not an impossible one, because the ultimate inquiry remains the same: the “entire fairness” of the transaction. 

Critically, even if these devices are used, Delaware courts have consistently held, up to now, that the business judgment rule does not protect the transaction. That rule, which protects most ordinary business decisions from shareholder challenge, is almost impossible for shareholders to overcome, because it provides that in making a business decision the directors of a corporation are presumed to have “acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” 

In his decision, Chancellor Strine (who was just nominated to become the next Chief Justice of the Delaware Supreme Court), ruled that where a transaction with a controlling person is conditioned on both negotiation and approval by an independent, special committee and a fully-informed, un-coerced vote of the majority of the minority, the proper standard of review is that of business judgment. According to Chancellor Strine, because Perelman conditioned the deal on implementation of procedural protections that essentially neutralized his controlling influence, the transaction is no different from routine corporate transactions in which the deferential business judgment standard is applicable. 

At oral argument, the Supreme Court seemed interested in the policy arguments both for accepting and rejecting the Chancellor’s reasoning. Chancellor Strine’s ruling, if adopted by the Supreme Court, could provide a roadmap for corporate boards to forestall litigation on even the most one-sided controlling shareholder transactions. Though too early to predict fully the repercussions of such a ruling, there is fear that institutional investors will use the power of the purse to reduce their holdings in controlled corporations over time, if their assets lose the valuable protections they are currently afforded.

Supremes About to Hear Historic Challenge to Fraud on the Market Theory

ATTORNEY: LOUIS C. LUDWIG
Pomerantz Monitor, January/February 2014

Twenty five years ago, in Basic Inc. v. Levinson, the Supreme Court adopted the so-called “fraud on the market” (“FOTM”) theory in securities fraud class actions. That theory holds that a security traded on an “efficient” market presumably reflects all public “material” information about that security, including any public misrepresentations by the defendants; and that in such cases investors rely on the market price as a fair reflection of the totality of information available. Because investors purchase their shares at the market price, assuming that that price reflects all available material information, it is fair to presume that all investors relied, indirectly, on defendants’ misrepresentations when they purchased their shares. 

Reliance is an essential element of securities fraud claims. The FOTM presumption allows investors to establish reliance on a class-wide basis, without having to show that each member of the class personally relied on defendants’ misrepresentations. If reliance had to be shown separately for each of the hundreds of thousands, or even millions, of investors, individual questions of reliance would overwhelm the case. In legalese, individual questions would “predominate” over common questions in the action, and it would be next to impossible to certify a class. The FOTM theory adopted in Basic is therefore a foundation of securities fraud class actions. The importance of class-wide reliance was apparent to the courts from the outset of the modern class action era in 1966. Just two years later, the Second Circuit rejected a defendant’s argument “that each person injured must show that he personally relied on the misrepresentations” because, the court concluded, “[c]arried to its logical end, it would negate any attempted class action under Rule 10b-5 ….” Because most investors do not suffer large enough losses from securities fraud to support prosecution of an individual action, class actions are often the only way for most investors to obtain redress for securities fraud. In recent years, some members of the Supreme Court have become more critical of securities fraud class actions, echoing Chamber of Commerce arguments that the mere act of certifying a class in a securities fraud action puts enormous financial pressure on defendants, forcing them to settle claims regardless of their merit. Before Halliburton, defendants had mounted a series of efforts to get the courts to make it harder to certify a class, arguing that plaintiffs should be forced to prove, at the class certification stage, that the misrepresentations were material (the Amgen case), or that they caused plaintiffs’ losses (an earlier Halliburton case). Both of those efforts failed. 

Those were merely the preliminary bouts; the main event is now here. For years, corporate interests have been mounting attacks on the FOTM theory, arguing that markets are not as efficient as economists previously thought. With the Supreme Court agreeing to revisit its decision in Basic, these well-funded efforts have finally paid off. On November 15, 2013, the Court granted certiorari in Halliburton Co. v. Erica P. John Fund. In Halliburton, the Supreme Court will decide two issues: 

 (1) Whether it should overrule or substantially modify the holding of Basic to the extent that it recognizes a presumption of class-wide reliance derived from the fraud-on-the market theory; and

(2) Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock. 

For everyone involved in litigating securities fraud class actions, the answers to these questions could be game-changers; and Pomerantz’s clients are among the potentially affected. If Basic is overruled and FOTM is jettisoned, securities fraud class actions as we have known them for a quarter century will be a thing of the past. 

Another possibility is that the Court will modify, rather than reject, Basic and FOTM. This possibility exists because FOTM theory actually consists of two distinct, but related, parts: first, “informational efficiency,” the idea that the market is capable of efficiently and speedily processing material information; and second, “price distortion,” whether fraudulent statements injected into the informationally-efficient market in a particular case actually distort a given security’s market price. After Basic was decided, courts weighing class certification in securities fraud cases focused primarily on informational efficiency, allowing the FOTM presumption of reliance to attach where that test was satisfied. By contrast, inquiries into price distortion were rare, if they occurred at all, on class certification motions. The Court could keep FOTM while requiring that plaintiffs establish both an informationally-efficient market, and some price distortion, perhaps using event studies of a type already much in use in securities fraud litigation. 

Defendants are arguing that the issue of price distortion is closely related to another element of a securities fraud claim, “loss causation,” proof that defendants’ misstatements, once corrected, caused the price of the stock to drop, causing plaintiff’s losses. A court that simply assumes price distortion also, to some extent, assumes loss causation. Second, the FOTM presumption is essentially predicated on another independent element of a securities fraud claim, “materiality.” By presuming reliance, courts presume the materiality of the alleged misstatement, and on the class certification motion defendants cannot offer rebuttal evidence negating materiality. Defendants argue that plaintiffs should not be entitled to such presumptions in their favor on a class certification motion. 

At the end of the day, at summary judgment or at trial, defendants will have their opportunity to rebut all these presumptions. But, the argument goes, that is too late, as a practical matter. Once a class is certified, defendants have a strong incentive to settle. Very few defendants have the chutzpah to take a “bet the company” securities fraud class action to trial. 

Even if the Court abrogates Basic and the FOTM theory completely, class actions will still be possible in cases involving failures to disclose (rather than misrepresentations), or involving violations of the Securities Act, which relates primarily to initial public offerings. In other cases, however, investors will be left to pursue individual actions, mostly on behalf of large institutional investors, and possibly in state court. Pomerantz’s current BP litigation, which alleges common law fraud and negligence claims stemming from over two dozen clients’ losses associated with BP common stock investments, provides a glimpse into what this post-Basic world might look like. In such cases, institutions with significant losses can pursue individual actions even without the FOTM presumption, if their advisors actually relied on defendants’ misrepresentations. 

Oral arguments in Halliburton are set for March 5, 2014. In the meantime, Pomerantz attorneys continue to work with economists, Supreme Court consultants, and the law firm that will argue the case, to craft an amicus brief that will support the continued viability of FOTM. Barring the outright affirmance of Basic, we will urge the Court to adopt an approach that leaves FOTM in place – as securities fraud class actions are untenable without some version of it – while adopting a limited inquiry into price distortion.

Pomerantz Reaches Major Healthcare Settlement With Aetna

Pomerantz Monitor, January/February 2013 

Readers of the Monitor may recall our reports on our $250 million settlement with Health Net, followed by our $350 million settlement with United Healthcare. Both actions involved underpayments by health insurers of claims for out-of-network medical services based on miscalculations of “usual, customary and reasonable,” or “UCR,” rates. The $350 million settlement with United Healthcare represented the largest cash settlement of an ERISA healthcare class action ever. 

We continued to pursue UCR claims against other healthcare insurers, and are now pleased to report that we have reached a settlement with Aetna, Inc. This settlement, in In re Aetna UCR Litigation, pending in the District of New Jersey, will -- once it is approved by the Court -- result in the reimbursement, through three settlement funds Aetna will create, of up to $120 million to providers and plan members who were also subjected to out-of-network underpayments based on miscalculated UCR rates. 

This settlement arises out of an action that alleged that Aetna used databases licensed from Ingenix, a wholly-owned subsidiary of United Healthcare, to set UCR rates for out-of-network services. We alleged the Ingenix databases were inherently flawed, statistically unreliable, and unable to establish proper UCR rates. Aetna, United Healthcare, and a number of other healthcare insurers had agreed to stop using the Ingenix databases pursuant to settlements with the New York Attorney General in 2009 simultaneous with Pomerantz’s settlement with United Healthcare. The settlement involves Aetna’s use of other non-Ingenix-based reimbursement mechanisms as well. 

The Aetna settlement represents another successful milestone for Pomerantz’s Insurance Practice Group. We are proud of this latest success in forcing managed care companies to follow the law. This settlement provides an opportunity for providers to obtain reimbursement for monies taken by Aetna in the guise of usual, customary and reasonable payments. It brings to a successful close years of litigation on behalf of providers, for whom we have long fought against the largest health insurers in the country, including Aetna. 

Pomerantz’s Insurance Practice Group represents hospitals, provider practice groups and providers in litigation involving such issues as recoupments and offsets, internal medical necessity policies that are inconsistent with generally accepted standards, and misrepresentations of insurance coverage.

Whistleblower Program Picks Up Steam

Pomerantz Monitor, November/December 2013 

The Whistleblower Bounty Program created by the Dodd-Frank Act mandates that the Securities and Exchange Commission (“SEC”) pay significant financial rewards to individuals who voluntarily provide the agency with original information about securities law violations. If the information provided leads to a successful enforcement action resulting in $1 million or more in sanctions, the whistleblower may receive between 10 and 30% of the sanctions collected. The SEC is required to maintain confidential treatment and anti-retaliation measures for tipsters. 

In a report issued by the SEC staff on November 15, the agency reported that it had received 3,238 tips in fiscal 2013, and had paid out $14.8 million in whistleblower awards that year, $14 million of which went to a single tipster in an award announced on October 1. In announcing the award, SEC Chair Mary Jo White stated that “Our whistleblower program already has had a big impact on our investigations by providing us with high quality, meaningful tips…. We hope an award like this encourages more individuals with information to come forward.” 

As more investigations are resolved, observers expect that more and greater awards will be granted. Currently, the SEC has over $400 million available for the program. 

While this program is new, it may ultimately supplement securities class actions in two important ways. The fundamental purpose of the Whistleblower program is to detect fraud. Unlike the basic purpose of securities class actions – to deter and hopefully monetarily punish fraud – the Whistleblower program incentivizes tipsters to come forward with information to the SEC – thus improving fraud detection. Generally, both corporate insiders (those with independent knowledge of misconduct from non-public sources) and corporate outsiders (those who detect misconduct through independent analysis and investigation of publicly available data) are incentivized to tip information to the SEC. 

Opponents of the program insist that, because the monetary incentives are so high, whistleblowers will turn first to the SEC before disclosing problems internally to obtain corrective action. However, SEC rules seek to preserve the attractiveness of internal reporting, and the SEC reports that most whistleblowers who have come forward since the program’s inception used internal channels of resolution before turning to the SEC. In addition, the SEC has indicated that its standard practice involves contacting the involved corporation directly upon receipt of a tip, describing the allegations, and giving the firm a chance to investigate the matter internally. On balance, the deterrent and detection benefits of the program, coupled with the SEC’s measures to encourage initial internal reporting, outweigh any incentive to simply run to the SEC first on the chance that a tip will result in a large reward.

The Purple Pill and “Pay for Delay”

ATTORNEY: JAYNE A. GOLDSTEIN
Pomerantz Monitor, November/December 2013 

Pomerantz is serving as interim co-lead counsel in an antitrust lawsuit against various pharmaceutical companies. We allege that the brand company, AstraZeneca, paid generic drug manufacturers Ranbaxy Pharmaceuticals, Teva Pharmaceuticals and Dr. Reddy’s Laboratories (“Generic Defendants”) to keep generic versions of the blockbuster drug Nexium from coming to market for six years or more. Nexium, a prescription medication commonly advertised as “the purple pill,” is used to treat heartburn and gastric reflux disease. Pomerantz represents consumers, self-insured insurance plans and insurance companies who were forced to pay monopoly prices for Nexium because there was no generic competition. 

Generic versions of brand name drugs contain the same active ingredient, and are determined by the Food and Drug Administration (“FDA”) to be just as safe and effective as their brand name counterparts. The only significant difference between them is their price: when there is a single generic competitor, generics are usually at least 25% cheaper than their brand name counterparts; and when there are multiple generic competitors, this discount typically increases to 50% to 80% (or more). The launch of a generic drug usually brings huge cost savings for all drug purchasers. 

We allege that in order to protect the $3 billion in annual Nexium sales from the threat of generic competition, AstraZeneca agreed to pay the Generic Defendants substantial sums in exchange for their agreement to delay marketing their less expensive generic versions of Nexium for as many as six years or more, i.e., from 2008 until May 27, 2014. 

Under the Hatch Waxman Act, the law which governs how generic pharmaceuticals come to market, when a generic drug manufacturer wants to sell a generic equivalent of a patented drug, it must file an Abbreviated New Drug Application (“ANDA”) which must certify either that (1) no patent for the brand name drug has been filed with the FDA; (2) the patent for the brand name drug has expired; (3) the patent for the brand name drug will expire on a particular date and the generic company does not seek to market its generic product before that date; or (4) the patent for the brand name drug is invalid or will not be infringed by the generic manufacturer’s proposed product (a so-called “Paragraph IV certification”). 

In the case of Nexium, the generic manufacturers filed a Paragraph IV certification. This filing gave the brand manufacturer forty-five days in which to sue the generic companies for patent infringement. If the brand company initiates a patent infringement action against the generic filer, the FDA will not grant final approval of the new generic drug until the earlier of (a) the passage of thirty months, or (b) the issuance of a decision by a court that the patent is invalid or not infringed by the generic manufacturer’s ANDA. In this case, AstraZeneca sued all three of the Generic Defendants. 

As an incentive to spur generic companies to seek approval of generic alternatives to branded drugs, the Hatch Waxman law rewards the first generic manufacturer to file an ANDA containing a Paragraph IV certification by granting it a period of one hundred and eighty days in which there is no competition from other generic versions of the drug. This means that the first approved generic is the only available generic for at least six months, a large economic benefit to the generic company. Brand name manufacturers can “beat the system” by claiming a valid patent even if such patent is very weak, listing and suing any generic competitor that files an ANDA with a Paragraph IV certification (even if the competitor’s product does not actually infringe the listed patents) in order to delay final FDA approval of the generic for up to thirty months. 

In Nexium’s case, when the Generic Defendants filed their Paragraph IV certifications they alleged, among other reasons, that the Nexium patents were not valid because Nexium was not significantly different from AstraZeneca’s prior drug, Prilosec. The active ingredient in Prilosec is omeprazole, a substance consisting of equal parts of two different isomers of the same molecule. 

Nevertheless, after receiving the Paragraph IV certifications from the Generic Defendants, AstraZeneca filed patent infringement litigation. Just as the thirty months was about to expire and generic Nexium would have been able to come to market, the companies settled the patent litigation. AstraZeneca used the strength of its wallet as opposed to the strength of its patents to obtain the Generic Defendants’ agreement to postpone the launch of their generic Nexium products. In light of the substantial possibility that AstraZeneca’s Nexium patents would be invalidated, in which case AstraZeneca would have been unable to keep generic versions of Nexium from swiftly capturing the vast majority of Nexium sales, AstraZeneca agreed to share its monopoly profits with the Generic Defendants as the quid pro quo for the Generic Defendants’ agreement not to compete with AstraZeneca in the Nexium market until May 27, 2014. 

These cases are commonly called either “pay for delay” or “reverse payment” cases. Until recently, the various federal appellate courts were divided on whether these “settlements” violated the antitrust laws by improperly prolonging the monopoly granted by the patent laws. In June of 2013, the U.S. Supreme Court held that such settlements are subject to antitrust scrutiny. 

The trial of this case is scheduled to begin on March 3, 2014.

Health Insurers’ “Recoupment” Tactic Derailed

Pomerantz Monitor, November/December 2013 

In Pennsylvania Chiropractic Ass’n v. Blue Cross Blue Shield Ass’n, Pomerantz’s Insurance Practice Group obtained summary judgment on behalf of our client health providers against Anthem and Independent Blue Cross in a recoupment case. Recoupment itself has been described as a “legal gray zone” that insurers exploited prior to Pomerantz’s challenges. Recoupment occurs when insurers such as Blue Cross Blue Shield (“BCBS”) pay claims initially and later decide that the claims should not have been paid, demanding repayment and claiming fraud. When the provider refuses to return the money, the insurer deducts the full amount from payment of future claims that are not challenged as improper. 

When these subsequent denials are made in the context of an employee health insurance plan, they are controlled by ERISA, which requires disclosure and appellate rights. In its decision, the court found that Blue Cross insurers violated ERISA by improperly denying beneficiary rights and making arbitrary and capricious benefit denials. The court also denied BCBS’s motion for summary judgment against several chiropractic associations, also represented by Pomerantz, for injunctive relief. This ruling paved the way for a December trial to modify the way Blue Cross obtains benefit recoupments from chiropractors across the country. 

This decision has national significance. As we stated to Law 360, an online legal publication: “The decision found for us on the merits of our claim that an insurer must comply with ERISA when seeking to recover previously paid health care benefits from providers. Given the hundreds of millions of dollars recouped by insurers every year, this decision will have widespread implications.” 

The decision follows Pomerantz’s successful trial verdict on behalf of other providers in another recoupment and fraud case in the District of Rhode Island, Blue Cross & Blue Shield of R.I. v. Korsen, and our win in yet another recoupment case in the Third Circuit in Tri3 Enterprises, LLC v. Aetna, Inc. We have other recoupment cases ongoing, the results of which we will report in future editions of the Monitor.

FIRREA: No, It’s Not a Disease, Unless You Are a Naughty Financial Institution

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, November/December 2013 

As JPMorgan Chase struggled to put the finishing touches on its $13 billion settlement with the federal government over its misadventures in the mortgage-backed securities area, a major ingredient in the government’s success seems to have come from out of nowhere – or, more precisely, from the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"). This provision, enacted in the wake of the savings and loan meltdown of the 80’s, has been pulled out of the mothballs to punish some of the misbehaving financial institutions that brought about the financial crisis of 2008. 

Section 951 of FIRREA authorizes the Justice Department to seek civil money penalties against persons who violate one or more of 14 enumerated criminal statutes (predicate offenses) that involve or “affect” financial institutions or government agencies. On April 24, 2013, the U.S. District Court for the Southern District of New York issued the first judicial interpretation of the phrase "affecting a federally insured financial institution" as used in FIRREA. In United States v. The Bank of New York Mellon, the DOJ sued the bank and one of its employees under FIRREA. Defendants allegedly schemed to defraud the bank’s custodial clients by misrepresenting that the bank provided "best execution" when pricing foreign exchange trades. The DOJ contended that the defendants' fraudulent scheme "affected" a federally insured financial institution—namely the bank itself—as well as a number of other federally insured financial institutions. The bank, on the other hand, contended that a federally insured financial institution may be "affected" by a fraud only if it were the victim of or an innocent bystander, but not if it were the perpetrator. 

The court disagreed, concluding that a federally insured financial institution could be "affected" by a fraud committed by its own employees, even though it may actually have profited from that fraud in the short run. The court reasoned that the fraud exposed the bank to a new or increased risk of loss, as shown by the fact that BNY Mellon had been named as a defendant in numerous private lawsuits as a result of its alleged fraud, which required it to incur litigation costs, exposed it to billions of dollars in potential liability, and damaged its business by causing a loss of clients, forcing BNY Mellon to adopt a less-profitable business model, and harming its reputation. 

Every fraud committed by bank employees could lead to such consequences; and because mail and wire fraud are very broad statutes that apply to virtually all fraudulent schemes, FIRREA has wide scope and potentially devastating impact. 

Other features of FIRREA also cause bankers to lose sleep. Although the DOJ has to prove that certain criminal statutes have been violated, the burden of proof is not “beyond a reasonable doubt” but, rather, only a “preponderance of the evidence.” The statute of limitations is ten years, which is important given that the five-year limitations period applicable to securities fraud and other statutes is expiring on many cases involving the 2008 financial meltdown. 

Finally, and most spectacularly, the potential penalties under FIRREA are astronomical. The statute authorizes penalties of up to $1.1 million per violation; for continuing violations, the maximum increases up to $1.1 million per day or $5.5 million per violation, whichever is less. That’s not much; but FIRREA allows the court to increase the penalty up to the amount of the pecuniary gain that any person derives from the violation, or the amount of pecuniary loss suffered by any person as a result of the violation. 

The DOJ has invoked this special penalty rule to seek more than $5 billion in civil money penalties in a current litigation involving fraud allegedly committed by the credit ratings agency Standard & Poors. 

The U.S. Attorney in Manhattan has now filed civil fraud actions against Wells Fargo, BNY Mellon and Bank of America, among others, and in October a jury found Bank of America liable. Finally, potential FIRREA liability reportedly has played a major role in convincing JPMorgan Chase to pony up $13 billion to settle with the DOJ.

A New Way to Curtail Class Actions?

ATTORNEY: MARK B. GOLDSTEIN
The Pomerantz Monitor, September/October 2013 

A recent decision by the Third Circuit has the potential to further restrain consumer and other types of class actions. Last August, in Carrera v. Bayer Corp., the Third Circuit reversed and remanded the certification of a class of Florida consumers who purchased Bayer's One–A–Day WeightSmart diet supplements. 

This was a potential class action by consumers claiming that Bayer falsely and deceptively advertised its supplement. When the District Court certified the class, Bayer appealed, arguing that class certification was improper because the class members were not “ascertainable”. This requirement means that “the class definition must be sufficiently definite so that it is administratively feasible to determine whether a particular person is a class member.” This is important because all class members have to be notified if a class has been certified or if a settlement has been reached, and because, if there is a recovery for the class, the court can determine who is entitled to share in it, and who isn’t. 

Here the class was to consist of everyone who purchased the supplement in Florida. Figuring out who these people are is no easy matter. In securities cases, for example, there are brokerage and other records identifying everyone who bought or owned a particular security at a particular time. Similarly, records are kept of everyone who purchases prescription drugs. But no one keeps a comprehensive list of everyone who buys consumer products like over the counter diet supplements. If such a list must exist in order to certify a class action, it will be a major roadblock in many cases. 

Plaintiffs here proposed that class members could be identified through retailers’ records of online sales and of sales made through store loyalty or reward cards. They also suggested that when class members file their individual proofs of claim to share in any recovery, they could submit affidavits attesting that they purchased WeightSmart and stating the amount they paid and the quantity purchased. 

The Third Circuit rejected those arguments, concluding that it could not know for certain whether retailers’ records would identify all or most of the class members. It also held that affidavits from people who claimed, without documentary proof, that they bought the product could be unreliable. 

It is too soon to know whether other Circuits will follow suit and adopt this standard for ascertainability. If they do that would be a problem. There are many products sold for which there is no comprehensive and authoritative source identifying all purchasers. In such cases, purchasers may have no feasible method for seeking recourse if defendants engage in deceptive or illegal conduct.

The Dust Starts to Settle After Halliburton

ATTORNEY:  MICHAEL J. WERNKE 
THE POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014

It has been a little over two months since the Supreme Court issued its decision in Halliburton Co. v. Erica P. John Fund, Inc., reaffirming the “fraud-on-the-market” presump­tion of class-wide reliance that makes most securities fraud class actions possible. Even in such a short period, we have seen significant developments in this area of the law.

In Halliburton, the Supreme Court declined to create a new requirement that the plaintiff, in order to invoke the fraud on the market presumption, had to demonstrate “price impact” at the class certification stage—i.e., that the misrepresentation actually affected the price of the stock. However, the Court did authorize defendants to try to defeat class certification by submitting “evidence showing that the alleged misrepresentation did not actually affect the stock’s market price.”

Since then, lower federal courts have begun interpreting Halliburton’s impact on current class certification stan­dards. In several cases the courts have concluded that it represents no fundamental change at all, particularly because even before Halliburton, many circuits had already permitted defendants to show the absence of price impact at the class certification stage.

More important are decisions of two courts that have addressed the question of whether Halliburton forecloses the so-called “price maintenance theory.” One textbook example of a fraud-on-the-market claim is that the defen­dant made misrepresentations that caused the market price of the company’s stock to move up, and that the price came back down only when the truth finally came out. In these cases the “price impact” occurred when the misleading financial information was first released.

The price maintenance theory, on the other hand, comes into play if the alleged fraud did not cause the price of the company’s stock to move up but, instead, prevented it from moving down. This can occur if the company falsely reports that its results are about the same as before, in line with market expectations, when in fact something bad has happened and the true results were really far worse.

Under this theory, the “price impact” of the fraud does not occur at the time of the misrepresentations, but only when the truth finally comes out and the price of the stock drops dramatically. If “price impact” is equated with price movement, and has to occur at the time of the misrepresentations, price maintenance cases – which are legion – will not qualify for the fraud on the market presumption.

The two courts that have ruled on this issue post-Halliburton have both concluded that price maintenance cases can qualify for the fraud on the market presumption. In a case involving Vivendi Universal, Judge Shira Scheindlin of the Southern District of New York denied the defendant’s request to make a renewed motion for judgment as a matter of law in light of Halliburton, reaffirming the continued viability of the price maintenance theory. The court emphasized that Halliburton made mention of how a plaintiff can prove price impact, but only discussed when a defendant can establish a lack of price impact.

Potentially even more important is a recent decision by the Eleventh Circuit in a case against Regions Financial, where the court also affirmed the continued validity of the price maintenance theory. The court rejected the defendant’s argument that a finding of fraud on the mar­ket always requires proof that the alleged misrepresenta­tions had an “immediate effect” on the stock price. In such situations, the court held, a plaintiff can satisfy the critical “cause and effect” requirement of market efficiency merely by identifying a negative price impact resulting from a corrective disclosure that later revealed the truth of the fraud to the market. The court explained that Halliburton “by no means holds that in every case in which such evidence is presented, the presumption will always be defeated.”

In upholding the price maintenance theory, the court in Regions reaffirmed that, under Halliburton, there is no sin­gle mandatory analytical framework for analyzing market efficiency, and district courts have flexibility to make the fact-intensive reliance inquiry on a case-by-case basis. This flexible approach to reliance is a boon to investors because plaintiffs may be able to use various tools to show an efficient market existed—even where there are a few number of traded shares, or where a company is not followed widely by analysts, or where the market is generally accepted to be inefficient.

Beyond its holding, the Eleventh Circuit’s decision can also be viewed optimistically by investors as potentially a first step in courts permitting plaintiffs to establish Basic’s presumption merely through evidence of a corrective disclosure’s price impact on a stock, rather than general market efficiency for the stock. In Halliburton, the Court rejected the “robust” view of market efficiency proposed by Halliburton. The Court emphasized that Basic’s presumption is based on the “fairly modest premise that market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices” and that the question of a market’s efficiency is not a yes/no “binary” question, but rather a spectrum analysis:

The markets for some securities are more efficient than the markets for others, and even a single market can pro­cess different kinds of information more or less efficiently, depending on how widely the information is disseminated and how easily it is understood. . . Basic recognized that market efficiency is a matter of degree. . .

In permitting defendants to present evidence of no price impact, the Court noted that market efficiency is merely indirect evidence of price impact, and defendants should be able to provide direct evidence of what plaintiffs seek to establish indirectly. Arguably, the door has now been opened for plaintiffs themselves to eschew the indirect method of market efficiency when there is clear evidence of price impact.

SEC Wrests Admissions in Settlement of Falcone Case

ATTORNEY: MURIELLE STEVEN WALSH
Pomerantz Monitor, September/October 2013 

The JPMorgan “London Whale” case is not the first time the SEC has insisted on admissions of wrongdoing as part of its settlement agreements. A few weeks earlier, for example, the SEC secured admissions as part of its settlement of charges against Hedge Fund manager Philip Falcone. 

The current push to insist on admissions of wrongdoing in these settlements can probably be traced to November of 2011, when Judge Rakoff of the Southern District New York famously rejected Citigroup’s $285 million settlement with the SEC, primarily because it did not contain any admission of wrongdoing by the bank. The judge found that the deal was "neither fair, nor reasonable, nor adequate, nor in the public interest." Judge Rakoff has been highly critical of settlements that allow defendants to neither “admit nor deny,” and has called them “a stew of confusion and hypocrisy unworthy of such a proud agency as the S.E.C.” 

Judge Rakoff was criticized as overstepping his bounds and challenging the authority of the SEC. Wall Street interests argued that admissions of wrongdoing in SEC settlements would encourage private investor litigation. Others pronounced that a requirement for admissions would make it difficult, if not impossible, for the SEC to settle cases. The Second Circuit is now reviewing whether, in fact, the court went too far. 

But regardless of the outcome of that appeal, Judge Rakoff’s opinion has had profound repercussions. When Mary Jo White was first appointed as the new SEC chair, she announced that henceforth the Commission would require admissions of wrongdoing as a condition to settlement in certain situations. 

Judge Rakoff’s colleague in the Southern District, Judge Marrero, recently approved a settlement between SAC Advisors and the SEC that also had no admissions of wrongdoing. However, he conditioned his approval on a finding by the Second Circuit in the Citigroup matter that district courts lack the authority to reject SEC settlements solely because of “admit or deny” policy. If the Second Circuit does not make such a finding, SAC will be back on the hook. 

The recent $18 million civil settlement between hedge-fund manager Philip Falcone and securities regulators is a case in point. Falcone and his hedge fund, Harbinger Capital Partners, had been accused of engaging in an illegal “short squeeze” to force short-sellers to sell distressed, high yield bonds at inflated prices, and favoring certain investors over others when granting redemption requests. An earlier agreement reached between Falcone and the SEC’s enforcement staff did not contain any admissions of wrongdoing. In a rare move, the SEC commissioners rejected the agreement and sent the parties back to the table. The new deal contains Falcon’s admissions of underlying facts of alleged improper behavior, specifically, that he had acted “recklessly” with regard to several market transactions. It does not, however, include admissions of specific securities law violations. Obviously, the facts can potentially be used as fodder in private litigation – in this case, an admission of reckless conduct has important ramifications for fraud claims. 

At the same time, Falcone won’t be limiting his legal options in other lawsuits that may follow on the heels of this settlement. As noted by James Cox, a law professor at Duke University School of Law, the admitted facts “may be helpful, but not perfectly helpful, to follow-on litigation."

Not So Fabulous After All

ATTORNEY: TAMAR A. WEINRIB
Pomerantz Monitor, September/October 2013 

In August, the SEC scored a much-needed win when a nine-member jury, after deliberating for two days, found Fabrice Tourre, a former Goldman Sachs bond trader once known as “Fabulous Fab,” liable on six of seven civil fraud charges. 

The SEC brought the action in 2010 against both Mr. Tourre and Goldman Sachs, accusing both of misleading investors about a complex mortgage-based financial product known as “Abacus 2007-AC1.” Abacus was a “collateralized debt obligation,” a financial vehicle based on a collection of underlying mortgage-related securities. Tourre played a major role in putting Abacus together; but he (and Goldman) allegedly failed to disclose to potential investors that hedge fund titan John Paulson, a key Goldman Sachs client, had also played a major role in selecting the securities underlying Abacus. Paulson’s involvement was critical because he himself made a huge bet against Abacus, selling millions of shares short, and made a killing when Abacus failed. In other words, the SEC claimed that Abacus was secretly designed to fail so that Paulson could make a killing at the expense of Goldman’s other clients. 

Goldman settled the SEC’s claims some time ago, agreeing to pay a $550 million fine, without admitting or denying wrongdoing. Abacus, and the large fine it generated, heavily damaged Goldman’s reputation, helping to earn it the sobriquet “great vampire squid.” 

Even after Goldman settled, Tourre fought on, and lost. Tellingly, his lawyers opted not to call any witnesses at trial, an interesting strategy which perhaps reflected the weakness of their case. The SEC called two witnesses, Laura Schwartz from the ACA Financial Guaranty Corporation, and Gail Kreitman, a former Goldman saleswoman, who testified that they were misled about who was investing in Abacus. Also key to Mr. Tourre’s downfall was a number of emails to his girlfriend, which he called “love letters,” in which he joked about selling toxic real estate bonds to “widows and orphans.” 

As of Monitor press time, Mr. Tourre was planning to ask the court at the end of September to either overturn his securities fraud verdict or grant a new jury trial. If the judge declines that request, the question will then become one of punishment. Mr. Tourre faces three potential remedies. First, the court can impose civil monetary penalties ranging from $5,000 to $130,000 for each violation. Second, the court can order that Mr. Tourre forfeit any profits he received from his violations, though it is unclear at this point what that would encompass. Third, Mr. Tourre could also face an administrative proceeding before the SEC, which could permanently bar him from any future association with the financial industry. One potential obstacle for the SEC in pursuing a bar, however, is that it obtained the power to do this when Congress passed the Dodd-Frank Act in 2010, three years after Mr. Tourre’s violations occurred. It is unclear whether the SEC’s authority to issue a bar applies retroactively. Given that Goldman continues to bankroll all of Mr. Tourre’s legal fees, it is likely he will appeal any bar order, challenging retroactivity, and continue to drag this case on further. 

Mr. Tourre is now enrolled in a doctoral economics program at the University of Chicago and seems to be gearing up for a future in academia. Other than damage to his reputation, which he has already incurred in spades, it is questionable whether a bar would make much of a difference. 

Meanwhile, the Tourre trial, though clearly a success for the SEC, has led many to question why the agency continues to pursue mid-level employees like Mr. Tourre while leaving the high-level executives unscathed. Mr. Tourre clearly did not commit these violations on his own.

Mergers Foreclose Derivative Litigation

ATTORNEY: SAMUEL J. ADAMS
Pomerantz Montitor, September/October 2013 

In a case involving the notorious Countrywide Corporation, with implications for derivative actions filed across the country, the Delaware Supreme Court, has declined to expand the circumstances under which a derivative action, brought on behalf of the injured corporation, can survive a merger of that corporation into another. Because mergers often happen while derivative suits are pending, and in fact are sometimes motivated by the directors’ desire to eliminate derivative claims against them, this decision will make it harder in many cases to hold directors of Delaware corporations accountable for their reckless mismanagement. 

As is well known, Countrywide played a major role in the financial crash of 2008, because it was probably the most prolific perpetrator of toxic mortgage securities. When the mortgage market imploded, Countrywide nearly collapsed and was sold under the gun to Bank of America (“B of A”) – the unlucky purchaser of last resort not only of Countrywide but also of equally ill-fated Merrill Lynch. If ever there were directors who deserved to be sued for destroying their company, the directors of Countrywide fit the bill. Yet, when they were sued by Countrywide shareholders, they claimed that the sale to B of A wiped out the plaintiffs’ claims. 

The directors were invoking the so-called “continuous ownership” rule, which says that in order to assert a derivative claim a plaintiff shareholder must have owned stock in the injured corporation continuously from the time of the alleged wrong until the resolution of the litigation. Should the corporation be sold in a cash-out merger before the litigation is resolved, the shareholder plaintiff would be divested of his holdings, and therefore his chain of continuous ownership would be broken. 

Here, plaintiffs sued the former directors of Countrywide in California federal court, claiming that they were responsible for allowing Countrywide to engage in a host of reckless and fraudulent mortgage practices. The District Court dismissed the derivative claims under the “continuing ownership” rule, holding that under Delaware law plaintiffs lost standing to pursue the derivative claims upon consummation of Countrywide’s Merger with B of A. Plaintiffs had argued that there was an exception to this rule in cases where it was the alleged wrongdoing that forced the company to enter into the merger in the first place. On appeal, the United States Court of Appeals for the Ninth Circuit asked the Delaware Supreme Court to consider, as a “certified question,” whether this exception actually existed and, if so, whether it applied here. The certified question was prompted, in part, by the fact that state and federal courts had reached divergent results in previous cases applying Delaware law in this situation. 

In a famous decision decades ago in Lewis v. Anderson, the Delaware Supreme Court recognized a “fraud exception” to the continuous ownership rule, allowing plaintiffs to litigate post-merger derivative claims “where the merger itself is the subject of a claim of fraud,” meaning that the merger served “no alternative valid business purpose” other than eliminating derivative claims. Although there is a very low threshold for finding a “valid business purpose” for a merger, it is a short step from this doctrine to the proposition that the exception should apply if the very fraud that was the subject of the derivative action also drove the corporation to enter into the merger. 

Arguing before the Delaware Supreme Court, plaintiffs, in a twist, urged the court to consider resolving the certified question by creating a new cause of action, which they referred to as a “quasi-derivative” claim. Defendants argued that there is “no need and no basis” to recognize an exception to the continuous ownership rule even where the conduct in question forced the company to merge with another company. 

The Delaware Supreme Court found in favor of defendants, holding that shareholders cannot pursue derivative claims against a corporation after a merger divests them of their ownership interest, even if a board's fraud effectively forced the corporation into the merger. However, the court was careful to note that shareholders who lose derivative standing in a merger may nonetheless have post-merger standing to recover damages from a direct fraud claim, should one be properly pleaded.

The Oxford Decision: the Silver Lining?

ATTORNEY: JENNIFER BANNER SOBERS
Pomerantz Monitor, July/August 2013 

Ten days before the American Express decision, the Supreme Court, in a case involving the Oxford health insurance company, unanimously affirmed an arbitrator’s decision to authorize class arbitration. He held that because the arbitration agreement stated that “all disputes” must be submitted to arbitration -- without specifically saying whether “all disputes” includes class actions -- nonetheless the agreement means that class action disputes can be arbitrated. 

This case was filed in court by a pediatrician in the Oxford “network” who alleged that Oxford failed to fully and promptly pay him and other physicians with similar Oxford contracts. The court granted Oxford’s demand that the case be arbitrated. The parties then agreed that the arbitrator should decide whether the contract authorized class arbitration. In finding that the contract did permit class arbitrations, the arbitrator focused on the language of the arbitration clause, which stated that “all” civil actions must be submitted to arbitration. Oxford tried to vacate the arbitrator’s decision, claiming that he exceeded his powers under the Federal Arbitration Act. The District Court denied the motion, and the Third Circuit affirmed. 

In agreeing with the lower courts, the Supreme Court held that when an arbitrator interprets an arbitration agreement, that determination must be upheld so long as he was really construing the contract. Whether this interpretation is correct is beside the point, as far as the courts are concerned. Judicial review of arbitrators’ decisions is far more constrained than the review of lower court decisions. 

This case may turn out to be the silver lining to the Supreme Court’s series of rulings curtailing class actions in arbitration. This decision will specifically benefit plaintiffs, including those, like the plaintiff here, whose claims lie in the health care arena. 

Moreover, the decision seems to narrow the effect of the court’s previous decision in 2010, which held that “silence” in an arbitration agreement usually means that the parties did not agree to arbitrate on a class-wide basis. To the extent that arbitrators in future cases interpret an agreement to arbitrate “all disputes” as including class-wide disputes, plaintiffs will be more likely in the future to have a realistic chance to have their claims resolved. That is, unless there is an explicit class action waiver. 

Many consumers are subject to arbitration agreements, including physicians who often have no choice but to accept such agreements if they want to be in-network providers for insurers. As Pomerantz and co-counsel argued in an amicus brief on behalf of the American Medical Association and the Medical Society of New Jersey in support of the pediatrician, without being able to arbitrate on a class-wide basis, physicians will have no effective means by which to enforce their contracts with insurers and challenge underpayments. The typical claim by a doctor against an insurer is relatively small. Prosecuting such small claims in individual arbitration is impossible, given that the cost of bringing an arbitration will almost always exceed the amount an individual doctor could potentially recover through arbitration. Moreover, individual arbitrations could not adequately address certain pervasive wrongful practices by insurers such as underpayment or delayed payment of claims and do not provide injunctive relief to stop such practices – a critical remedy sought in many class actions.

SEC Approves Use of Facebook and Twitter for Company Disclosures

Pomerantz Monitor, July/August 2013 

The Securities and Exchange Commission has issued a report that allows companies to use social media outlets like Facebook and Twitter to disclose material information as required by with SEC regulations, provided that investors are notified beforehand about which social media outlets the company will use to make such disclosures. In supporting the use of social media, the SEC stated that "an increasing number of public companies are using social media to communicate with their shareholders and the investing public. . .[w]e appreciate the value and prevalence of social media channels in contemporary market communications, and the commission supports companies seeking new ways to communicate." The new “guidance” is likely to change dramatically the way companies communicate with investors in the future. 

The SEC’s action actually began as an investigation into whether Netflix violated Regulation FD by disclosing financial information in the CEO’s personal Facebook page. Regulation FD requires companies to distribute material information in a manner reasonably designed to get that information out to the general public broadly and non-exclusively. It was designed to curtail preferential early access to information by institutions and other well-connected industry heavyweights. 

Netflix, as you may have heard, runs a service providing subscribers with online access to television programs and movies. In July of 2012, Netflix CEO Reed Hastings announced on his personal Facebook page that Netflix’s monthly online viewing had exceeded one billion hours for the first time. Netflix did not report this information to investors through a press release or Form 8-K filing, and a subsequent company press release later that day did not include this information either. The SEC claimed that neither Hastings nor Netflix had previously used his Facebook page to announce company financial information, and they had never before told investors that information about Netflix would be disseminated in Hastings’ personal Facebook page. The Facebook disclosure was nonetheless picked up by investors, and boosted the Netflix share price. 

In responding to the SEC investigation, Hastings contended that since his Facebook page was available to over 200,000 of his followers, he was in compliance with Regulation FD. The SEC ultimately refrained from bringing an enforcement action against Hastings or Netflix, stating in a press release that the rules around using social media for company disclosures had been unclear. 

Now the SEC has concluded that companies can comply with Regulation FD by using social media and other emerging means of communication, much the same way they can by making disclosures in their websites. The SEC had previously issued guidance in 2008, clarifying that websites can serve as an effective means for disseminating information to investors if they’ve been told to look there. The same caveat now applies to the use of social media. 

The SEC’s guidance brings corporate reporting into the social media age, where over one billion users of Facebook and 250 million on Twitter are sharing information. Indeed, a recent study suggests that while over 60% of companies will interact with customers using social media, very few use the medium to communicate business developments to investors. That could well be about to change dramatically.

Supreme Court Holds that “Pay-To-Delay” Deals Can Violate Antitrust Laws

ATTORNEY: ADAM G. KURTZ
Pomerantz Monitor, July/August 2013 

Last fall, we wrote about how brand name drug manufacturers have been paying large amounts of money to generic drug makers to induce them to delay bringing low-cost generic drugs to market. For years prior to this recent U.S. Supreme Court decision, many federal courts have refused to declare these pay-to-delay payments anti-competitive, or even subject them to the antitrust laws. 

On June 17, 2013, in a case involving the testosterone supplement Androgel, the U.S. Supreme Court handed healthcare consumers and union health and welfare funds a victory. Androgel, a treatment for low testosterone, had sales of $1 billion a year. It has no competition from generic alternatives. If there were generic competition, sales of the branded version would probably drop by 75% and its manufacturer, Solvay, would lose approximately $125 million in profits a year. To postpone generic competition, Solvay paid the generic company, Actavis, as much as $42 million a year to delay their competing generic version of Androgel until 2015. 

The Supreme Court ruled, 5-3, that such pay-to-delay deals are, in fact, subject to the antitrust laws. This is truly a big win, given the amount of healthcare costs involved. There were 40 such deals this past year alone, and they cost American consumers $3.5 billion a year in higher drug costs. The Androgel decision may not end pay-for-delay deals, but they will now be subject to the antitrust scrutiny. 

The legal arguments addressed by the Supreme Court were complicated and involved a clash between the antitrust and patent laws. On the one hand, the antitrust laws state that two competing companies cannot agree that one of them will stay out of the market. That is, the branded and generic company cannot agree to keep drug prices high by delaying introduction of a generic drug into the market. 

On the other hand, the patent laws give a company with a valid patent the right to exclude a competitor with a product that violates the patent. That is, a branded company can exclude a generic drug as long as the branded company had a valid patent. Pay-to-delay deals are part of a settlement in a patent infringement lawsuit, brought by the brand name manufacturer, alleging that the generic drug maker is violating the brand name patent. Settlements are generally encouraged as a good thing. 

In the end, the Supreme Court chose antitrust law over patent law and healthcare consumers over pharmaceutical companies in holding that, settlement or not, these deals can be struck down if they violate the antitrust laws. 

For years, Pomerantz – on behalf of health care consumers – and the Federal Trade Commission (“FTC”) have been fighting against pay-to-delay deals, arguing that they are anti-competitive and violate the antitrust laws. In fact, Pomerantz is co-lead counsel, on behalf of a putative end-payor class, in the companion case to the recently decided U.S. Supreme Court case, which is currently pending in the Northern District of Georgia. Now that the Supreme Court has agreed that pay-to-delay deals are not immune from the antitrust laws, Pomerantz will continue to represent vigorously our union health and welfare fund clients who end up paying unlawful supra-competitive prices for branded drugs as a result of these deals.

Appeals Court Grants Bail to Two Convicted of Insider Trading

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, July/August 2013 

Although it has had mixed results, at best, in cases related to the financial crisis of 2008, the government has done quite well in pursuing claims of criminal insider trading. For example, the U.S. Attorney in Manhattan has filed criminal charges against 81 defendants since he took office in 2009, and convicted 73 of them. Among them is former Galleon hedge fund boss Raj Rajaratnam, whose conviction and lengthy sentence were upheld by the Second Circuit in June. 

Insider trading may sound simple, but it isn’t. The federal courts have been struggling for decades to decide what inside information is, who may trade on it, and who can’t. If an investor or analyst calls someone up to ask how his company is doing, that can be legitimate information gathering, or it can be a violation. It all depends. 

One well-established element of an insider trading violation is that the tippee must know that the information is being disclosed in violation of the insider’s fiduciary duty. In one famous case, for example, someone disclosed that the company had received a takeover offer that had not yet been publicly disclosed. That kind of information is vital to the company; people working for the company cannot divulge it without breaching their fiduciary duties.

More recently, though, courts have been struggling with the question of whether the tippee also has to know that the person disclosing the information (the “tipper”) is receiving a “personal benefit” for disclosing it. If the tippee does know this, the Supreme Court held 30 years ago that he is liable; but the question now is, does the tippee have to know this in order to be liable? If the tippee is not paying for this information, he or she may not be aware that the tipper will benefit from the disclosure in some other way. 

This issue is coming to a head in a case now pending in the Second Circuit, which is hearing an appeal of an insider trading conviction involving two hedge fund managers. They did not pay for the information, and maintain that they did not know that the insiders were profiting from their disclosures in other ways. The trial court did not believe that this was a required element of the crime, and refused to instruct the jury on it. Defendants appealed on that issue. Defendants asked that they be granted bail pending their appeal. The trial court denied it, but the defendants appealed that decision as well. 

In late June, the Second Circuit granted their bail request. This has sent tongues wagging, because it may mean that the court is about to overturn the convictions and impose a “personal benefit” knowledge requirement for insider trading claims. 

This is happening just as the government is zeroing in on the biggest fish in the insider trading pond, Steve Cohen of SAC Capital Advisors. Several of his underlings have already pleaded guilty to insider trading charges, and SAC recently paid more than $600 million in a “no admit, no deny” settlement of insider trading charges with the SEC. Yet somehow, Cohen authorized this hefty settlement without obtaining an agreement from the feds that they would not seek additional punishments or remedies against either himself or the company. 

Perhaps he thought that, because it may be next to impossible for the feds to prove beyond a reasonable doubt that he had personal knowledge of the tippers’ motivation for revealing insider information, the would not pursue criminal charges against him. In this respect he is probably right. With the five year statute of limitations bearing down, the feds have reportedly given up on the idea of prosecuting Cohen on criminal charges. 

But he is not exactly getting a free pass. On July 19 the SEC brought an administrative action against him, seeking to bar him from the securities industry for life. The complaint alleges that Cohen ignored “red flags” of illegal insider trading by employees and allowed it to go on, violating his duty to supervise. 

And then, just before our press time, the feds announced that SAC Capital has been indicted. When and if that happens, it is all over. On Wall Street, an indictment is a death sentence.

SEC Weighs Companies' Disclosures of Their Political Expenditures

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, May/June 2013 

In the wake of the Supreme Court’s decision in Citizens United, a gusher of so-called “independent” spending by private groups and organizations flooded into the last election cycle, with much of it coming from corporations. 

In its decision, the Court assumed that any adverse effects of corporate or union cash entering politics could be ameliorated by public disclosure of where the money came from; and in August of 2011, a petition signed by two law professors was submitted to the SEC, asking it to adopt a rule requiring such disclosures. 

The petition has been publicly supported by the AFL-CIO; Public Citizens; the Corporate Reform Coalition, and some Democratic members of Congress. It has generated over half a million comments, the most the SEC has ever received on any proposed rule, and most of them reportedly want the SEC to act. 

But opponents are pushing back. Republicans have lined up against it, to the point of submitting a House bill seeking to prevent the SEC from adopting any disclosure rule. 

So far, the two SEC commissioners appointed by Democrats have come out publicly in support of such a rule, and the two appointed by Republicans have come out against. Mary Joe White, recently confirmed as the new SEC Chairman, has not yet taken a public position. Although the issue was on the Commission’s April agenda, no decision had been made as of Monitor press time. 

The business community, by and large, wants no part of such a rule, fearing that disclosure might provoke a backlash from interest groups, customers, shareholders, or even from the politicians they are targeting. Another possible motivation is the desire to disguise the underlying agendas of those advancing particular political positions. Voters are likely to react differently to an ad that ostensibly comes from an independent group they never heard of, rather than from a group that they know is heavily financed by corporate interests with a particular axe to grind. 

It might be in a company’s interest for its involvement in political activities to remain hidden, but the public at large may have an even greater interest in knowing who is really responsible for the political speech to which they are being subjected. Perhaps the Federal Election Commission would, in theory, be the more logical place to hash this out. But that agency is moribund, permanently paralyzed by partisan gridlock. 

Currently, companies don’t have to disclose their political expenditures unless the amounts involved are “material.” But in this context, “materiality” is in the eye of the beholder. Even if the amount contributed is not that significant compared to a corporation’s overall expenditures, it could be considered important by many investors depending on what candidate, or what issue, is being targeted. Moreover, amounts that are immaterial to a giant company like Apple or Exxon might have a huge impact in a political campaign. As huge as political expenditures have become by historical standards, they are still dwarfed by the amounts spent by businesses for other things. 

Typically, corporations make political expenditures by contributing to advocacy groups. The petitioners to the SEC estimate that about $1.5 billion in corporate cash has been funneled through such groups over the last five years. Some groups, such as political action committees, are required to disclose their contributors; but others, such as so-called 501(c)(4) groups, don’t. Increasingly, that is where the corporate cash is going: these groups spent hundreds of millions of dollars in the last election cycle, without disclosing where any of it came from. 

If the SEC staff proposes a rule, yet another political donnybrook is certain to follow, after which will be the inevitable court case. The Court of Appeals for D.C., which reviews challenges to agency rules, has become increasingly aggressive in blocking agency rules it doesn’t like, often demanding “cost benefit” analyses. 

We should hear something any day now. 

Reportedly, most of the candidates and issues promoted by the heaviest “independent” expenditures did not do well last time around. But there is no guaranty that secret money won’t swing elections sooner or later.

Private Equity Firms Fail to Get Antitrust Case Dismissed

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, May/June 2013 

Five years ago, investors sued 11 of the world’s largest private equity firms, including Kohlberg Kravis, TPG, Bain Capital, Apollo Capital Management and Goldman Sachs, on the grounds that defendants violated the antitrust laws by rigging the market for more than two dozen multibillion-dollar acquisitions of public companies, depriving those companies’ shareholders of billions of dollars they might have received in a true competitive bidding process. They claim that defendants had a gentlemen’s agreement not to outbid each other to acquire these companies. Defendants had tried nearly a dozen times in four years to get the suit tossed, with no luck. 

They were only partially successful this time. A federal judge in Boston has now refused to grant summary judgment dismissing the entire action. He narrowed the case significantly, however, dismissing all claims relating to 19 of the 27 deals that were targeted in the actions; and he dismissed JPMorgan Chase completely from the case. Nevertheless, he concluded that there was enough evidence of at least some collusion on eight of the deals among the rest of the defendants to take the case to trial. 

At the center of the case are “club deals,” acquisitions made by members of this “club” of private equity firms. Plaintiffs allege that there was a secret quid pro quo arrangement: If you don’t bid on my deal, I won’t bid on yours. 

In his summary judgment decision, Judge Harrington concluded that there was no grand conspiracy across all the 27 deals, but rather “a kaleidoscope of interactions among an ever-rotating, overlapping cast of defendants as they reacted to the spontaneous events of the market.” Yet he decided that there was enough evidence to sustain claims relating to 8 of the deals. 

As happens so often in litigation in the internet era, emails played a decisive role in this decision. Among them were comments from unnamed executives at Goldman Sachs and TPG in reference to the $17.6 billion takeover of Freescale Semiconductor by a consortium led by the Blackstone Group and the Carlyle Group. The Goldman executive said that no one sought to outbid the winning group because “club etiquette” prevailed. “The term ‘club etiquette’ denotes an accepted code of conduct between the defendants,” the judge wrote. “The court holds that this evidence tends to exclude the possibility of independent action.” 

Another email, from a TPG official said, “No one in private equity ever jumps an announced deal.” The judge also pointed to an e-mail sent by the president of Blackstone to his colleagues just after the Freescale deal was announced. “Henry Kravis [the co-founder of K.K.R .] just called to say congratulations and that they were standing down because he had told me before they would not jump a signed deal of ours.” 

The court singled out the $32.1 billion buyout of the hospital chain HCA as particularly problematic. K.K.R. expressly asked its competitors to “step down on HCA” and not bid for the company, according to an e-mail written by a then partner at Carlyle who is now the CEO of General Motors. One e-mail from Neil Simpkins of Blackstone Group to colleague Joseph Baratta said, “The reason we didn’t go forward [with a rival HCA bid] was basically a decision on not jumping someone else’s deal.” Baratta said, “I think the deal represents good value and it is a shame we let KKR get away with highway robbery, but understand decision.” 

KKR’s $1.2 billion investment in HCA has nearly doubled in value to $2 billion in four years.

Doing Well While Doing Good in Delaware

ATTORNEY: GUSTAVO F. BRUCKNER
Pomerantz Monitor, May/June 2013 

On April 18, 2013, Delaware Governor Jack Markell introduced legislation enabling the formation of public benefit corporations. Because Delaware is already the legal home of more than one million businesses, including many of the nation’s largest publicly traded corporations, this legislation, if adopted, has the potential to radically transform the corporate landscape. 

Public benefit corporations are socially conscious for-profit corporations. While not new, until recently most public benefit corporations were established by government, not the private sector. Social entrepreneurs, a growing sector of the economy, argue that the current system, with corporations focusing only on profits, almost assures a negative outcome for society. They have been pushing the corporate focus towards pursuit of a “triple bottom line” of people, planet and profits, with the mantra “doing well while doing good.” Shareholders who value socially responsibility seek to invest in companies that are serious about sustainability, and such companies want to differentiate themselves from competitors. While it may come as no surprise that California and Vermont allow for creation of public benefit corporations, so do Illinois, New York, and South Carolina. 

Some states have “constituency statutes” that explicitly allow corporate directors and officers to consider interests other than those strictly related to maximizing value for shareholders, including the interests of the community. Nearly a third of constituency statutes apply only in the takeover context, allowing directors to consider interests of employees, for example, in deciding how to respond to a takeover offer. On the other hand, directors of a public benefit corporation have an affirmative obligation to promote a specified public benefit. 

The proposed legislation identifies a public benefit as a positive effect, or a reduction of negative effects, on people, entities, communities or other non-stockholder interests. Such effects could include, but are not limited to, effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, and scientific or technological nature. 

Directors of a public benefit corporation would have to balance the financial interests of stockholders with the best interests of those affected by the corporation’s conduct, as well as the specific public benefits identified by the corporation. 

If enacted, the legislation will take effect on August 1, 2013.

Court Hears Argument in BP Case

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, May/June 2013 

As we have previously discussed in these pages, Pomerantz is currently representing several U.S. and foreign institutional investors seeking to recover investment losses caused by BP’s fraudulent statements issued prior to, and after, the April 20, 2010 Deepwater Horizon oil spill. Although the Supreme Court’s decision in Morrison v. National Australia Bank, Ltd. prevents investors from pursuing federal securities fraud claims for their BP common stock losses (because those shares traded on the London Stock Exchange), we are arguing that Texas state common law fills this enforcement void. 

On May 10, 2013, Judge Keith Ellison of the United States District Court for the Southern District of Texas held oral argument on BP’s motion to dismiss our claims. 

As we expected, much of the argument focused on the Dormant Commerce Clause, a Supreme Court doctrine which says that state statutes or regulations may not “clearly discriminates against interstate commerce in favor of intrastate commerce”; “impose a burden on interstate commerce incommensurate with the local benefits secured;” or “have the practical effect of ‘extraterritorial’ control of commerce occurring entirely outside the boundaries of the state in question.” BP argued that this doctrine prevented Texas state common law from reaching BP’s misconduct. In response, we pointed out that the doctrine did not apply to common law claims and that those claims targeted BP’s misstatements, not the underlying securities transactions on the London Stock Exchange. We also advanced a variety of policy-based arguments in support of our position. 

Although it is impossible to predict how the Court will come out on this issue, we believe that the oral argument advanced our cause. We expect the Court to issue a decision on the motion in the next few months.

Walking Dead Directors

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, May/June 2013 

Did you know that forty-one directors who last year failed to receive the votes of 50% of the shareholders, are still serving as directors? At Cablevision, for example, three directors are still sitting there even though they lost shareholder elections twice in the past three years, and were renominated in 2013. Two directors of Chesapeake Energy in Oklahoma, V. Burns Hargis, president of Oklahoma State University, and Richard K. Davidson, the former chief executive of Union Pacific, were opposed by more than 70 percent of the shareholders in 2012. Chesapeake requires directors receiving less than majority support to tender their resignations, which they did. The company said it would “review the resignations in due course.” The company refused to accept one of the resignations but, mercifully, they both left. Other cases where this has occurred, according to Institutional Shareholder Services, include Loral Space and Communications, Mentor Graphics, Boston Beer Company and Vornado Realty Trust. 

Our favorite story, though, involves Iris International, a medical diagnostics company based in Chatsworth, Calif. There, shareholders rejected all nine directors in May 2011. They all submitted their resignations, but then voted not to accept their own resignations. The nine stayed on the board until the company was acquired the following year. 

Many of these cases involve companies that do not require directors to receive a 50% majority vote to win election to the board.

Securities Fraud Cases Involving Foreign Companies Shift From Federal Courts

Pomerantz Monitor, March/April 2012  
by Robert J. Axelrod and Marc I. Gross

Two years ago, in the wake of the Supreme Court’s decision in Morrison concerning the extraterritorial application of United States securities laws, we noted that most legal commentators predicted a major decline in securities litigation. In that case the Supreme Court created a bright line rule that lawsuits alleging securities fraud involving companies whose securities were traded on a non-U.S. exchange could not be brought under U.S. law. This ruling extended even to cases where the conduct at issue – such as the alleged fraudulent misrepresentations – actually took place at a company’s U.S. headquarters.
 
Of course, many institutional investors routinely purchase securities on many different exchanges throughout the world. When a company whose stock trades on a non-U.S. exchange engages in securities fraud, are investors who purchased those securities outside the United States simply out of luck?
 
Class Cases Filed in Foreign Courts
The answer is decidedly “no.” Since the Supreme Court decided Morrison, we have seen an increase in securities actions brought in jurisdictions outside the United States. Some of these are class actions, or actions similar to U.S.-based class actions. Others are individual securities actions.
 
For example, there are by our count more than two dozen active securities class actions pending in Canada. A recent report by the consulting firm National Economic Research Associates confirms that last year alone, 15 securities class actions were filed there, the most ever. Similar actions are also pending in the Netherlands, Germany, and Israel. New laws allowing class actions were passed in Mexico, and England also allows “group actions,” which can be pursued on a representative basis, just like class actions.
 
A good example of the migration of securities fraud class actions is the action against Fortis, a financial services company based in Belgium. The plaintiffs in that action – some of the largest European pension funds, which purchased their Fortis securities on a foreign exchange – initially brought a class action in the U.S., but their case was dismissed by a U.S. court under Morrison. A year later they brought their case, which mirrors the allegations of the U.S. action, in a Dutch court.
 
There are a number of differences in the procedural and substantive law in these foreign jurisdictions, of course, including how damages may be calculated, whether attorneys fees can be shifted to the losing party, the rules for defining and certifying a class, and (particularly in the case of Canada) whether, as in the U.S., discovery is going to be held up until a motion to dismiss is decided. Whether it may be worthwhile to bring a securities fraud action in a foreign jurisdiction, whether the action should see certification of a class of all similarly situated investors or be brought as an individual action, and how to litigate and win whichever action is brought, are critical questions investors should ask their securities counsel. That counsel must also have relationships with the few securities practitioners in other countries who represent plaintiffs, rather than corporate clients, and who may be willing to forego hourly fees in favor of the contingent fee structure utilized by many U.S. based securities firms who represent institutional investors.
 
Individual Cases Under State Law
 
Morrison made clear that class actions for recovery of fraud related to damages arising from purchases abroad cannot be pursued under the federal securities laws. In so doing, the Supreme Court relied principally on the text of the 1934 Exchange Act. However, there is no such textual limitation for fraud claims arising under state statutory and common law. Thus, to the extent that a domestic investor purchased shares on a foreign exchange, and relied upon materials disseminated in the U.S., the injury arose in the U.S. at the place where the purchaser was misled -- not where the trade was executed. Thus, the case could be brought under the state law where the purchaser resided.
 
By the same token, if wrongdoing that contributed to the fraud occurred in a particular state (e.g., improper accounting for revenues by a U.S. subsidiary), that state should have an interest in protecting all persons injured by the misconduct, regardless of where they reside or purchased the shares. Under this rationale, even foreign investors could bring claims under the laws of the state where the subsidiary of the corporation was domiciled. These cases must be brought individually, not on a class basis, in order to avoid the federal statutory preemption of securities fraud class actions under SLUSA. There will likely be forum-non conveniens hurdles as well, but these obstacles should be minimal if class actions are otherwise pending for those who purchased ADRs of the same company on U.S. exchanges.

Delaware Takes On “Don’t Ask, Don’t Waive” Provisions

ATTORNEY: OFER GANOT
Pomerantz Monitor, March/April 2013 

In a previous issue of the Monitor, we discussed the relatively new concept in mergers and acquisitions of “don’t ask, don’t waive” provisions in standstill agreements between companies and potential acquirers. Under the law of Delaware and other states, the acceptance of a merger proposal by the target does not end the bidding process: directors must be free to consider better proposals that may come in after the merger agreement is signed, but before it is approved by shareholders. Bidders try to limit this risk by demanding “no solicitation” provisions in the merger agreement, preventing the target company from actively soliciting “topping” bids. 

However, coupling the no solicitation provisions with the don’t ask, don’t waive provisions essentially locks up the deal from all angles. Don’t ask, don’t waive provisions, set in advance of the actual bidding process, prevent bidders from increasing their bid for the target company – unless specifically invited to do so by the target’s board of directors – and from asking the target board to waive the prohibition. If losing bidders can’t make a topping bid for the target, nor ask its board to allow them to do so, and if the target can’t solicit or even consider post-merger-agreement bids, the deal is effectively locked up once the merger agreement is signed. In such a case, even if the merger agreement provides a grossly inadequate price, a court will be reluctant to enjoin its consummation for fear of killing the only offer that is actually on the table. 

Although in don’t ask, don’t waive situations the target can still consider unsolicited bids from bidders that were not part of the original bidding process and therefore never signed such standstill agreements, that doesn’t happen often. As we noted in our previous article, in the Delaware Court of Chancery’s recent ruling in the Celera Corporation litigation, Vice Chancellor Parson cast doubt on the legality of the combination of no solicitation and don’t ask, don’t waive provisions. “Taken together,” he said, these devices “are more problematic,” and that “[p]laintiffs have at least a colorable argument that these constraints collectively operate to ensure an informational vacuum” as to the best price reasonably available for the company, and that “[c]ontracting into such a state conceivably could constitute a breach of fiduciary duty.” 

In two more recent decisions, the Delaware Court of Chancery revisited this issue and reached different conclusions. In Complete Genomics, Vice Chancellor Laster echoed Judge Parsons, explaining that “by agreeing to this [“don’t ask, don’t waive”] provision, the Genomics board impermissibly limited its ongoing statutory and fiduciary obligations to properly evaluate a competing offer, disclose material information and make a meaningful merger recommendation to its stockholders.” The Court then enjoined the merger pending certain corrective disclosures and prevented the company from enforcing the standstill agreement with a certain bidder that contained this “don't ask, don't waive” provision, allowing it, if it chooses to do so, to make a topping bid. 

Three weeks later, in Ancestry.com, Chancellor Strine expressed a different view, holding that “don't ask, don't waive” provisions may actually be consistent with directors’ fiduciary duties to maximize shareholder value. Chancellor Strine stated that he was not “prepared to rule out that [the “don't ask, don't waive” provisions] can't be used for value-maximizing purposes” as long as the purpose allows the “well-motivated seller to use it as a gavel” as part of a meaningful sale process. According to the Court, if the “don’t ask, don’t waive” provisions are assigned to the winner of an auction process, allowing the winner to decide whether to let the losing bidders make a topping bid (highly unlikely), rather than left in the hands of target’s board, the Court was “willing to indulge that could be a way to make it as real an auction as you can.” 

If, on the other hand, the target’s board has the power to waive these provisions, and chooses not to waive them after signing a merger agreement with a buyer, there is “no reason to give any bid-raising credit” to this mechanism, “it has to be used with great care,” and the board has to disclose to its shareholders the fact that it continues to preclude certain potential bidders from making a superior bid for the company. Chancellor Strine cautioned board members employing don't ask, don't waive provisions to remain informed about the provisions’ potency, suggesting that a “nanosecond” after a definitive acquisition agreement was signed, he would have notified all parties subject to the provisions that they are waived, allowing them to make a superior offer. 

The court ultimately enjoined the deal at issue because the board did not disclose that certain bidders were foreclosed by a “don't ask, don't waive” provision, emphasizing that shareholders must be made aware of these provisions' effect if the provisions are to be used. 

The facts in Ancestry.com differed from those in Complete Genome, among other things, because the “don’t ask, don’t waive” provisions were already waived by the time Chancellor Strine had to rule on the issue. Would he, too, have enjoined such standstill agreements following the announcement of a merger -- as was the case in Complete Genome? That remains to be seen.

Second Circuit Hears Appeal of Citigroup Settlement Rejection

ATTORNEY: LOUIS C. LUDWIG
Pomerantz Monitor, March/April 2013 

In a decision heard around the world – or at least around Wall Street – in December of 2011, Federal District Judge Jed S. Rakoff famously rejected a settlement between the SEC and Citigroup. The SEC claims that, during the waning days of the housing bubble, Citi misrepresented facts when it sold investors over $1 billion of risky mortgage bonds that it allegedly knew would decline in value. Investors allegedly lost about $600 million on this deal. The same day the SEC filed its complaint, in October, 2011, it also filed a proposed “consent judgment”, a settlement agreement resolving those claims. The proposed deal called for $160 million in disgorgement (of fees and profits made by Citi on the deal), plus $30 million in interest and a civil penalty of $95 million. The settlement agreement did not require Citi to admit to any wrongdoing, allowing it to “neither admit nor deny” the charges, a staple provision of government settlement agreements. In addition to the financial penalties, the settlement would permanently restrain and enjoin Citigroup from future securities laws violations and would impose court-supervised “internal measures” designed to prevent recurrence of the type of securities fraud that (allegedly) occurred here. 

In deciding whether to approve a settlement between agencies and private parties, courts typically defer to the judgment of a federal agency, and rejections of settlements are rare. But Judge Rakoff is an exception to this rule: he is no rubber stamp for SEC settlements, and has used settlements to express his disdain for the SEC’s efforts to police the securities industry. Two years earlier, in 2009, he rejected a settlement between the SEC and Bank of America. 

In his decision in the Citi case, announced on November 28, 2011, Judge Rakoff did it again. He did not accept the “no admit, no deny” provision, and held that the settlement failed to provide the court with enough facts relating to the merits of the case “upon which to exercise even a modest degree of independent judgment.” He also noted that “there is an overriding public interest in knowing the truth,” and the reminded the SEC that it “has a duty ... to see that the truth emerges.” These comments leave the distinct impression that the judge was looking for a more or less definitive resolution of the allegations against Citi, as a price of a settlement. The opinion also rejected the $285 million in financial penalties, deriding it as mere “pocket change” for a bank Citi’s size, a penalty that would not deter future misconduct. 

The ruling has roiled the securities bar, to say the least. Any across-the-board requirement that defendants admit wrongdoing, or that the “truth” be established in order to settle a case, would make many cases almost impossible to settle. Such admissions or determinations could then be used by investors to recover even more in private lawsuits. Some have argued that, forced to try almost every case, federal agencies would be overwhelmed and the wheels of justice would come to a grinding halt. 

Others (the author included) have viewed the ruling as a long-overdue comeuppance to an agency that has not done enough to punish the miscreants who precipitated the financial crisis. The penalties imposed by the settlement would have no chance at all of reining in Citi’s bad behavior. 

Both the SEC and Citi appealed Judge Rakoff’s ruling to the Second Circuit. In his October 2011 ruling, Judge Rakoff had directed the parties to be ready for trial on July 16, 2012. On December 27, 2011, the SEC, joined by Citigroup, asked him to stay all proceedings, including the upcoming trial, pending determination of their appeals. When he denied the motions, Citi and the SEC appealed that decision as well; and in March 2012, the Second Circuit not only granted the stay, it expedited the appeals, chiding Judge Rakoff: “The district court believed it was a bad policy, which disserved the public interest, for the S.E.C. to allow Citigroup to settle on terms that did not establish its liability. It is not, however, the proper function of federal courts to dictate policy to executive administrative agencies[.]” 

In August, 2012, at the court’s direction, an attorney for Judge Rakoff filed a brief with the Second Circuit on his behalf, contending that he had never sought definitive proof of wrongdoing or an admission of Citigroup’s “liability” (as the court of appeals put it) but simply wanted to see some evidence before rendering a decision on a proposed settlement allegedly backed up by that same evidence. 

On February 8, 2013, the Second Circuit heard final argument on the merits, and comments from the judges seemed to confirm the impression that the Court intends to approve the settlement. The SEC – clearly emboldened by the first ruling in its favor – characterized the lower court’s ruling as being at odds with a century of judicial practice. Federal agencies’ decisions to settle cases, the SEC said, have historically been entitled to – and received – great deference. Citigroup agreed, arguing that, with respect to federal agencies, “the scope of a court’s authority to second-guess an agency’s discretionary and policy-based decision to settle is at best minimal.” At one point Judge Raymond Lohier “asked about deference and why an Article III judge would question the judgment of an executive agency that presumably reached its decision based on a sound review of the evidence.” When Judge Rakoff’s lawyer responded that the SEC was entitled to deference – but only to the point that they are wrong – his comment did not go over well. 

This appeal has thus largely turned into a referendum on how much deference a trial court should give to an agency proposing a settlement, and the extent to which the trial court can and should do its own review of the underlying evidence in the case, to test whether the agency has abused its discretion. 

Judge Rakoff’s ruling has spurred some federal judges elsewhere to demand more information before signing off on settlements brokered by the SEC and other government agencies, and even to question whether the “neither admit nor deny” clause is appropriate. And in the wake of Judge Rakoff’s ruling the SEC itself announced that it would no longer allow defendants to “neither admit nor deny” civil fraud or insider trading charges when, at the same time, they admit to or have been convicted of criminal violations. While this policy shift would have no impact on the Citigroup case – which lacked accompanying criminal charges – observers, including Edward Wyatt, writing in The New York Times, immediately noted a connection to Rakoff’s decision, which was then less than two months old. 

While the appeal was pending, Judge Rakoff presided over a jury trial of the agency’s claims against former Citigroup executive Brian Stoker in connection with in the same transaction that sparked the SEC’s initial complaint against Citi. After a full trial on the merits of these claims, the jury cleared Stoker of all wrongdoing. At this point, Judge Rakoff had more than enough information to evaluate the SEC’s settlement with Citigroup. By then, however, the significance of the case had moved well beyond the settlement itself to the role the courts are going to play in evaluating settlements proposed by the SEC and other agencies. 

The one silver lining here should be the existence – and persistence – of a vigorous plaintiff’s bar championing the rights of defrauded investors. Despite roadblocks like the Private Securities Litigation Reform Act of 1995 (devised as a “filter” to “screen out lawsuits”), the private shareholder class action remains investors’ – and the public’s – best hope of curtailing the financial sector’s worst excesses. The Supreme Court’s recent decision in Amgen v. Connecticut Retirement Plans bodes well for the future ability of investors to pool their limited resources to seek results the federally-designated “watchdogs” at the SEC appear either unwilling or unable to attain, a situation not likely to improve through the proposed handcuffing of the very courts meant to mete out justice.

Amgen Decision Favorable for Institutional Investors

ATTORNEY: MATTHEW L. TUCCILLO
Pomerantz Monitor, March/Apri 2013 

In order for a court to certify a case as a class action, it must usually determine that common questions “predominate” over questions that affect only individual class members. In securities fraud actions, plaintiffs must show, among other things, that investor “reliance” on defendants’ misrepresentations can be established on a class-wide basis. Otherwise, individual questions of reliance will “predominate”. 

A quarter century ago, in the landmark decision Basic v. Levinson, the Supreme Court adopted the so-called “fraud on the market” theory to address this problem. According to this theory, if the subject company’s stock trades on an “efficient market” (e.g. the NYSE), a court can presume that the market price of that company’s stock reflects all available information, including the facts misrepresented by the defendants. All investors presumably relied on the market price in buying their shares, reliance on the fraudulent statements can be established, indirectly, on a class-wide basis. The Basic decision held that the fraud on the market presumption was rebuttable by the defendant, but until recently that was interpreted to mean rebuttable at trial, not at the class certification stage. 

As the stakes have risen dramatically in securities fraud litigation, big corporations have been trying to find ways to make it more difficult for courts to certify class actions, since their settlement leverage drops precipitously once a class is certified. In the past few years they have been arguing that classes should not be certified unless plaintiffs can actually prove, and not merely allege, at the class certification stage that common questions will be established in their favor. For example, some defendants have argued that plaintiffs should have to prove, at a hearing, that the fraud actually caused investor losses on a class wide basis (“loss causation”). Such arguments would turn a class certification procedure into a “mini trial” on issues relating to the merits of the case, which would have to be re-litigated at trial. Last year, in Halliburton, the Supreme Court rejected the argument that loss causation should have to be proven at the class certification stage. 

Now, in Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds, the Supreme Court has rejected attempts to force a mini-trial on the fraud on the market contention at the class certification stage. Specifically, Amgen had argued that plaintiff should be required to prove, and not merely allege, that the fraudulent misrepresentations were material enough to affect the market price of its stock, and that it should be given a chance to rebut the basic presumption that the market price actually was affected by the fraud. If the fraud did not affect the market price, Amgen argued, plaintiff could never establish on a class-wide basis that the entire class relied on the fraudulent representations in buying their shares. Individual issues would predominate, so the argument went, making class certification inappropriate. 

In a victory for investors, the Supreme Court rejected Amgen’s arguments, holding that all a securities fraud plaintiff has to do -- at the class certification stage -- is plausibly allege facts showing that the fraud was material; and that defendants cannot attempt to rebut the fraud-on-the-market presumption at that stage in the case. 

Writing for a 6-3 majority that included Chief Justice Roberts and Justices Breyer, Alito, Kagan, and Sotomayor, Justice Ginsberg’s opinion holds that proof of materiality is not a class certification prerequisite. The question of whether fraudulent statements are material is provable (or not) through objective evidence common to all investors. Thus, even if defendants prevail on this issue at trial, they will do so in a manner that is common to the entire class, and as such, materiality is a common question to all class members. Moreover, if at trial the plaintiff failed to prove the common question of materiality, the result would not be a predominance of individual questions, but rather, the end of the litigation, because materiality is an essential element of each class member’s securities fraud claim. In that sense, the entire class lives or dies based on the common resolution of the question. 

In so holding, the majority rejected Amgen’s argument that materiality should be treated like certain other fraud on the market prerequisites (e.g., that the misrepresentations were public, that the market was efficient, and that the transaction at issue occurred between the misrepresentation and the time the truth was revealed), which do have to be proven at the class certification stage. The majority found these other issues relate solely to class certification and are not ultimate merits determinations for the entire class. It also rejected Amgen’s argument that barriers should be raised to class certification because the financial pressure of a certified class forces the settlement of even weak claims, finding it significant that Congress had addressed the settlement pressures of securities class actions through means other than requiring proof of materiality at the class certification stage. In so doing, Congress had rejected calls to undo the fraud on the market presumption of reliance. Finally, the majority noted that, rather than conserving judicial resources, Amgen’s position would require a time- and resource-intensive mini-trial on materiality at the class certification stage, which is not contemplated by the federal rules and which, if the class were to be certified, might then have to be replicated in full at trial. 

In separate dissents, Justice Thomas and Scalia expressed hostility toward certification of classes where the materiality of the alleged statements had not been established. Thomas and, in a separate concurrence, Alito also questioned the continued validity of the fraud-on-the-market theory, in light of more recent research questioning its premises. These remarks may only invite additional challenges to the fraud-on-the-market presumption itself in years to come.

Government Goes After Insider Trading

ATTORNEY: EMMA GILMORE
Pomerantz Monitor, January/February 2013 

Whatever one thinks of the government’s record in punishing Wall Street for fomenting the financial crisis, the success rate against insider trading has been strong. Ever since Preet Bahara was appointed U.S. Attorney for the Southern District of New York in 2009, he has focused heavily on insider trading cases. In a 2010 speech to a room jam-packed with white collar criminal defense attorneys, he declared that “unfortunately from what I can see, from my vantage point as the United States Attorney here, illegal insider trading is rampant.” 

The law imposes liability for insider trading on anyone who improperly obtains material non-public information and trades based on such information, and also holds liable any “tippee,” the person with whom the “tipper” shares the information, as long as the tippee knows the information was obtained in breach of a duty to keep the information confidential or abstain from trading. Since the beginning of Bharara’s tenure in 2009, his office has secured 69 convictions or guilty pleas of insider trading without losing a single case. Many of those cases were developed jointly or in parallel with the SEC, which has commenced over 200 enforcement actions of its own since 2009. 

Critical to the prosecutors’ unblemished record of securing insider trading convictions has been the aggressive use of wiretaps and of informants. Private plaintiffs contemplating insider trading lawsuits can benefit from the treasure-trove of incriminating evidence collected by the government that private parties cannot get themselves through the normal “discovery” process. 

Of the 75 people recently charged by Bharara’s office, until now the biggest fish caught were Raj Rajaratnam, a billionaire investor who once ran Galleon Group, one of the world’s largest hedge funds, and Rajat Gupta, a former McKinsey chief and Goldman Sachs director who allegedly fed inside information to Rajaratnam. 

Wiretaps were key to the case against Mr. Rajaratnam. The case broke when prosecutors, while investigating a hedge fund owned by Rajaratnam’s brother Rengan, uncovered a slew of incriminating e-mails and instant messages between Raj and his brother, and wiretapped their conversations. In a call, Rengan told his brother about his efforts to extract confidential information from a friend who was a McKinsey consultant. Rengan referred to the consultant as “a little dirty” and touted that he “finally spilled his beans” by revealing non-public information about a corporate client. Other powerful evidence obtained from wiretapped calls was used to place Rajaratnam squarely in the forefront of the insider trading scheme: “I heard yesterday from somebody who’s on the board of Goldman Sachs that they are going to lose $2 per share,” Rajaratnam said to one of his employees ahead of the bank’s earnings announcement. 

Rajaratnam was found guilty on all 14 counts levied against him, and was sentenced to 11 years in prison and fined $10 million. It was the longest-ever prison sentence for insider trading, a watershed moment in the government’s aggressive campaign to rout out the illegal exchange of confidential information on Wall Street. He is currently appealing his conviction to the Second Circuit. 

Gupta, for his part, was accused of passing a flurry of illegal tips to Rajaratnam, including advance news that Warren Buffet was going to invest $5 billion in Goldman Sachs. Gupta received a two-year prison sentence and was ordered to pay $5 million in fines. 

More recently, in what federal prosecutors describe as the most lucrative insider trading scheme, prosecutors and the SEC filed separate insider trading charges against Mathew Martoma, a portfolio manager at CR Intrinsic Investors. CR Intrinsic is an affiliate of SAC Capital Advisors, a $10 billion hedge fund founded by billionaire Steven Cohen, one of Wall Street’s most successful and prominent investors. 

Martoma is accused of illegally trading on confidential information ahead of a negative public announcement poised to disclose the results of a clinical trial for an Alzheimer’s drug jointly developed by Elan Corporation and Wyeth Ltd. Armed with confidential information, Martoma allegedly emailed Cohen requesting that they speak (“Is there a good time to catch up with you this morning? It’s important.”). Martoma and Cohen subsequently spoke by phone for approximately 20 minutes. The next day, Cohen and Martoma instructed SAC’s senior trader to quietly begin selling the Elan position. At day’s end, the trader e-mailed Martoma that he had sold 1.5 million shares of Elan, and that “obviously no one knows except you me and [Cohen].” A few days later, the senior trader e-mailed Cohen the results of the week’s activity: “We executed a sale of over 10.5 million ELN for [four internal Hedge Fund account names] at an avg price of 34.21. This was executed quietly and effectively over a 4 day period through algos and darkpools and booked into two firm accounts that have very limited viewing access. This process clearly stopped leakage of info from either in [or] outside the firm and in my viewpoint clearly saved us some slippage.” 

From one end of Wall Street to the other, people are wondering whether Martoma, facing the likelihood of serious jail time, will “flip” on Cohen, creating probably the most sensational insider trading case ever. There is no doubt that Martoma is facing intense pressure: reportedly, when confronted by an F.B.I. agent in his front yard, Martoma fainted. If Martoma is convicted of the charges, federal guidelines call for a stiff 15-19 year sentence. And, while no SEC charges have yet been brought against Cohen, the Commission recently issued a Wells notice to SAC Capital, indicating that the staff is probably going to recommend that the SEC take action against SAC.

Companies Fight to Keep Their Political Contributions Secret

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, January/February 2013 

In the wake of the Supreme Court’s 2010 Citizens United decision, which allowed corporations and unions to make unlimited expenditures for political purposes, a new battle has erupted to force companies to disclose these expenditures. Writing for the majority in that case, Justice Anthony Kennedy noted that prompt disclosure of political expenditures would allow stockholders and citizens to hold corporations accountable. Shareholders, he said, could determine whether the corporation’s financing of campaigns “advances the corporation’s interest in making profits.” But in many, perhaps most cases, disclosure and accountability are the last things that corporate managers want. 

Although dozens of major companies have voluntarily disclosed their political spending, most do not. Currently, the most common shareholder proposals submitted to public companies are those requesting information on political spending. Most, however, have not fared well. Many companies probably fear that revelation of their political expenditures would be an invitation to backlash from shareholders and others at the opposite end of the political spectrum. 

Months ago the “Committee on Disclosure of Corporate Political Spending,” headed by Professors Lucian Bebchuck of Harvard Law School and Robert M. Jackson of Columbia Law School, filed a rulemaking petition asking the SEC to adopt a disclosure rule for corporate political spending. Over 300,000 responses to this petition flooded the Commission, all but 10 of which supported it. The SEC recently announced that by April it plans to issue a Notice of Proposed Rulemaking to require disclosures of political spending. 

The Committee said that one of the main reasons for its proposal is that a significant amount of corporate political spending currently occurs under investors’ radar screen, particularly when public companies spend shareholder money on politics through intermediaries, who are never required to disclose the source of their funds. Investors clearly want to receive information about such spending. 

While we await action by the Commission, one investor, the New York State Comptroller Thomas P. DiNapoli, has taken matters into his own hands. He controls the New York State Common Retirement Fund, which holds about $378 million in stock of Qualcomm, one of the country’s largest makers of computer chips for mobile devices. After Qualcomm allegedly rebuffed his multiple requests for access to information on political spending, DiNapoli sued Qualcomm late last year in Delaware Chancery Court, seeking to allow him to review documents showing the company’s political expenditures. Mr. DiNapoli is trying to determine whether Qualcomm made corporate contributions to tax-exempt groups and trade associations that are not required to disclose their donors. Those groups poured hundreds of millions of dollars into the 2012 election, including money from large corporations seeking to avoid negative publicity or customer outcries. Although DiNapoli is a prominent Democratic politician, he cannot be accused of filing the petition for political purposes: Irwin Jacobs, Qualcomm’s controlling shareholder, is a prominent contributor to Democratic candidates and causes. 

Delaware, where Qualcomm is incorporated, has a statute that allows shareholders to gain access to corporate records, so long as they have a “proper purpose” for doing so. As we have noted previously in the Monitor, the question of what a shareholder has to show to establish a “proper purpose” has generated heated debate over the past few years, with corporations making some headway in raising the bar for shareholder access. 

Typically, shareholders have tried to gain access to company books and records to determine whether wrongdoing has occurred, such as breach of fiduciary duties by directors or executives. It is a novel question whether discovery of political activities is a proper purpose. Even if it can be a proper purpose in some cases, such as if the expenditures create some risk for the corporation, the next question is whether the investor will have to show some reason to be concerned in a particular case. Otherwise, the courts may view his request as simply a “fishing expedition.” 

The Council of Institutional Investors, an association of pension funds, foundations and endowments, supports Comptroller Di Napoli’s suit. Amy Borrus, deputy director of CII, reportedly has stated that the suit offers hope to investors stonewalled in their search for basic information about corporate political spending after Citizens United. “Shareholders have tried proxy proposals, and they’ve tried asking, but some companies are unfortunately resistant to providing basic disclosures," Borrus said Thursday. The present suit “certainly opens up a new avenue,” she said. 

If DiNapoli succeeds in obtaining this information, the next question will be whether he can publicly disclose it, allowing other shareholders and interested parties to weigh in on the appropriateness of the company’s actions.

“Collective Action” Permitted in Citibank Overtime Pay Case

ATTORNEY: MURIELLE STEVEN WALSH
Pomerantz Monitor, March/April 2012

A federal judge has conditionally certified a nationwide “collective action” in Pomerantz’s overtime pay case against Citibank, and has authorized us to send a notice to personal bankers who may have been affected by the misconduct we allege in our complaint.
 
We brought this case on behalf of Citi personal bankers (PBs) nationwide who we allege worked “off-the-clock” overtime but were not paid for it. This alleged conduct would violate the Fair Labor Standards Act (FLSA), as well as several state laws, including New York’s.
 
Under the relevant law, we had to make a “modest showing” that there are others who are “similarly situated” to our clients. Here, Citibank has at least 4,000 PBs, of whom we have been able to identify, so far, about two dozen employees who were not paid for overtime work. Citi argued that this was not enough.
 
To bolster our contention that there are a lot more PBs who were “similarly situated” we relied on evidence of dual-edged nationwide policies that created an environment that was ripe for FLSA/overtime violations. We argued that the court could infer from the existence of these policies that there are probably many more PBs who suffered the same fate as our clients. Citi had a nationwide job policy and high sales quotas that effectively forced PBs to work overtime to keep their jobs; but Citi also had a nationwide “no overtime” policy that strongly discouraged the incurring of overtime expenses. The natural result of these conflicting policies was that people worked overtime but were not paid for it, either because they were intimidated into underreporting their time, or in some instances, their managers altered their time records to show no overtime worked. Our plaintiffs testified that this in fact occurred.
 
Because the policies were carried out nationwide, it was reasonable to infer that there are many other PBs who are “similarly situated” to our clients. Citi argued that its policies were “facially lawful,” and that the court could not infer a pattern of FLSA violations simply because it had otherwise lawful policies that had conflicting goals. The Court disagreed.

Say on Pay is Having Its Day

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, March/April 2012

Although only 45 companies – less than 2% of all publicly held companies – lost “say on pay” votes last year, the Wall Street Journal reports that many of those companies are going out of their way to do better this year. Jacobs Engineering and Beezer Homes, for example, have already obtained approval, after revamping executive pay, to bring it into better alignment with overall corporate performance. Beezer, in particular, got a new CEO, hired a new compensation consulting firm and adopted a new performance-based stock plan that stopped giving executives automatic restricted stock grants, and went to great lengths to consult with investors about compensation. As a result, at its annual meeting in February it received 95% shareholder approval of its pay plans. Jacobs did much the same thing (though it kept its CEO) and increased its shareholder “yea” vote from 45% last year to 96% at its annual meeting in January of this year.
 
Executive turnover at loser companies has been roughly twice the average rate. About 1 in 4 installed a new CEO after the vote, and about 1 in 5 put in a new CFO, both more than double the average turnover rate.
 
Corporate governance mavens will be looking ahead to votes later this spring at other loser companies from last year, including Hewlett Packard and Cincinnati Bell. H-P has a new CEO, Meg Whitman, who is pulling in $1 in compensation, and has reportedly held compensation discussions with 200 or so of its nearest and dearest institutional investor shareholders, in an effort to tie compensation more closely to corporate performance. Cincinnati Bell, which was sued by shareholders after losing last year’s vote, agreed to revamp disclosures and to dump its compensation consultants if it loses another say on pay vote.
 
The effect of say on pay votes is largely attributable to the attention that Institutional Investor Services (“ISS”), the proxy advisory firm, has been paying to this issue. The WSJ reports that a study published in the journal Financial Management concluded that a negative ISS recommendation on a management proposal influences between 13.6% and 20.6% of investor votes; and in 2011, ISS advised investors to vote “no” on pay proposals about 11% of the time. Some are predicting that the ISS will say “no” far more often this year than last. In one highly publicized incident, ISS got into a brawl with Disney over its pay packages. Disney won this won, by aggressively fighting back.
 
Also amplifying the impact of “say on pay” votes is the SEC ruling that executive compensation matters fall into the “Broker May Not Vote” category under its Rule 452. That means that brokers, who tend to vote reflexively with management, cannot vote shares held by their investor customers, if those customers have not sent them instructions on how to vote. This means that companies will have to work that much harder to secure investor “yea” votes on compensation.