by T. GormanPosted on Posted in SECActions

The SEC’s investigation relating to children’s clothing manufacturer Carter’s Inc. is the inquiry which keeps on giving. At a time when the pipeline of enforcement actions seems to have all but dried up, the Carter’s investigation keeps generating cases. To date there have been six actions. Now the Commission and the U.S. Attorney have new insider trading cases tied to the company. SEC v. Megalli, Civil Action No. 1:13-CV-03783 (N.D. Ga. Filed Nov. 14, 2013); U.S. v. Magalli, Case No. 1:13-cr-00442 (N.D. Ga. Filed Nov. 14, 2013).

Mark Megalli was an executive at now defunct investment adviser Level Global Investors, L.P. from August 2009 through the fall of 2011. During that period he is alleged to have traded on inside information in Carter’s shares in four instances, yielding profits or losses avoided of about $3 million.

The inside information came from then former Carter’s executive Eric Martin who at one time with the vice president of Investor Relations for the firm. By the time of the transactions here Mr. Martin had departed from the company after having engaged in insider trading. Indeed, Mr. Martin eventually pleaded guilty to one of eleven counts in an indictment charging him with insider trading. He has also consented to the entry of a permanent injunction and an officer/director bar in the Commission’s parallel case.

In late 2009, however, Mr. Martin continued to obtain material non-public information about Carter’s. His source was Richard Posey, then the firm’s vice president of operations. The information was furnished “in exchange for reputational benefit, i.e. to show that Posey was a source of valuable information, to further their friendship, and in expectation of future business contacts and benefits,” according to the SEC complaint.

Mr. Megalli entered into a consulting agreement with a firm owned by Eric Martin on September 14, 2009. The agreement was executed on behalf of Level Global, a firm Mr. Megalli had recently joined as head of its consumer section. Under the terms of the six month agreement, Level paid $50,000 to the Martin owned company.

Subsequently, Mr. Martin provided Mr. Megalli with inside information in four instances:

October 27, 2009 accounting practices announcement: In mid-September 2009 Mr. Megalli directed Level to purchase 350,000 shares of Carter’s stock at a total cost of $9 million. The acquisition was based on positive information about the company from Mr. Martin. In late October, however, Mr. Martin advised the hedge fund executive that Carter’s had incurred an unexpected accounting issue. The information came from Mr. Posey. Level, at the direction of Mr. Megalli, liquidated its position. The firm avoided a loss of $2,110,910.

November 9, 2009 restatement announcement: In early November Mr. Megalli learned in a telephone call with Mr. Martin that Carter’s would announce a restatement of its financial statements as a result of an accounting fraud. Mr. Megalli directed Level to “lighten up” on Carter’s without “killing the stock.” The firm sold 150,000 of a 600,000 share stake the same day as the announcement. This avoided a loss of $268,500.

December 23, 2009 restatement announcement: On November 10, 2009 Level purchased 50,000 shares of Carter’s stock at the direction of Mr. Megalli. During the balance of the month, and the first part of December, Mr. Martin continued to give Mr. Megalli positive information on Carter’s. Following the announcement in December regarding the restatement the share price increased. Global had a profit of $205,000.

July 29, 2010 earnings release: In early July 2010 Megalli learned from Eric Martin, who had been tipped by Mr. Posey, that Carter’s quarterly earnings would be below expectations. Level then built a short position in the stock which grew to 300,000 at the direction of Mr. Megalli. Following the announcement the share price dropped and Level covered its position, yielding profits of $648,655.

The complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is in litigation. See Lit. Rel. No. 22870 (Nov. 14, 2013).

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by T. GormanPosted on Posted in SECActions

rtiorari in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317 (S.Ct.) for the second time the High Court will consider two key issues. The first is whether the Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988), which adopted the fraud-on-the-market theory of reliance that many view as the foundation of securities class actions, should be overruled. The second is whether a defendant in a securities class action may rebut the Basic presumption at the class certification stage by introducing evidence that the alleged misrepresentations did not distort the market price of the stock.

Background

This is the second time this case has been before the Supreme Court. The first time the Court considered Halliburton the question was whether the plaintiffs in a securities class action were required to prove loss causation at the class certification stage. In a narrow opinion written for a unanimous Court by Chief Justice Roberts the Court held that loss causation is a merits issue, not a Rule 23 class certification question. Indeed, Chief Justice Roberts held that since the district and circuit courts had previously concluded that the Rule 23 requirements had been met, the case was resolved. Erica P. John Fund, Inc. v. Halliburton Co., 131 S.Ct. 2179 (2011)(“Halliburton I”).

On remand the district court granted class certification where efficiency of the market had been conceded and based on a complaint alleging violations of Section 10(b) as a result of false statements made by the company and certain officers. The Fifth Circuit affirmed, rejecting claims that the defendants should be permitted to offer evidence demonstrating that there was no impact on price from the claimed statements based on Amgen, Inc., v. Connecticut Retirement Plans & Trust Funds, 133 S.Ct. 1184 (2013)(materiality need not be established at certification stage).

The Petitioners

Noting that four justices in Amgen had signaled a willingness to reconsider Basic – Justices Alito, Thomas, Scalia and Kennedy – Petitioners advanced four key reasons for the Court to again review this case:

Economic theory: In adopting the Basic presumption, the four Justice majority focused on “considerations of fairness, public policy and probability, as well as judicial economy . . . [and] trusted in the accuracy of then [r]ecent empirical studies” . . . to engraft the efficient capital markets hypothesis into federal securities laws.” (internal quotes omitted). Now however “[a]cademics have largely given up on Basic’s economic premises . . . This efficient-market hypothesis showed early promise, but ‘empirical research became more specialized and sophisticated, and evidence of potential inefficiencies began to accumulate . . . There are now hundreds of papers documenting price anomalies, even for the most actively traded stocks.’”

Difficulty of application: Because Basic is built on a “binary” approach, the lower federal courts have struggled to apply it. State courts have rejected it.

Proper case: This case presents an ideal vehicle to review Basic. Although Halliburton’s shares are traded in an efficient market, that “hardly means that any particular misrepresentation will be efficiently incorporated into Halliburton’s stock price.” (emphasis original). Yet under the binary approach of Basic this is the result.

Alternative: Even if the Court is not inclined to overrule Basic, the decision should “be modified to require plaintiffs to prove price impact in order to invoke the presumption . . .”

Respondents

Respondents opposed granting the petition, arguing three key points:

Importance: Basic and the “fraud-on-the-market presumption is critical to private securities actions, as this Court has repeatedly noted.” In addition, meritorious private securities actions are a necessary supplement to criminal prosecutions and civil enforcements as the Court and enforcement officials have repeatedly stated.

Congress: Congress had repeatedly amended and adjusted the federal securities laws since Basic was decided without altering it. Indeed, at the time the PSLRA was passed Congress considered and rejected calls to undo the fraud-on-the-market presumption as the Court acknowledged in Amgen.

Economic theory: The underpinnings to Basic have not been undercut. That decision is predicated in part on the same theory Congress “expressly relied on . . . [in the Exchange Act,] that securities markets are affected by information . . .” Furthermore although the economic theory regarding the efficiency of markets has evolved, “the semi-efficient market hypothesis continues to enjoy widespread support among economists.” The “Semi Strong Efficient Market Hypothesis . . . has been subjected to perhaps the most intensive and extensive testing of any hypothesis in all of the social sciences—and this extraordinary scrutiny has confirmed the strong empirical support for the theory.”

Amicus

Calling the “fraud-on-the-market” theory the “most powerful engine of civil liability ever established in American law, a group of former SEC Commissioners and officials and law professors filed an amicus brief in support of Petitioners. That brief argues two key points:

Text of statute: While the text of Section 10(b) does not reveal how reliance should be established since the cause of action under it was implied by the courts, comparison to the nearest, most analogous statutory provision demonstrates that plaintiffs should be required to establish the element. This is illustrated by considering Exchange Act Section 18(a) where Congress required this approach.

Basic is inconsistent: The approach of Basic is “at war with itself . . .” While the case holds that there is a presumption, in fact it effectively can not be rebutted. Rebuttal requires “an individualized inquiry into the buying and selling decision of particular class members . . . And the cases in which such an individualized inquiry has rebutted the presumption after it has attached are . . . as rare as hen’s teeth.” (internal quotations omitted).

Analysis

Revisiting Basic has the potential to rewrite the law applicable to federal securities class action litigation. Overruling the case could compel plaintiffs to prove reliance by the individual class members, something which may will be impossible. At the same time adopting the alternative approach suggested by Petitioners has the potential to intertwine the class certification requirements of Rule 23 with the merits of a fraud claim under Section 10(b), something the Court has repeatedly avoided. It also has the potential to turn the certification hearing into a min-trial. Yet many commentators argue that class certification is, for all practical purposes, the trial since certification virtually assures settlement in view of the potential liability defendants face.

To date four justices have indicated a willingness to revisit Basic. Four justices were required to vote for granting the petition. Whether there will be five votes to overrule or modify Basic, and perhaps Halliburton I and Amgen, will be determined later this term.

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