APPLYING THE BESPEAKS CAUTION DOCTRINE

The Second Circuit clarified the application of the bespeaks caution doctrine, drawing a line between statements which might invite an inference of reducing risk in the future and characterizations which communicate a present or historical fact. Iowa Public Employees’ Retirement System v. MF Global, Ltd., Docket No. 09-3919-cv (2nd Cir. Sept. 14, 2010).

Plaintiffs claim that MF Global, Ltd. made material misstatements and omissions in its IPO prospectus and registration statement. The complaint asserts claims under Securities Act Sections 11, 12(a)(2) and 15. MF Global was the brokerage arm of Man Group, Plc., a hedge fund. The complaint names as defendants MF Global, Man Group, the IPO underwriters and various MF Global officers and directors.

The factual claims focus on allegations that on February 27, 2008, a broker at MF Global lost $141.5 million speculating in wheat futures. The losses resulted when the broker took positions vastly in excess of the firm’s trading limits and collateral requirements. MF Global was responsible for settling the broker’s trades and absorbing the losses. When the news of the losses reached the markets the next day, MF Global’s stock price fell 28%. The next day it declined another 17% for a total two-day market capitalization loss of over $1.1 billion. The revelation of the loss informed the market that MF Global’s internal risk controls had not been applied to brokers trading for their own account. A class action followed centered on claims that this omission and others rendered the offering documents false and misleading.

The district court dismissed the claim based on the bespeaks caution doctrine. The court concluded that “Plaintiffs’ objections to misrepresentations about specific or general shortcomings in MF Global’s risk management system that existed at the time the prospectus was issued are, in fact, objections to Defendants’ alleged failure to disclose the possibility that the risk management system might be unable to prevent future negative outcomes.”

The Second Circuit remanded the case for reconsideration. To prevail, plaintiff must show that the relevant communication either misstated or omitted a material fact the court noted. The bespeaks-caution doctrine is a corollary of the long-established principle that a statement or omission must be considered in context.

A forward looking statement accompanied by sufficient cautionary language is not actionable because a reasonable investor could not have found the statement materially misleading. Stated differently, projections about the future cannot be assumed to be settled facts by any reasonable investor. The bespeaks caution doctrine is one of the rules developed to deal with forward-looking statements.

It is settled that the doctrine only applies to projections about the future and those of optimism concerning future performance, but has no application to existing and past facts. While the principle appears straightforward, its application can be difficult.

Here, the question is whether it applies to statement in the prospectus about MF Global’s risk management system. Plaintiffs claim that the prospectus omitted the fact that it did not apply to company employees. This claim relates to an ascertainable fact when the challenged statements were made. It is error to apply the bespeaks caution doctrine to such a statement.

The court went on to note, however, that a statement specifying the risk of default is distinct from a statement of present or historical financial instability. At the same time, a statement of confidence in a firm’s operations may be forward looking and thus insulated by the bespeaks caution doctrine.

In this case “characterizations of MF Global’s risk-management system – that the system was ‘robust,’ for example – invite the inference that the it will reduce the firm’s risk. However, bespeaks caution does not apply insofar as those characterizations communicate present or historical fact … .” The case was remanded to the district court to apply these principles to the statements here.

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MEASURING THE SUCCESS OF SEC ENFORCEMENT

For over a year an a half, there has been an on-going effort to rejuvenate SEC enforcement. Enforcement has new personnel, new organization and new initiatives. During this process the SEC’s market crisis investigations have yielded some significant cases such as the action against Goldman Sachs (here).

At the same time, a new key focus of SEC enforcement appears to be Ponzi scheme cases. On Friday, the Commission brought another of this seeming endless series of cases. SEC v. LADP Acquisition, Inc., Civil Action No. CV 106835 (C.D. Cal. Filed Sept. 14, 2010). See also Litig. Rel. 21655 (Sept. 17, 2010) (dated Sept. 16, 2010 on the SEC website index).

LADP is similar to many other investment fund fraud cases. Here, the action names as defendants William A. Goldstein, Marc E. Bercoon and their related entities. The complaint claims that Messrs. Goldstein and Bercoon perpetrated a “bait-and-switch” scheme on investors. The “bait,” or perhaps the lure, was high profile Hollywood films and TV shows. Specifically, investors were told their funds would ultimately be put in L.A. Digital Post, Inc., a television and film post production company. The offering materials listed well known movie studios and television networks that had been clients of L.A. Digital. It also contained a so-called client list which contained well known TV shows and movies for which L.A. Digital had performed post production services. These claims drew about 100 investors to put about $3.2 million into the defendants’ scheme since mid-2009.

The switch came in what investors actually obtained – certificates representing shares in LADP Acquisition. According to the SEC, that entity had no business operations. Its shares were worthless. Investors were assured that LADP Acquisition was about to conduct an IPO and have its shares listed on a public exchange for trading. Unfortunately no public offering has occurred. Rather, defendants misappropriated over $800,000 of the investor funds and diverted them to their own use.

In filing the complaint, which centers on alleged violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b), the SEC obtained an order: imposing an temporary freeze on the assets of the defendants; preventing the destruction of documents; requiring an accounting from the three defendants; and temporarily enjoining the defendants from future violations of the registration and antifraud provisions of the federal securities laws.

There was a time when investment fund and Ponzi scheme cases such as LADP Acquisition were viewed as difficult to detect. That was the common wit and wisdom as the market crisis began to unfold and Madoff and other high profile failures by SEC Enforcement were discovered. Clearly that is no longer the case. The reason these schemes could not be detected pre-market crisis and pre-Maddoff is the subject of much debate. The reason they are now being discovered with such frequency is also unclear. It may be the market crisis, the new management at the Enforcement Division or simply an intensified focus on Ponzi schemes.

Whatever the reason for the continuous stream of investment fund cases, it is beyond dispute that the dozens of market crisis investigations need to be completed. Those inquiries were launched in the wake of the crisis to root out its causes. These on-going investigations have consumed significant resources. While the few high profile cases spawned from those investigations may suggest that Enforcement is heading in the right direction, its job is far from done. The dominant event of the last few years and quite possibly for years to come is the market crisis. Accordingly, the measure Enforcement’s success may not be how it improved management, but its response to this huge challenge. The question is: Where are those cases?

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