CLASS CERTIFICATION, SECTION 11 AND EFFICIENT MARKETS

In affirming the district court’s certification of the class in In re Constar International Inc. Sec. Litig., No. 08-2461 (3rd Cir. Oct. 29. 2009), the circuit court drew a sharp distinction between the requirements of a claim under Securities Act Section 11 and Exchange Act Section 10(b). The court rejected defendants’ primary argument that plaintiffs could only meet the dictates of Federal Civil Rule 23(b)(3), requiring that the questions of law or fact common to class members predominate, if they established the efficiency of the market for the securities. The court also rejected defendants’ related contention that, absent an efficient market, questions of materiality, loss causation and injury would need to be decided on an individual basis, thus requiring reversal of the certification order.

The case arose out of a November 2002 IPO in which Constar’s parent, Crown Holdings, sold 10.5 million shares to the public at an offering price of $12.00. According to plaintiffs, the offering price was inflated because the registration statement contained false and misleading statements. Constar, a manufacturer of plastic food and beverage containers, was a deteriorating business burdened with much of its parent’s debt, according to plaintiffs. This contrasts with the claims in the registration statement which depicted the company as a competitive business with a strong future.

In the summer of 2003, the truth about the business emerged. In a July press release, the company acknowledged that its results were disappointing. In the related earnings call, the company attributed the poor results to a loss of major customers. The share price dropped about 30%. The next month, the company issued a press release stating that its financial good will had been impaired by the trading price of the stock and other factors. Plaintiffs claim this means that the market had already absorbed this fact. The next month, after the share price had tumbled to just over $5, suit was filed.

The district court granted class certification, concluding that the Rule 23 requirements had been met. The Third Circuit affirmed, in an opinion devoted largely to a discussion of defendants’ claims regarding the efficient market hypothesis. The error in defendants’ claim that the efficiency of the market must be established, the court stated, is that the complaint is predicated on Section 11, not Section 10(b). A “prima facie case under Section 11 is straight forward, requiring only a showing of a material misrepresentation or omission from a defendant’s registration statement,” the court noted. Materiality, measured, by the “total mix” standard of the Supreme Court’s decision in TSC Industries, can be gauged through a post hoc look at the price movement immediately following the disclosure. This test, however, does not necessarily require that there be a demonstration that the market is efficient, according to the court.

Loss causation for a Section 11 claim is equally straight forward. In such a case, plaintiffs do not have to prove this element or reliance. Rather, defendants can assert it as a defense. Indeed, damages are simply the difference between the price paid and the price at the time of suit or at which the security was sold. Any decline in value is presumed to be caused by the misrepresentation in the registration statement. These Section 11 requirements contrast sharply with those of a Section 10(b) damage claim.

The court went on to acknowledge that the efficient market hypothesis can be of assistance in assessing materiality in both a Section 11 and Section 10(b) case. This however, does not mean that if there is no proof of efficiency materiality is an investor by investor inquiry as defendants contend. Since reliance is not an element of a Section 11 claim, the question in such a case is the conduct of the defendants, not the knowledge of the plaintiffs. The misrepresentation is material if a reasonable investor would have considered it important. This means that the impact of the false statement is uniform across the class of investors, regardless of market efficiency.

Likewise, loss causation under the Supreme Court’s decision in Dura is not an issue. In a Section 11 case, there is no requirement of individualized loss causation because it is presumed. Thus the court concluded “on both the materiality and loss causation fronts . . . the market efficiency issue . . . [is] a red herring.”

INSIDE TRADING AND HEDGE FUNDS – RECURRING THEMES

Hedge funds and insider trading are recurring themes in SEC enforcement these days. The SEC and DOJ recently brought a blockbuster set of insider trading cases involving the founder of Galleon fund, discussed here. Insider trading has, of course, been an SEC enforcement priority since the early 1980’s when the Commission led the charge in this key area. Now, DOJ seems to be the leader much of the time. Hedge funds are much discussed as an SEC enforcement priority, but now seem more of a legislative imperative, although the antifraud provisions seem to be a very adequate policing mechanism.

The SEC’s latest insider trading case has all of these elements. SEC v. Tang, Case No. CV 09 05146 (N.D. Cal. Filed Oct. 30, 2009). The case centers on two key traders, Chen Tang, who was the CFO of a private equity fund (“PEF”) in 2007 and 2008 and his brother-in-law, Ronald Yee, who was the CFO of a venture capital fund (“VCF”) from 2005 to 2007. Five other defendants include Zisen Yu, Ming Siu, Joseph Seto, James Tang and Eddie Yu. Each is described as a trading partner of Chen Tang, Joseph Seto and Ming Siu. James Tang is also the brother of Chen Tang and Eddie Yu is Ronald Yee’s brother. The case centers on trading based on information obtained from PEF in the shares of Tempur-Pedic International, Inc. and from VCF in the stock of Acxiom Corporation. The complaint also names twelve relief defendants whose accounts were used in the two trading schemes by the defendants, according to the SEC.

The first scheme concerns trading in the shares of Tempur. Chen Tang learned in February 2008 that PEF was considering making a significant investment in the securities of Tempur. At the time, a partner in PEF sat on the board of Tempur. As CFO, Chen Tang arranged the necessary credit for the investment. Shortly after learning about the proposed deal, Chen Tang told Ming Siu and Joseph Seto. Mr. Seto purchased 8,000 shares of the company over two days while Mr. Siu made six separate purchases of shares and bought 132 call options. PEF did not go forward with its purchase at that time, however.

The next month the PEF partner attended a Tempur board meeting where he learned that the company would miss its earnings projection by a significant amount. Earnings were due to be announced on March 17. After the board meeting the deal team at PEF decided to acquire a significant stake in Tempur after the earnings announcement. The acquisition was tentatively scheduled to move forward two days after the announcement.

On March 12 and 13 Chen Tang had telephone calls with Ming Siu, Joseph Seto and Zisen Yu. During this two day period Chen Tang, Joseph Seto, Ming Siu and Zisen Yu acquired over 2,300 put options for Tempur shares while selling short 6,500 shares using several different accounts.

After Tempur announced earnings on March 17 its share price dropped about 37%. Each of the traders closed their positions over the next two days collectively making a profit of over $1.1 million.

Following the earnings announcement, PEF made the final decision to acquire Tempur shares. Chen Tang transmitted the decision to the other trading defendants. Between March 17 and 20, 2008 Chen Tang, Joseph Seto, Ming Siu and Zisen Yu acquired a significant number of Tempur shares and call options. After PEF purchased about 6% of the outstanding shares over a two day period the price increased about 18%. The trading defendants then sold their holdings for a profit of over $800,000.

Tempur was the second trading scheme executed by the defendants according to the complaint. The first took place in 2007 while Ronald Yee was the CFO of VCF. There he learned about a transaction involving the shares of Acxiom. Previously, VCF held a significant stake in the company and had commenced a hostile take over-bid which it eventually dropped. In February 2007, VCF learned another fund had expressed an interest in Acxiom. When Ronald Yee began working on matters related to the potential deal, he told Chen Tang who in then told the Ming Siu, Joseph Seto and Zisen Yu.

On May 24, VCF submitted a bid to Acxiom based on a decision made at a meeting the prior day. Ronald Yee attended that meeting. On May 23 and 24 Chen Tang, James Tang, Joseph Seto, Ming Siu and Zisen Yu purchased a substantial number of shares in the company as well as call options through a variety of accounts. In one account, for example, Ming Siu acquired over 50,000 shares of Acxiom in one day. In two other accounts Chen Tang purchased over 63,000 shares on one day while combining with three other defendants to purchase another 68,000 shares in yet another account.

Over the next several days while the deal was being negotiated, these same traders made almost 100 additional purchases of shares and options for Acxiom. On May 17, when Acxiom announced it was being acquired, its share price increased about 18%. The traders then sold their positions reaping profits of over $5.1 million.

The deal eventually collapsed, however. On August 27, 2007 Ronald Yee learned at a VCF meeting that the deal was in peril. This information was conveyed to Chen Tang and the other traders, according to the complaint. Chen Tang and the others then began shorting the shares. Following the announcement that the deal collapsed on October 1, the share price dropped 20%. The traders sold their stake at a profit of over $850,000.

During the SEC’s investigation, Chen Tang, Zisen Yu, Joseph Seto, James Tang and Eddie Yu lied about their relationships and knowledge, according to the complaint. At one point, the SEC alleges Chen Tang denied knowing his brother-in-law, Ronald Yee.

The complaint alleges violations of the antifraud provisions of the securities laws and seeks injunctions, disgorgement, prejudgment interest and civil penalties. The case is in litigation. See also Litig. Rel. 21271 (Oct. 30, 2009).