The Ninth Circuit And Tellabs — Ignoring The Supreme Court?

The Ninth Circuit Court of Appeals handed down a pair of decisions last week construing the Supreme Court’s decision in Tellabs, Inc. v. Makor Issuers & Rights, Ltd., 127 S.Ct. 2499 (2007). In that decision, the Supreme Court resolved a split among the circuits over the construction of the PSLRA Section 21D(b)(2) “strong inference” of scienter requirement. One of these decisions, Zucco Partners, LLC v. Digmarc Corporations, Case No. 06-35758 (9th Cir. Jan. 12, 2009), is discussed here. https://www.secactions.com/?p=738 The second, handed down one day after Digmarc Corporation, is Rubke, Trustee v. Capital Bancorp LTD, Case No. 07-15083 (9th Cir. Jan. 13, 2009). The court’s opinions raise a significant question regarding the application of Tellabs’ teachings in the Ninth Circuit.

In Capital Bancorp, plaintiffs filed a complaint alleging violations of Section 10(b) and 14(e) of the Exchange Act and Section 11 of the Securities Act. The defendants are Capital Bancorp, a bank holding company, and Joseph Reid, its CEO and Chairman. The suit was brought by minority shareholders of Napa Community Bank, whose shares were being acquired by Capital. The case centered on two groups of allegations. The first claimed that defendants knew the offer price of 150% of book value in a registration statement was unfair, rendering the offering circular false. The second group focused on phone calls board members made to shareholders claiming that they should sell or see their shares become worthless.

The district court dismissed the Section 11 claim for failing to plead fraud with particularity as required by Rule 9(b) and the Exchange Act claims for not meeting the PSLRA pleading requirements. Plaintiffs declined to amend their complaint and appealed.

The Ninth Circuit affirmed. The Section 11 claims, the court held, had to be pled in accord with the particularity requirements of Federal Civil Rule 9(b). The PSLRA standards however, do not apply to that claim. Those allegations were based on “information and belief.” Since defendants failed to specify the facts supporting their belief the court concluded that plaintiffs failed to meet the Rule 9(b) pleading requirements regarding their registration statement claim.

The court also found that the Exchange Act claims were not properly pled. These allegations must meet the pleading requirements of the PSLRA the court held. Since the allegations regarding the registration statement failed to meet the particularity requirements of Rule 9(b), it is clear that they also did not meet the requirements of the PSLRA.

The court then examined the Exchange Act fraud claims and the allegations regarding the telephone calls in view of the PSLRA pleading requirements. To determine whether a strong inference of scienter was pled the court reviewed the Supreme Court’s decision in Tellabs. Under that ruling, all of the allegations in the complaint must be considered, the circuit court concluded. This contrasts with the circuit’s prior jurisprudence which required that each allegation be considered separately and that the facts pled demonstrate that the statements or omissions were made either “intentionally” or with “deliberate recklessness” under In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 985 (9th Cir. 1999). To harmonize its prior jurisprudence, with Tellabs, the court held that both approaches should be used. This requires a two step analysis: First, the court must examine each allegation under Silicon Graphics; second, the holistic Tellabs approach will be used. This is the same conclusion the court reached in Digmarc Corporation – but that decision is not cited here.

The court concluded that plaintiffs failed to plead a strong inference of scienter under its two step analysis. The court characterized the claims in the complaint as little more than allegations regarding “motive and opportunity” which are insufficient to plead a strong inference of scienter.

The approach of the Ninth Circuit in Digmarc Corporation and Capital Bancorp appears at odds with Tellabs. In that case, the Supreme Court resolved a dispute among the circuits over what constitutes a strong inference of scienter within the meaning of the PSLRA. The split the court resolved focused on the meaning of the “strong inference” language incorporated in the Reform Act from the then-existing Second Circuit case law. Essentially the circuits adopted conflicting readings of the complex legislative history of the Section.

In the dispute among the circuits, the Second Circuit concluded that its “motive and opportunity” test was a type of proof which could establish a strong inference. The Ninth Circuit took a different approach. After reviewing the legislative history of the Section and the statutory language in Silicon Graphics, the court concluded that a strong inference is only pled if it constitutes intentional conduct or deliberate recklessness. Every other circuit which considered the Ninth Circuit test rejected this standard.

Tellabs resolved the split among the circuits, holding that all inferences must be considered and that the competing inferences must be compared. This holding is based squarely on the PSLRA statutory language.

By combining Silicon Graphics with Tellabs, the Ninth Circuit reaffirmed its pre-Tellabs reading of Section 21D(b)(2), which was part of the circuit split the Supreme Court resolved. This is clearly an incorrect reading of Tellabs. Digmarc Corporation and Capital Bancorp thus appear to be setting the stage for another split among the circuits over the proper pleading standard.

This Week In Securities Litigation (January 16, 2009)

In Senate confirmation hearings on Thursday, SEC Chairwoman nominee Mary Schapiro vowed to re-energize the Enforcement Division. Earlier in the week, the SEC resolved a long running insider trading case against a former corporate general counsel and filed another insider trading case in conjunction with the Justice Department against a former Blackstone Group employee.

In the high profile criminal case against Bernard Madoff this week, the government lost repeated efforts to jail Mr. Madoff pending the resolution of his case. At the same time, the Department of Justice sought to follow up on its Siemens FCPA case by initiating a forfeiture action to freeze funds in Singapore alleged to have been paid by the company as bribes.

Finally, a New York Court of Appeals affirmed the dismissal of an option backdating derivative suit brought against Bed Bath and Beyond which had been dismissed for failure to establish demand futility, while the Northern District of Illinois held that filing a final Form 10-K does not waive privilege as to earlier drafts. And, the Ninth Circuit harmonized its pre-Tellabs rulings on pleading a strong inference of scienter with the Supreme Court’s teachings in that case.

Schapiro confirmation hearings

The Senate held confirmation hearings on President-elect Barack Obama’s choice to become Chairwoman of the Securities and Exchange Commission this week, Mary L. Schapiro (discussed here). Ms. Schapiro, who has been called a regulator “with a light touch” by The Wall Street Journal, promised the committee to be a tough enforcer. During her testimony, Ms. Schapiro vowed to overhaul the enforcement program and reconsider procedures which she views as hindering the enforcement staff. Ms. Schapiro also said she supported requiring hedge funds to register and would reconsider the up-tick rule regarding short sales. She also indicated that she wants to reconsider the time table for adopting international accounting standards.

SEC enforcement

SEC v. Heron, Civil Action No. 07-cv-01542 (E.D. Pa. Filed April 18, 2007): The SEC settled an insider trading case against the former General Counsel of Amkor Technology, Inc. The Commission’s complaint alleged that Mr. Heron repeatedly traded in the shares of his company prior to announcements of its financial results as discussed here. To resolve the case, Mr. Heron consented to the entry of a permanent injunction, the payment of disgorgement of $75,000 and to an order barring him from serving as an officer or director. The settlement followed Mr. Heron’s conviction on criminal charges based on similar allegations. Mr. Heron is serving a fifteen-month jail sentence from that case.

Criminal cases

U.S. v. Madoff: Prosecutors in the Bernard Madoff case were rebuffed twice this week in their efforts to have Mr. Madoff’s bail revoked. First, the magistrate rejected the government’s claims that Mr. Madoff was a flight risk and that the conditions of release were not sufficient to protect the safety of the community. The claims were based on allegations that Mr. Madoff mailed packages to family members and friends containing jewelry and other property as “gifts.” The magistrate imposed additional restrictions over the personal property in Mr. Madoff’s apartment and rejected the government’s motion. In his ruling, the magistrate concluded that the government failed to establish either flight risk or that the conditions of bail were insufficient to protect the community. U.S. v. Madoff, No. 08 Mag. 2735 (S.D.N.Y. Ruling: Jan. 19, 2009). The district court rejected the government’s appeal of that ruling for the same reasons.

U.S. v. Chakrapani, Case No. 1:09-mj-00094 (S.D.N.Y. Filed Jan. 13, 2009): Ramesch Chakrapani, a managing director of the Blackstone Group’s London office, was charged with insider trading. According to court papers Mr. Chakrapani tipped an analyst about the proposed take over of Albertson’s supermarket chain by a group of retailers and private equity firms in 2006. The analyst then either tipped his parents or traded through their account. The scheme netted $3.6 million in trading profits. At the time, Mr. Chakrapani was a member of Blackstone’s mergers and acquisitions advisory group in New York where he worked on the deal. The SEC filed a parallel civil action, SEC v. Chakrapani, Case No. 109-cv-00325 (S.D.N.Y. Filed Jan. 13, 2009). Both cases are pending.

FCPA

U.S. v. All Assets, Case No. 1:09-cv-00021 (D.D.C. Filed Jan. 8, 2009): As a follow-up to the Siemens AG FCPA case, discussed here, the government filed this forfeiture action to confiscate nearly $3 million in bank accounts in Singapore. The amounts are alleged to have been paid to bribe ex-Bangladesh Premier Khaleda Zia’s younger son, Arafat Rahman Koko. The payments were from Siemens AG and China Harbor Engineering Company through financial institutions in the U.S and later deposited in accounts in Singapore. Siemens Bangladesh has admitted that from May 2001 to August 2006 it caused corrupt payment of at least $5.3 million to be made through business consultants to various Bangladeshi officials in connection with a mobile phone projects.

Private actions

Wandel v. Eisenberg, Case No. 603665/06 (NY Sup. Ct., App. Div. 1st Dept): The New York Court of Appeals affirmed the dismissal of a derivative complaint filed against Bed Bath & Beyond. The complaint alleged option backdating. The appeals court affirmed the dismissal for failure to adequately plead demand futility. Although the complaint alleged that demand would be futile, it failed to allege detailed facts supporting this claim according to the initial ruling. The appeals court affirmed, noting that only three of the board members named as defendants actually received backdated options.

Roth v. Aon Corporation, Case No. 04 C 6835 (N.D. Ill. Ruling Jan. 8, 2009): Here, the district court concluded that a draft of part of a Form 10-K transmitted to in-house counsel and several employees of the company during preparation remained privileged when the final Form 10-K was filed with the SEC.

Circuit courts

In Zucco Partners, LLC v. Digmarc Corporations, Case No. 06-35758 (9th Cir. Jan. 12, 2009), the court harmonized its earlier rulings on pleading scienter with Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007). The court also ruled on the adequacy of allegations from confidential witnesses offered to support an inference of scienter.

In its pre-Tellabs opinions, the court held that allegations regarding state of mind must demonstrate either intentional conduct or deliberate recklessness. Those allegations must them be considered individually – an approach the court called “segmented” – to determine if a PSLRA strong inference of scienter has been pled. This approach, the court concluded, is not consistent with the “holistic” approach of Tellabs. To comply with the Supreme Court’s ruling, the circuit court concluded that both its “segmented” approach and the Tellabs holistic test should be used. The court also ruled that statements from confidential witness can be used to establish scienter if they are pled with particularity, demonstrate personal knowledge and scienter. Here, the court affirmed the dismissal of the complaint for failure to meet this pleading standard as discussed here.