by T. GormanPosted on Posted in SECActions

Option backdating cases continue to be a focus of the regulators and the courts. The Brocade option backdating case, and the charges brought against its former CEO Gregory Reyes, were the first and perhaps the most high profile of these cases. Announced at a sensational joint press conference, the U.S. Attorney and former SEC Chairman Cox painted a portrait of crass criminal actions.

Yet, many option backdating cases and settlements later, the Ninth Circuit Court of Appeals reversed the conviction of Mr. Reyes “because of prosecutorial misconduct in making a false assertion of material fact to the jury in closing argument.” U.S. v. Reyes, No. 08-10047 (9th Cir. Filed August 18, 2009). This is the overwhelming case from the joint press conference? The ruling is significant. The point it did not consider is more significant.

Mr. Reyes was charged with securities fraud, falsification of corporate books and records, and violating related statutes and regulations. All of these charges were based on the backdating of stock options. At trial, the primary defense was that Mr. Reyes signed-off on the backdated grants without any intent to deceive. Mr. Reyes contended that he relied in good faith on the finance department which knew about the backdating and the falsification of the books.

The government took a different position. At trial, it presented the testimony of Elizabeth Moore, a low level finance department employee. Ms. Moore testified that she did not know about the backdating. The government theorized that since finance department did not know about the scheme it was thus powerless to get the books and records right.

In final argument the government reiterated Ms. Moore’s testimony, arguing that it should not have to bring in everyone from the department to establish the point. It went on to argue that in fact the finance department did not know about the backdating scheme.

The government knew better. During its investigation the FBI had interviewed senior finance department officials who stated that in fact they did know about the scheme. At the same time, the SEC filed charges alleging that senior finance officials engaged in fraud because they did know about the backdating scheme. Nevertheless, the district court refused to grant a mistrial. The court concluded that both sides knew about this evidence and engaged in misconduct in final argument. The government misstated the evidence. The defense argued the evidence without presenting it to the jury, an error almost as bad, the district court decided.

The Ninth Circuit did not agree with the district court. The government, as the prosecutor and representative of the United States, cannot engage in such misconduct the court ruled. Since the government misrepresented what it knew to the jury, the court reversed the conviction of Mr. Reyes and remanded the case for a new trial.

While the Ninth Circuit’s decision is clearly correct, based on the record, a more fundamental question is at stake. The reason the government’s final argument was wrong is because its case was wrong. A key part of the government’s case, according to the court’s opinion, was that the finance department did not know about the scheme. It presented this point of view by electing to have Ms. Moore testify and choosing not to present the other finance department witnesses the FBI had interviewed. In view of Ms. Moore’s position in the department and the other FBI interviews, the government clearly knew that, at a minimum, it was misleading the jury and that quite possibly its theory was wrong.

Viewed in this context the error by the government was far more serious than a misleading final argument. Indeed, it was fundamental to the trial process. In this case the government skewed the fact finding process through a selective presentation of the evidence. The misleading final argument was just the final brush stroke in a false picture painted through a win-at-all-cost mentality. As the Supreme Court said long ago while the prosecutor “may strike hard blows, he is not at liberty to strike foul ones. It is as much his duty to refrain from improper methods calculated to produce a wrongful conviction as it is to use every legitimate means to bring about a just one.” Berger v. U.S., 295 U.S. 78, 88 (1935). When the fact finding process is skewed as here, the remedy is not a new trial, it should be dismissal.

by T. GormanPosted on Posted in SECActions

The Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), holding that loss causation is an element of a Section 10(b) claim for damages, continues to have a significant impact on securities litigation. One aspect is in pleading the element as discussed in the recently completed occasional series that began here. As that series detailed, there is an emerging split in the circuits over the pleading requirements for loss causation.

Another area where Dura is having a significant impact is class certification. The Fifth Circuit recently applied its interpretation of Dura to that question, affirming the denial of certification in Fenner v. Belo Corporation, Case No. 08-10576 (5th Cir. Decided Aug. 12, 2009).

That case involved a securities fraud suit against Belo, a media company that owns television stations, websites, and newspapers, and its officers. The complaint claimed that the company engaged in a fraudulent scheme designed to inflate the circulation figures for the Dallas Morning News, a newspaper owned by the company. Plaintiffs alleged that Belo paid bonuses for achieving circulation targets, rigged audits of the circulation figures and had a no-return policy that eliminated any incentive for distributors to return unsold papers. Collectively, these actions caused the circulation figures to be inflation which led to higher advertising revenues for the Dallas Morning News and larger profits for the company.

On March 9, 2004, the company announced declining circulation rates. Subsequently, on August 5, Belo announced the results of an internal investigation which revealed questionable circulation practices. According to the press release, the claimed fraudulent practices resulted in a 1.5% daily paper declines and a 5% Sunday decline. The release also stated that the declines were coupled with the circulation declines announced in March and with lower anticipated circulation for the next six months. New controls were being put in place, according to the release. The next day the price of the stock dropped at the open by about $5 from over $23 to $18. In subsequent press releases, the company projected circulation declines.

To establish loss causation using the fraud on the market theory, a securities law plaintiff must demonstrate two points, the court held: 1) that the negative truthful information causing the decrease in price is related to the claimed false statement made earlier; and 2) that it is more probable than not that the negative truthful statement and not others “caused a significant amount of the [price] decline.” This proof at the summary judgment stage “should not be conflated” with the requirements at the pleading stage, the court cautioned.

In this case, the key question is the proof required when there are multiple sources of negative information. Under such circumstances the plaintiff must demonstrate that it is more probable than not that it is the negative statement revealing the truth, and not others, which caused the price decline.

In initially seeking class certification, plaintiffs relied on SEC reports, stock price charts and analyst reports along with similar information. They did not submit any expert testimony. This, the court held, is insufficient because it is “little more than well-informed speculation.” While this information is helpful, “the testimony of an expert — along with some kind of analytical research or event study — is required to show loss causation,” the court held.

Subsequently, both sides offered expert testimony on the question of loss causation. The testimony offered by plaintiff’s expert is flawed, the court found. The event study on which it is based viewed the key press release as having only one piece of news. This is incorrect, the court held, because in fact, on its face, it has three distinct items of information. Without the event study, the testimony is not sufficient and plaintiffs fail to establish the necessary link between the inflated price and the claimed loss. Here, it is clear that the price drop could have resulted from the long term decline in circulation of the newspaper.

The approach here is not dissimilar from that used by the Tenth Circuit in In re Williams Sec. Litig. — WCG Subclass, 558 F.3d 1130 (10th Cir. 2009). There, the court also rejected the expert testimony offered by plaintiffs and then concluded that loss causation has not been established.