This Week In Securities Litigation (August 15, 2008)

This week, the Exchanges announced a new arrangement to police insider trading in an effort to streamline and enhance current enforcement efforts. At the same time, the SEC moved through its inventory of option backdating cases, Stoneridge continued to narrow those who may be held liable in private actions, but the Ninth Circuit, in a decision which seems contrary to the trend, apparently adopted a more permissive approach toward loss causation at the pleading stage. In another decision however, the Ninth Circuit gave the SEC a victory, narrowing the circumstances under which those involved in reverse mergers can obtain shares that can immediately sold into the market without registration.

New regulatory efforts re insider trading

A new regulatory agreement was announced this week which is intended to enhance insider trading surveillance. The new agreement brings together NYSE Regulation and the Financial Industry Regulatory Authority to supervise eleven current insider trading programs. Under the arrangement, each participating exchange assigns responsibility for the detection of insider trading to NYSE Regulation for New York Stock Exchange and NYSE Acra listed securities and to FINRA for American Stock Exchange and NASDQ listed securities.

The exchanges participating in this arrangement are the American Stock Exchange, Boston Stock Exchange, CBOE stock Exchange, Chicago Stock Exchange, International Securities Exchange, NASDAQ Stock Market, National Stock Exchange, New York Stock Exchange, NYSE Acra, Philadelphia Stock Exchange and FINRA.

Under the agreement, NYSE Regulation and FINRA, both supervised by the SEC, will receive referrals from the participating exchanges as to possible insider trading. Each regulator will then conduct an inquiry and, if appropriate, refer the matter to the SEC. Previously, each participating exchange conducted its own investigation. The new arrangement is designed to promote efficiency and increased scrutiny of possible insider trading since each regulator will pursue the matter regardless of where in the U.S. the matter arose.

Despite the renewed emphasis on insider trading this year, referrals to the SEC are down. FINRA has referred 104 matters to the SEC compared to 118 last year. NYSE has referred 90 cases to the SEC compared to 141 last year.

Former Apple GC settles option backdating case

Former Apple GC Nancy Heinen settled the SEC’s option backdating case against her. SEC v. Heinen, Case No. C-07-2214 (N.D. Cal. Filed Aug. 14, 2008). Under the terms of the settlement, Ms. Heinen consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions of the securities laws, as well as Exchange Act Section 16(a) and various books and records provisions. In addition, she consented to the entry of an order directing that she pay disgorgement of over $1.5 million, which represents the in the money portion of the proceeds she received from exercising the backdated options, over $400,000 in prejudgment interest and a civil penalty of $200,000. Ms. Heinen also agreed to being barred from being an officer or director for five years and to an order suspending her from practicing before the Commission as an attorney for three years.

The complaint alleged that Ms. Heinen caused Apple to fraudulently backdate two option grants to senior executives. As a result, Apple underreported its expenses by nearly $40 million. The complaint also alleges that Ms. Heinen altered company records to conceal the fraud.

Previously, former Apple CFO Fred D. Anderson settled with the SEC as discussed here. No action has been brought against Apple CEO Steven Jobs.

The impact of Stoneridge

The Supreme Court’s decision earlier this year rejecting scheme liability in Stoneridge Investors Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008) continues to have a significant impact on securities class actions. In an order dated August 12, 2008, Judge Lewis Kaplan dismissed Bank of America, Banc of America Securities, Citibank, Eureka Securitisation and Pavia e Ansaldo in In re Parmalat Securities Litig., Case No. 04-Civ-0030 (S.D.N.Y.). Previously, the court had denied a motion to dismiss these banks and securities firms from the giant Parmalat fraud. In re Parmalat Securities Litig., 376 F. Supp. 2d 473 (S.D.N.Y. 2003).

In an order last week, the court concluded that the action must be dismissed as to these defendants: “Stoneridge made plain that investors must show reliance upon a defendant’s own deceptive conduct before that defendant, otherwise a secondary actor, may be found primarily liable. Plaintiffs’ evidence falls well short of this standard. Nothing about Parmalat’s disclosures describes any defendant’s own conduct, much less conduct that was deceptive.”

Parmalat is not the first huge class action to be impacted by Stoneridge. Previously Enron, Homestore and others have been similarly impacted as discussed here.

Twombly and Dura

The Ninth Circuit also considered the impact of two recent Supreme Court decisions on securities class actions. In In re: Gilead Sciences-Securities Litig., Case No. 06-16185 (9th Cir. Aug. 11, 2008), the court reversed a determination by the district court which had dismissed the fourth amendment complaint in a securities class action. Although there was a months long gap between the time of a disclosure that a company had been improperly marketing a key drug and a stock price drop which followed issuance of poor financial results, the court rejected the conclusion that the complaint was not plausible and that loss causation had not been adequately pled as required by Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005); see also Bell Atlantic Corp. v. Twombly, 127 S.Ct. 1955 (2007) (requiring that complaint be plausible).

In reaching its conclusion, discussed in detail here, the court seemed to refocus the issue of Dura loss causation from the pleading to the trial stage of the case. This shift appears to be contrary to the dictates of the PSLRA and other Supreme Court cases, including Dura, which have focused on eliminating insubstantial cases at the outset before discovery.

Auction rate securities

What appears to be the template for regulatory settlements in the auction rate securities market emerged from the office of New York AG Andrew Cuomo in its agreement with UBS last week. Under that agreement, which followed an earlier arrangement with Citigroup Global Markets, UBS will repurchase all auction rate securities sold to retail customers. The agreement includes a schedule which requires that small customers be bought out first followed later by larger customers. UBS also agreed to pay a penalty of $75 million to New York and an additional penalty of $75 million to the North American Securities Administration. The SEC, which also issued a press release about the settlement, has deferred any penalty.

Reverse Mergers and Rule 144

In SEC v. M&A West Inc., Case No. 06-15165 (9th Cir. August 12, 2008), the Ninth Circuit narrowed the circumstances under which promoters and others involved in reverse mergers can obtain stock which can then be traded under Rule 144 without registration. In this case, the court affirmed a grant of summary judgment in favor of the Commission, concluding that the promoter of three reverse mergers violated Section 5 when he sold stock acquired as compensation in the deals.

The court concluded that where a promoter received shares of unregistered stock in a reverse merger from individuals who were affiliates at the start of the transaction, but as a result of the structure of the deal were no longer affiliates at the end, that the promoter could not rely on Rule 144(k) to sell the shares immediately in the open market. Essentially, the court held that the substance of the deal controlled, rejecting the promoter’s argument that he could rely on the structure of the deal.

Reverse Mergers and Rule 144: Substance Is The Key

The SEC has long sought to close avenues through which companies gain access to the capital markets without going through the usual Securities Act registration process and by which promoters and others acquire unregistered shares which can be traded. One popular method is a reverse merger in which a privately held company acquires a publicly traded corporation thereby allowing the private company to become public without going through the registration process. Promoters and others frequently acquire shares from former affiliates in these transactions which can be traded following the merger without registration.

In SEC v. M&A West Inc., Case No. 06-15165 (9th Cir. August 12, 2008), the Ninth Circuit aided the SEC’s cause. The court affirmed a grant of summary judgment by the district court in favor of the Commission, concluding that the promoter of three reverse mergers violated Section 5 when he sold stock acquired as compensation in the deals.

The ruling is predicated on three reverse mergers. While there are variations in the deals, essentially each involved the merger of a public shell company into a private company. Under the terms of the agreements, the affiliates of the public company became non-affiliates at the closing when they were replaced by persons from the private company. Defendant Stanley Medley, who arranged the deals, was paid in shares that he later sold. All of this occurred at the closing.

The SEC argued that Mr. Medley, in practical terms, received his shares from affiliates despite the structure of the deals. Mr. Medley contended however, that under the terms of the transactions, the public company affiliates of the issuer were first replaced thus becoming non-affiliates. Then, in a second step the new non-affiliates transferred stock to him. According to Mr. Medley his shares were not restricted because Rule 144(k) permits a person who is not an affiliate of the issuer, and who has not been an affiliate for the past three months (such as him) to sell the shares. Here, all of the terms of Rule 144 were fully complied with in all three transactions, according to Mr. Medley.

The court rejected defendant’s argument, concluding that despite the two-step structure of the transactions, in substance Mr. Medley received shares from affiliates and thus could not avail himself of Rule 144. Citing the Supreme Courts seminal decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the court concluded that “[w]here a single transaction accomplishes both a change in status from an affiliate to a non-affiliate and a transfer of stock from that person or entity, the transfer must be viewed as a transfer from an affiliate for the purposes of determining Rule 144(k) eligibility. The existence of multiple agreements bears little effect when the agreements collectively constitute a single transaction.” This conclusion is bolstered by the purpose of Section 5, the court noted, which is intended to ensure that adequate information was available to the investing public, something not present here.

Judge Ikuta dissented from the ruling of the majority on two of the transactions. Those two transactions involved multiple agreements to complete the transaction rather than just one. Judge Ikuta argued that parties are entitled to structure transactions based on the plain language of a Rule such as 144.

Rule 144 has been amended since this case was litigated. Now excluded from its safe harbor are shares of companies with no or nominal operations and assets consisting solely of cash or cash equivalents. The revised Rule may in effect preclude transactions such as this. Nevertheless, the ruling is important for those structuring transactions. Clearly more attention must be paid to the substance as well as the structure. This will be particularly true for transactions designed to avoid statutory and regulatory requirements.