The Second Circuit Rules On The Application Of The Basic Presumption

The Second Circuit Court of Appeals rejected claims in In Re: Salomon Analyst Metromedia Litig., Case No. 06-3225 (2nd Cir. Sept. 30, 2008) asserting that a plaintiff relying on the fraud-on-the-market presumption of Basic, Inc. v. Levinson, 485 U.S. 224 (1988) must establish that the claimed representations actually affected the price of the securities traded in the open market and that it can only be used as to issuers. The court remanded the case to the district court with instructions.

Plaintiffs claimed that Citicorp USA, Inc., Salomon Smith Barney, Inc., their ultimate parent, Citigroup, Inc., and SSB research analyst Jack Grubman engaged in a scheme to defraud investors in Metromedia. The complaint alleged that defendants issued and disseminated research reports that contained false and misleading statements and material omissions. While the district court dismissed portions of the complaint, certain claims were permitted to move forward. The court certified the class as to those claims relying in part on the Basic presumption.

On appeal, defendants argued that the Basic presumption should not be applied to statements of someone other than the issuer – such as those of the research analyst here – and that plaintiff had to demonstrate that the statements impacted price. The Second Circuit rejected these claims as inconsistent with Basic.

First, the court concluded that there is no case which limits the Basic presumption to statements or omissions made by issuers. This is because the presumption is premised on the theory that in an efficient market share price reflects all publicly available information, including any misrepresentation. This conclusion is consistent with the Supreme Court’s recent decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, 128 S.Ct. 761 (2008), which applied the Basic test to statements of non-issuers.

Second, actual price impact need not be established because, under Basic, “if plaintiffs can show that the alleged misrepresentation was material and publicly transmitted into a well-developed market, then reliance will be presumed, for if a reasonable investor would think that the information would have ‘significantly altered the ‘total mix’ of information … then it may be presumed that, in an efficient market, investors would have taken the omitted information into account, thereby affecting market price ….'” (Citations omitted) This holding is based on principles of common sense, fairness and congressional policy, not economics, the court noted.

The Circuit Court remanded the case to afford defendants an opportunity to rebut the Basic presumption prior to certification, reversing the district court’s ruling on this point. In this regard, the Court stated that “we hold that plaintiffs must show that the statement is material (a prima facie showing will not suffice). However, once that is done, the burden shifts to the defense to show that the allegedly false or misleading material statements did not measurably impact the market price of the security.” (Emphasis original).

AN SEC SUBPRIME CASE; JURY ACQUITS ON OPTION BACKDATING

As the House of Representatives passed the market crisis bill on Friday, the Commission filed what may be the first of a series of actions arising out of its sub-prime mortgage investigations. At the same time, a jury in Northern California found the former General Counsel of McAfee, Inc. not guilty on fraud charges based on option an option backdating scheme at that company.

Subprime investigations

SEC v. Ainsworth, Case No. EDCV 08-1350 (C.D. Cal. Oct. 3, 2008) is a case in which the claims are based on what is alleged to be unscrupulous subprime mortgage lending. The complaint is based on a scheme in which defendants fraudulently sold unsuitable securities to home owners which were paid for with cash obtained from refinancing the investor’s home with a subprime negative amortization mortgage. The transactions generated fees for defendants at each step.

The complaint names four individuals as defendants. The individual defendants were employed by a group of companies that acted as a broker dealer, mortgage company and life insurance company. The Commission’s complaint details a series of transactions in which individual home owners were defrauded. Typically, the individual home owners identified in the complaint had no prior investment experience, limited education, some worked multiple jobs and they did not have the cash for the unsuitable investments defendants induced them to make.

Each investor had a home with a fixed rate mortgage that defendants tapped to generate cash to make the investments and generate fees for themselves. Typically, Defendants would convince the investor to make an investment with one of the affiliated companies, such as mutual fund shares or variable annuity. The investment would be paid for with the equity from the home and by refinancing the investor’s fixed rate to get lower payments. This transaction, which generated more cash for the investments, was done with a variable rate subprime mortgage that had negative amortization. According to the complaint, the investments defendants convinced the investors to make were not suitable for these first time investors. In convincing the investors to enter into these transactions, defendants did not disclose the fees and insurance charges associated with the deals.

The Commission’s complaint requests an injunction prohibiting future violations of Sections 17(a) and 10(b), disgorgement and prejudgment interest and civil penalties. The case is in litigation.

Option backdating

Kent H. Roberts was acquitted of two counts of securities fraud in his option backdating trial on Friday. The jury was unable to decide a third count based on falsifying records. U.S. v. Roberts, Case No. 070100 (N.D. Cal. Feb. 27, 2008). The SEC filed similar claims against Mr. Roberts last year. That case is still pending. SEC v. Roberts, Case No. 1:07 cv 00407 (N.D. Cal. Feb. 28, 2007).