by T. GormanPosted on Posted in SECActions

A key Supreme Court decision which impacts not just pleading, but also proof requirements is Dura Pharmaceuticals, Inc., v. Broudo, 544 U.S. 336 (2005). There, the Court held that plaintiffs must plead and proof loss causation to establish a Section 10(b) cause of action for damages.

Prior to Dura, the circuits had split over the question of loss causation. The Second, Third and Eleventh Circuits required more than price inflation to establish a link between the claimed misrepresentation or omission and injury. See, e.g., Emergent Capital Inv. v. Stonepath Group, 343 F.3d 189 (2nd Cir. 2003).

In contrast, the Eighth and Ninth Circuits held that the fraud on the market theory of Basic v. Levinson, 485 U.S. 224 (1988) (holding that where there is an efficient market there is a presumption of reliance on the integrity of the market), permitted the presumption that when stock prices were inflated, it made sense to conclude that plaintiffs were harmed by paying too much for the shares. See, e.g., Gebhardt v. ConAgra Foods, 335 F.3d 824 (8th Cir. 2003).

Dura rejected the notion that price inflation alone was sufficient to establish a Section 10(b) cause of action for damages. The complaint in Dura claimed that the company made false statements about its drug profits and future FDA approval of a new asthmatic spray device. Subsequently, the company announced that its earnings would be lower than expected, principally due to slow drug sales. The next day, its share price fell almost 50%. Eight months later, the company announced that the FDA would not approve its new asthmatic spray device. The share price fell temporarily, but almost fully recovered within one week. Plaintiffs claimed that their economic loss resulted from paying artificially inflated prices for Dura shares.

The district court dismissed the complaint, concluding that it failed to adequately allege scienter as to the drug profitability claim. As to the spray device claim, the court concluded that plaintiffs failed to adequately allege loss causation. The Ninth Circuit reversed on the causation question, holding that price inflation was sufficient because loss causation is established on the date of purchase.

The Supreme Court reversed, holding that price inflation alone is not sufficient to establish a causal link between the claimed fraud and injury. The Court’s opinion has six key points:

1. The elements of a private cause of action under Section 10(b) are based in part on common law principles and in part on those added by Congress. At common law a causal link was required between the claimed misrepresentation and the alleged injury, that is, loss causation.

2. As a matter of logic, an inflated price alone is not sufficient. While an inflated price might mean there is a loss, this does not necessarily follow.

3. Loss causation is consistent with the goals of the PSLRA of maintaining confidence in the markets but not insuring against loss.

4. The decision of the Ninth Circuit lacks precedent and is not supported by common law tort principles in which the Section 10(b) damage action is rooted.

5. Basic Rule 8(a) notice pleading requirements require that “fair notice” be given to the defendant as to the claim. This should not be that difficult of a burden for plaintiff. (This point in the opinion later became part of the rationale for the Court’s Twombly plausibility pleading requirement discussed earlier in this series here).

6. Absent loss causation, baseless claims could go forward.

On remand, the district court found that the complaint adequately pled loss causation because plaintiff’s “explained how the misrepresentations … caused economic loss.” This conclusion is based on the fact that plaintiffs amended the complaint regarding their medical device claim to allege that the misrepresentations inflated the stock price and that the share price dropped following corrective disclosures made on three different dates.

The precise impact of Dura is somewhat controversial. Most commentators would agree that the decision has had an impact. Some, however, argue that the Court left open more questions than it resolved.

Next: The impact of Dura

by T. GormanPosted on Posted in SECActions

This week, the Attorney Client Protection Act of 2008, pending in the Senate following passage in the House, received support from a group of former federal prosecutors.

In securities damage actions, Brooks Automation reached a tentative settlement in a class action. At the same time a decision by the Second Circuit Court of Appeals raised questions as to the pleading standards for scienter in the circuit.

Finally, as the week drew to a close, the SEC prevailed in a long-pending insider trading case where criminal charges had been dropped against the defendant. Earlier in the week, the SEC filed a settled insider trading case where the vague allegations of the complaint raise questions regarding what inside information was actually available to a defendant.

Privilege waivers

The Attorney Client Protection Act got a vote of support this week from 32 former federal prosecutors this week. In a letter to Senator Patrick Leahy, the former prosecutors argued that the Act should be passed because the “widespread practice” of requiring waivers has undercut the privilege and the constitutional rights of employees involved in corporate investigations. Former Deputy Attorney General Paul McNulty was not among those urging passage of the Act. Mr. McNulty authored a 2006 revision of DOJ’s prosecution and cooperation standards which sought to place limits on the circumstances under which prosecutors could request waivers. The revision had little impact in the view of many commentators.

The Act, previously passed by the House, is pending in the Senate. Essentially, the Attorney Client Protection Act would bar any federal prosecutor or attorney, including those at the SEC, from requesting a waiver of privilege.

What impact, if any the proposed legislation would have, is at best debatable. The Act would still permit business organizations to waive privilege and obtain cooperation credit. While there is no doubt that some business organizations would like the opportunity to consider waiving privilege under certain circumstances, the current situation presents clear difficulties.

In many instances, waivers are not the result of a direct request. Rather, they are the by-product of a pressure-packed charging system. On the one hand, prosecutors have very broad charging discretion guided by vague, almost open-ended standards. On the other, business organizations are offered little real guidance on what constitutes cooperation or what it can expect from such action. What is very clear is the potential harm to the company from being charged and the need to take any steps necessary to avoid it.

In this context, the about-to-be-charged business organization has little choice except to grasp for any desperate step that might help mitigate the potential liability. Those desperate steps frequently include privilege waivers which can undercut the rights of the organization and its ability to obtain legal advice, and which can have adverse consequences in private litigation. That waiver can also damage fundamental rights of employees who may want to cooperate with the company, but not necessarily the government. As long as there is cooperation credit to be had for a waiver born of desperation, whether it is the result of a direct request from prosecutors or it is a so-called voluntary waiver is of little moment: the result is the same. The Act may have some impact on waivers resulting from prosecutorial requests, but not on those compelled by the process.

Securities damage actions

Brooks Automation, Inc. tentatively settled a securities class action based on allegations of option backdating. Under the tentative settlement, $7.75 million will be paid into a settlement fund by the liability insurers for the company.

Previously, the company settled an option backdating case with the SEC. A separate enforcement action filed by the SEC against a company executive is still pending. Both are discussed here.

A decision this week by the Second Circuit raised questions concerning the pleading standards being followed in the circuit in securities damage actions. In Bay Harbour Management LLC v. Carothers, Case No. 07-1124-cv (2nd Cir. June 24, 2008), the court affirmed the dismissal of a securities damage action in part for failing to properly plead scienter under Section 21D(b)(2) of the PSLRA. The Supreme Court crafted a new “equipoise” standard in Tellabs v. Makor Issues & Rights, Ltd., 128 S.Ct. 61 (2007) last year for determining when a “strong inference” of scienter has been pled under the Section. Yet, Bay Harbour failed to cite the High Court’s decision or even mention its test. Rather, the Circuit Court used a test it first created prior to the passage of the PSLRA, raising questions about what pleading standards are being followed in the circuit.

Insider trading

The SEC obtained a jury verdict in its favor in a long pending insider trading case, SEC v. Patton, Civil Action No. 02 cv 2564 (E.D.N.Y. April 30, 2002). Following the verdict, the court entered a final judgment against defendant Constantine Stamoulis, enjoining him from violating Section 10(b) and Rule 10(b)-5 and directing him to disgorge his trading profits and prejudgment interest and to pay a fine equal to three times the amount of his gain.

The SEC’s complaint, filed in April 2002, named fourteen individuals as defendant. It alleged insider trading in the securities of WLR Foods, Inc. prior to a September 27, 2000, announcement that the company was being acquired by Pilgrim’s Pride Corporation. Among those named as defendants were Eric Patton, the former Director of Manufacturing for the Turkey division of the company, his brother Steve Patton, the owner of a Pennsylvania trucking company, Michael Nicolaou, Steve Patton’s former registered representative, Mr. Nicolaou’ friend Dimitrios Kostopoulos, also a former representative, and several others. The other defendants have settled with the SEC, consenting to injunctions prohibiting future violations and orders requiring the payment of disgorgement and penalties.

Criminal insider trading charges were also filed in 2002 against Eric and Steve Patton, Mr. Stamoulis, and several other defendants. Three of the defendants pled guilty to conspiracy and securities fraud charges while another defendant pled guilt to a perjury charge. The criminal charges were dismissed as to three defendants including Mr. Stamoulis.

Finally, the SEC also filed a settled insider trading case this week against a Williams-Sonoma, Inc. employee who held the position of manager for financial planning and analysis. The complaint claimed that defendant Di Vita learned inside information about the downward financial trend of the company at a management meeting and traded while in possession of that information prior to its release.

Although Mr. Di Vita settled the action by consenting to an injunction and agreeing to pay disgorgement, prejudgment interest and a penalty, the SEC’s complaint was, at best vague about what information was available at, and transpired during, the key meeting where the financial information was discussed. The case is discussed in more detail here. SEC v. Di Vita, Civil Action No. 1:08-cv-01060 (D.D.C. June 20, 2008).