by T. GormanPosted on Posted in SECActions

Today, a jury found former Brocade Communications Systems, Inc. CEO Gregory Reyes guilty on all charges in a case based on backdating stock options.  This is the first government enforcement action – civil or criminal – to go to trial.  That the government prevailed should not be surprising.  The Brocade case is the first options backdating case and was announced with great fanfare by the U.S. Attorney’s Office for the Northern District of California and the Securities and Exchange Commission in a joint press conference.  The allegations in the parallel criminal and civil enforcement actions suggested very strong cases.  Indeed, the government should be expected to select their best case to begin. 

What is perhaps surprising is the drawn out decision by Judge Breyer on the defense Rule 29 motion for acquittal, which was keyed to whether Mr. Reyes understood or knew much about the critical accounting issues involved.  Equally surprising is the length of time which the jury took to come to a verdict.  While this was clearly a big win for the government, at the same time it should be pause for reflection.  Judge Breyer’s long deliberations and those of the jury should at least suggest that prevailing in these cases is not a slam dunk.  

At the same time, every company and corporate official involved in the 140 or so investigations the SEC reportedly has underway (as well as those in parallel criminal investigations) must be wondering what this verdict means for them.  Had the government lost, it might have meant a re-evaluation of options backdating cases.  A win, however, should not necessarily mean “full steam ahead.”  No doubt that the verdict means that the government is on the right track with its option backdating cases.  At the same time, the fact that the verdict was hardly a slam dunk and at least appears to have been obtained only with significant difficulty in the government’s lead case, should at least suggest to government prosecutors and SEC enforcement officials that any future cases based on claims of option backdating be very carefully evaluated in terms of the knowledge of the individuals claimed to have been involved and their understanding of the accounting issues and the impact of those issues on the company.  At the end of the day, all of this suggests that government prosecutors would do well to proceed with a more narrow focus than a win in this case might otherwise indicate.  

by T. GormanPosted on Posted in SECActions

The Supreme Court’s recent decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), in some ways may appear to have resolved a question of little real import, since it deals only with the requirements for pleading one element of a Section 10(b) cause of action for fraud. While significant amount of time and ink have been expended on the decision that will be handed down next term in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc., No. 06-43, the significance of Tellabs and its recasting of the rules for resolving a motion to dismiss should not be over looked. Long term, the “jade falcon” standard crafted by the Court – a title borrowed from a hypothetical offered by Justice Scalia in his concurring opinion and adopted by the majority as an illustration of its holding – will have a significant impact on private securities litigation.Tellabs has its roots in the Private Securities Litigation Reform Act of 1995 (“Reform Act”) passed by Congress in 1995 and splits in the circuits concerning the pleading requirements for scienter, which predated and postdated that legislation. After hearing repeated testimony about lawyer-driven securities class actions suits filed by nominal plaintiffs based on complaints containing few facts, but which were used to drive huge settlements with no relation to the merit because of imposing discovery demands and costs, Congress passed the Reform Act. The aim of the package of substantive and procedural amendments incorporated into the Reform Act was to eliminate frivolous suits at the outset, while permitting those with merit to proceed. The Reform Act incorporates new requirements for selecting the lead plaintiff, adds procedural limits on settlements and fees and heightened new pleading requirements.

Tellabs has its roots in the Private Securities Litigation Reform Act of 1995 (“Reform Act”) passed by Congress in 1995 and splits in the circuits concerning the pleading requirements for scienter, which predated and postdated that legislation. After hearing repeated testimony about lawyer-driven securities class actions suits filed by nominal plaintiffs based on complaints containing few facts, but which were used to drive huge settlements with no relation to the merit because of imposing discovery demands and costs, Congress passed the Reform Act. The aim of the package of substantive and procedural amendments incorporated into the Reform Act was to eliminate frivolous suits at the outset, while permitting those with merit to proceed. The Reform Act incorporates new requirements for selecting the lead plaintiff, adds procedural limits on settlements and fees and heightened new pleading requirements.

Section 21D(b)(2), which was a key provision of the Reform Act, provides in pertinent part:

In any private action, the complaint shall … state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

Congress did not define “the required state of mind.” Likewise Congress did not define the phrase “strong inference,” or otherwise indicate how the courts should evaluate whether such an inference had been pled in a securities fraud complaint. And, Congress did not identify how the courts should make that evaluation in the context of existing Fed. R. Civ. P. 12(b)(6) motion to dismiss procedures which heavily favored plaintiffs by permitting most cases to proceed into discovery. Congress clearly did, however, specify that then-existing motion to dismiss procedures should be changed by including a provision in the Reform Act precluding discovery until a motion to dismiss is resolved. This contrasts sharply with standard procedure in other suits where the filing of a motion to dismiss does not preclude the commencement of discovery.

Congress did not write Section 21D(b)(2) on a clean slate. The backdrop to the section is a split in the circuits over how to plead scienter. Interestingly, the resolution by Congress of that split which is Section 21D(b)(2) spawned another split in the circuits which was resolved in Tellabs. The coming segments of this series will discuss these splits and analyze the significance of the Tellabs decision.