The line between civil and criminal violations of the securities laws is, at best, difficult to discern. That difficulty is compounded by the increasing criminalization of the federal securities laws. In some instances, this had led to overreaching by prosecutors in an effort to establish the charges filed as discussed here. In others, it has resulted in shifting theories of liability. Each of these should raise a red flag that the charges brought are inappropriate. Unfortunately, the red flags are at times ignored.

U.S. v. Schiff, No. 08-1903 & 08-1990 (3rd Cir. Apr. 7, 2010) is a case where the red flags were ignored, resulting in criticism from the district court of shifting legal theories and ultimately the dismissal of some charges. The Third Circuit affirmed.

Securities fraud charges were brought against the former CFO of Bristol-Myers Squibb, Frederick Schiff, and Richard Lane, another company executive. The fraud charges arose from statements made in an earnings call and corporate filings regarding a sales strategy implemented by the drug manufacturer. Under that strategy, Bristol-Myers paid millions of dollars each quarter to its wholesales as incentives to spur buying of its products in excess of demand projections. Mr. Schiff approved the payment of these sales incentives which were supposed to cover carrying costs and guarantee a return on the investment of the wholesales until the products were sold.

The government claimed that Defendants Schiff and Lane made false and misleading statements in analyst calls and SEC filings to conceal these practices from investors. For example, in analyst calls in April, July, October and December 2001, either Mr. Schiff or Mr. Lane stated that the company was closely watching wholesaler stocking inventories and no unusual items were observed. However, in an April 1, 2002 10-K, the company stated that average wholesaler inventories had increased during 2001 and exceeded levels the company considered desirable. Accordingly, the company stated that is was developing a plan to reduce those levels which will negatively impact its financial results in future periods. In an April 3, 2002 analysts call, the CEO of Bristol announced that Mr. Lane was leaving the company and reiterated the fact that current wholesaler inventory levels significantly exceeded the level considered desirable.

The government charged Messrs. Schiff and Lane with securities fraud based in part on statements he made as well as those of the other executive. In ruling on Mr. Schiff’s motion to dismiss the third superseding indictment in view of a bill of particulars filed by the government, the district court dismissed theories of fraud liability based on omissions. Specifically, the court dismissed a theory of duty based on the alleged falsity of reported sales and earnings in the SEC filings and a second theory called “all of a piece.” Under that theory, raised for the first time one month before trial, the government claimed Mr. Schiff is liable for omissions in the SEC filings stemming from prior misleading statements made on analyst calls. The theory thus sought to link alleged prior statements in the analyst calls to claimed omissions in the SEC filings. The district court rejected this theory and criticized the government for shifting theories, concluding it would permit no further “legal theory morphs.” The government only appealed on the “all of a piece” theory.

The Third Circuit affirmed. First, the court rejected the government’s claim that Mr. Schiff had a fiduciary duty to rectify the alleged misstatements of another executive. A duty to disclose only arises in three circumstances: 1) insider trading; 2) a statutory requirement; and 3) an inaccurate, incomplete or misleading prior disclosure. The court rejected the government’s claim that as a high corporate executive such as Mr. Schiff had a duty to rectify misstatements made by another.

Second, the court rejected the government’s theories of liability based on Mr. Schiff’s statements. Here, the government argued three theories: 1) “all of a piece;” 2) duty to update; and 3) duty to correct. Under the “all of a piece” theory the government claimed that statements made at the analysts calls were tied together with the statements in the SEC filing as essentially one event. The government, however, had stipulated that its theory of liability was based only on omissions, not misrepresentations. Under these circumstances, the court held that that it was “not logical” to conclude that an utterance in an analyst conference call must have other words written into it from a later made SEC filing. Liability under Section 10(b) and Rule 10(b)-5 arises from each statement made. Here, there was an insufficient nexus to tie the statements together.

The court also rejected claims of a duty to update and correct. Both of these were new theories which the court noted the government was trying to insert into the case at the eleventh hour. A duty to update arises only when a statement was reasonable at the time, but later became misleading when viewed in the context of other events. This is not the predicate of the government’s claim here. A duty to correct arises when a historical statement that at the time was true is revealed by subsequent events to be incorrect. Again, this is not the case here. Accordingly, the district court’s order dismissing the charges is affirmed. Clearly in its zeal to prevail, the government missed the red flags here.