THE SUPREME COURT TERM – SIGNIFICANT CASES FOR BUSINESS
The Supreme Court begins its term this week with all eyes on new Justice Sonia Sotomayor. Business organizations, together with directors, officers and general counsels should focus on the slate of cases before the High Court which may have a significant impact on the securities industry, the business community and their personal liability. Those cases include:
Merck & Co. v. Reynolds, Case No. 08-905 which raises the question of when the statute of limitations begins in securities fraud damage suits. Specifically, the Court will consider the issue of “inquiry notice” and when shareholders are on notice of a possible claim such that the limitation period begins. This case arises out of securities fraud class actions brought against Merck relating to its sales of Vioxx, a prescription pain drug. The FDA warned the company about minimizing the risks regarding this drug in September 2001. Three years later, the company withdrew Vioxx from the market.
The circuits all agree that the limitation period begins when investors have notice. The question is when do they have notice and what actions, if any, do they have to take in this regard. The Third Circuit held that shareholders do not have a duty to investigate the claim. The court held that the time for the two-year statute of limitations does not begin to run until shareholders have evidence of scienter. The Ninth Circuit agrees with this view. Other circuits take differing views of what is called “inquiry notice” and what investigative efforts, if anything, shareholders must take. The test adopted and whether shareholders must investigate or be aware, for example of information available from different sources, will have a significant impact on the scope of liability in securities class actions.
Jones v. Harris Associates, L.P. , No. 08-586, presents a question regarding the standard investors must meet under Section 36(b) of the Investment Company Act to challenge the fees of an investment advisor. Ultimately at issue in the case is whether the fees of investment advisers can effectively be challenged.
Section 36(b), as discussed here, was added to the Investment Company Act in 1970. Under that section, the investment adviser has a fiduciary duty with respect to compensation for services. The statute provides for a cause of action by a security holder with respect to the fees paid, noting that approval by the board of directors shall be given consideration as the court deems appropriate but that personal misconduct need not be established. The Seventh Circuit adopted what is essentially a disclosure standard, concluding that as long as all the facts are fully disclosed, the shareholders’ action is defeated. The court rejected the widely followed standard under Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982) which held that a cause of action could be maintained if the fee is “so disproportionately large” or “excessive” such that it bears no reasonable relationship to the services rendered as also discussed here.
The government’s brief before the Supreme Court adopts the Gartenberg standard. Interestingly, none of the parties opted for the disclosure approach of the Seventh Circuit. The decision has significant implications for the fund industry, as well as all mutual fund investors.
Free Enterprise Fund v. Public Company Accounting Oversight Board, Case No. 08-861 presents the question of whether the PCAOB violates separation of powers principles and the appointment power since it is overseen by the SEC, rather than the President. PCAOB was created in the wake of corporate scandals such as Enron, Worldcom and Global Crossing. PCAOB, supervised by the SEC, was created as part of the Sarbanes Oxley Act. It has broad authority over the auditors of public companies.
Plaintiffs present two constitutional issues in the district court. The first is whether the SOX sections creating the board violate separations of powers principles. The second focus on the appointment clause based on the fact that PCAOB board members are appointed by the SEC, rather than the President. The district court granted summary judgment in favor of the board. The circuit court affirmed as discussed here.
This case has the potential to undo the SOX accounting and auditing reforms. As such, the result may impact not just the auditing profession, but also every public company as well as the users of financial statements of those companies.
Weyhrauch v. U.S., Case No. 08-1196 and U.S. v. Black, Case No. 08-876 raise a question regarding the scope of “honest services” fraud under 18 U.S.C. § 1346. Specifically, the cases present the question of what limiting principles if any define the prohibited conduct under a statute. Alternatively, the statute may be unconstitutionally vague.
Section 1346 was passed in the wake of the Supreme Court’s decision in McNally v. U.S., 483 U.S. 350 (1987), which held that the theory of “honest services” fraud was outside the scope of the mail fraud statute. Since its passage, Section 1346 has been applied to a wide variety of private and public sector conduct, criminalizing actions which many claim are well beyond that which congress intended. For example, in Brown, discussed here, Merrill Lynch executives were charged with honest services fraud in the infamous “Enron barge” deal, when Enron executives booked the transaction in a manner which falsified the financial statements of that company. The convictions were reversed by the circuit court. Many critics of the statute argue that it is so open ended that virtually any breach of duty can become a federal crime.
Weyhrauch raises the question of what limiting principles should be applied in a public sector case. There the Ninth Circuit rejected state law as a source of limiting principles. Black presents the same question in a private sector case against the backdrop of the convictions of Canadian newspaper magnate Conrad Black. The Court’s recent decision in Stoneridge, discussed here, limited the scope of liability for business executives in securities fraud suits. The question in these cases is whether the Court will adopt similar limitations to honest services fraud where the stakes for business executives and public officials are much higher in view of the potential criminal liability.
Finally, a case seeking review by the Court which is of wide interest to sports fans and others is American Needle, Inc. v. National Football League, Case No. 08-661. In that case the question is whether the NFL and the NFL Players Association are “one person” for purposes of Section 1 liability of the Sherman Act. Stated differently, the question concerns the kind of joint ventures which are immune from Sherman Act liability because they are viewed as one entity. Plaintiff is a disappointed bidder who sought to market NFL licensed materials. Currently Reebok is the exclusive licensee of the NFL. The Seventh Circuit held that the NFL and the Players Association are one person for purposes of Section 1. The NFL, NBA and NHL have urged the Court to hear the case. Major League Baseball does not have a stake here since they have had antitrust immunity since a 1922 decision by the Supreme Court.