This Week In Securities Litigation (November 21, 2008)
In securities litigation this week, there were two significant circuit court cases. The SEC filed two new enforcement actions, while receiving a largely adverse ruling in another. And, the Supreme Court agreed to hear an appeal in a criminal case from a former Enron executive. In private litigation, a derivative suit based on option backdating was dismissed for lack of standing, as another was settled based on corporate governance changes.
Finally, the President’s Working Group on Financial Markets announced a series of policy objectives regarding the derivatives market, as the Federal Reserve Board of Governors, the Securities and Exchange Commission and the Commodity Futures Trading Commission executed an MOU regarding the development of CDS Central Counterparties.
The Circuit Courts
The Sixth Circuit concluded in Frank v. Dana Corp., No. 07-235 (6th Cir. Decided Nov. 19, 2008) that the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007) reduced the burden of pleading a strong inference of scienter under the PSLRA in the circuit. Other circuits, such as the Ninth, have reached similar conclusions while some, such as the Second, have applied the teachings of the case along with their prior case law.
Dana is a securities class action based on allegations that investors were misled by false statements about earnings, the financial outlook, and the adequacy of internal accounting controls. The Sixth Circuit reversed the district court’s dismissal for failure to comply with the PSLRA pleading standards as to scienter.
The Court concluded that Tellabs requires the application of a three part test. First, the facts in the complaint are deemed true. Second, the complaint must be considered in its entirety to determine whether the inference of scienter is cogent and compelling. Third, to assess whether the facts give rise to a strong inference, the court must examine the opposing inferences and determine if a reasonable person would conclude that the inference of scienter is at least as compelling as any opposing inferences.
Here, the district court properly applied the first two prongs of the Tellabs test, but not the third. Instead the court followed Helwig v. Vencor, Inc., 251 F.3d. 540 (6th Cir. 2001) (en banc) which held that the strong inference standard means that plaintiffs are entitled to the most plausible of competing inferences. The standard is “no longer good law” after Tellabs, the Sixth Circuit concluded.
In Staehr v. The Hartford Financial Services Group, Inc., No. 06-3877-cv (2nd Cir. Nov. 17, 2008), the Second Circuit reversed a decision which had dismissed a securities fraud class action on statute of limitations grounds.
The complaint claimed shareholders were misled in purchasing shares of the company by being led to believe that the stock price resulted from the strength of its business, rather than a fraudulent scheme involving the payment of kickbacks to secure business, bid rigging and inflated premiums. The district court dismissed the case for failing to file within the two-year statute of limitations imposed by SOX Section 804.
The Second Circuit reversed. Under the two year Section 804 limitation period, the question is: when did the plaintiff had actual knowledge of the claim? If there is no actual knowledge, the question becomes when plaintiff had sufficient facts to place it on inquiry notice – that is, when there are “storm warnings.” That question can be resolved on a motion to dismiss.
Here, the court first concluded that the district court properly took judicial notice of certain materials in making its rulings. Those materials included other lawsuits, media reports, publications such as the New York Times, industry publications and regulatory filings. The Court held that judicial notice can be taken of the fact that these materials are available to determine the “storm warnings” issue. Judicial notice is not taken of the facts in the materials, however.
After an extensive review of its prior decisions on “storm warnings,” the court concluded that for inquiry notice to exist, the “triggering information must relate directly to the misrepresentations and omissions the Plaintiffs later allege in their action against the defendants.” (citations omitted). This is an objective standard, which can be resolved as a matter of law based on the totality of the circumstances. After carefully reviewing all of the materials here, the Court concluded that, collectively, they were insufficient to put the plaintiffs on inquiry notice. Portions of the material did not provide adequate detail, while items such as industry newsletters were not sufficiently circulated to conclude as a matter of law that a reasonable investor would have found them. While normally, filings such as a 10-K might be sufficient, here the information in the filings was not adequate to provide notice.
SEC enforcement actions
In SEC v. Lee, Civil Action No. 08-CIV-9961 (S.D.N.Y. Nov. 18, 2008), the Commission brought an action based on a fraudulent scheme keyed to derivatives. It named as defendants David Lee, a former commodity option trader at a subsidiary of Bank of Montreal, and Kevin Cassidy, Edward O’Connor and Scott Connor, all former employees of Optionable, a commodity brokerage whose shares are traded on the OTC Bulletin Board.
The complaint alleges a scheme which victimized the shareholders of the bank and of the brokerage firm, as well as the New York Mercantile Exchange. The complaint claims that the bank’s shareholders were defrauded by the four defendants in a “u-turn” scheme. There, when Mr. Lee could not obtain market prices for trading positions in natural gas options, he inserted prices or marks which were verified by the Optionable defendants. As a result, the financial statements were falsified.
The shareholders of Optionable were also the victims. The periodic reports of this company were false. The New York Mercantile Exchange became the third victim, when Optionable used those false reports to sell over $10 million of its shares to the exchange. This case is in litigation.
The U.S. Attorney’s Office for the Southern District of New York announced the unsealing of a six count indictment against Mr. Cassidy at the same time the SEC filed its case. In doing so, the USAO noted that Mr. Lee had pled guilty to a four-count criminal information on November 13, 2008. The charges were based on the same scheme outlined in the SEC complaint. Mr. Lee also pled guilty to violating New York State’s Banking Law. In a separate action he consented to the issuance of a Consent Order of Prohibition, according to the Federal Reserve Board.
The Commission also brought a high profile insider trading case against the owner of the Dallas Mavericks, Mark Cuban. SEC v. Cuban, Civil Action No. 3-08-CV-2050 (N.D.Tex. Filed Nov. 17, 2008). Here, the claims are based on a PIPE offering made by Mamma.com Inc.. According to the complaint, in 2004 when the company was planning the offering, Mr. Cuban, its largest known shareholder, was contacted several times about the proposed offering. Before information about the transaction was provided to him, he agreed to maintain its confidentiality. Mr. Cuban was reportedly upset by the offering because it would dilute his interest and declined to participate. Shortly before the public announcement, Mr. Cuban sold his entire stake in the company, avoiding what the SEC claims was potentially a $750,000 loss. The case is in litigation.
To date, the SEC has had difficulty in the three cases it has litigated involving trading in connection with PIPE offerings as discussed here. In two of those cases claims are still pending, although some have been dismissed.
In SEC v. Beardsley, Civil Action No. 08-cv-10054 (S.D.N.Y. Filed Nov. 19, 2008) and SEC v. McNell, Civil Action No. 08-cv-10053 (S.D.N.Y. Filed Nov. 19, 2008), the Commission filed actions involving two day traders and the former CEO of a brokerage firm for participating in an alleged manipulative short selling scheme. The two traders are Robert Beardsley and George Lindenberg. They traded through accounts at Redwood Trading LLC. Dennis McNell is the former CEO and COO of Redwood, which is no longer in business.
According to the complaint, the two traders engaged in manipulative short selling by repeatedly trading in violation of the uptick rule (which has now been rescinded) with the intent to artificially depress the share price. The traders would later cover their short positions at favorable prices. Mr. McNell is alleged to have aided and abetted the scheme by disabling a feature in trading software that was designed to prohibit such trading.
Mr. McNell agreed to resolve the case against him by consenting to the entry of a permanent injunction prohibiting future violations of Sections 9(a)(2) and 10(b) and various broker dealer books and records provisions. He also consented to the issuance of an administrative order barring him from association with any broker or dealer with a right to reapply after five years in a non-supervisory capacity. No fine was imposed in view of his financial condition. Beardsley is in litigation.
The Court in SEC v. Goldsworthy, Civil Action No. 06-cv-10012 (D. Mass. Filed Jan. 4, 2006) rejected most of the SEC’s claims against former Applix, Inc. CEO Alan Goldsworthy and former CFO Walter T. Hilger. The SEC’s complaint claimed that Messrs. Goldsworthy and Hilger, along with then director of world-wide operations Mark Sullivan, engaged in two separate schemes to inflate the revenue of Applix in violation of the antifraud provisions.
The court rejected the SEC’s accusations of intentional fraudulent based on the findings of a jury made after a four-week trial. The court concluded however, that the Commission established violations of Section 17(a)(3) and Rule 13b2-1 as to Mr. Hilger. The court imposed a $5,000 penalty on Mr. Hilger. No injunction was entered.
The Court agreed to hear the appeal of a former Enron executive this week. Yeager v. U.S., Case No. 06-20321 (S.Ct. Filed July 14, 2008). Mr. Yeager is the former top strategist in Enron’s broadband division. He was acquitted on charges of conspiracy and fraud, but the jury was unable to reach verdicts on 90 counts of insider trading and money laundering. The Court agreed to determine whether Mr. Yeager could be retried under the double jeopardy clause in view of fact that he was acquitted on counts which are factually related to those on which he would be retried.
In Bussing v. Schwartz, Civil Docket No. 3:06-cv-04669 (N.D. Cal. Filed Aug. 1, 2006), the court dismissed for lack of standing the second amended complaint in a shareholders derivative suit based on claims of illegal option backdating. The complaint, brought by three claimed shareholders, alleged fraudulent stock option grants in August 1995, June 2000, October 2001 and April 2002. The complaint, according to the court, failed to demonstrate that plaintiff’s stock ownership was sufficient to confer standing with respect to any of the grants. There were still questions regarding when plaintiffs owned their shares. The court granted leave to re-file if two of the shareholders were dropped.
In another derivative suit based on options backdating claims, the parties reached a tentative settlement. Sheet Metal Workers Local 28 Pension Fund v. Roberts, Case No. 15:0078 (S.D. Fla. Filed March 6, 2007). The complaint claimed that members of the company’s board of directors and certain officers violated the securities laws and breached their fiduciary duties by backdating option grants. The tentative settlement calls for the company to adopt a package of corporate governance procedures. The settlement also includes two related state court actions. Previously, the SEC closed its investigation without bringing an enforcement action.
The President’s Working Group on Financial Markets (“PWG”) announced a series of policy objectives regarding the over-the counter-derivatives market last Friday. At the same time, the group announced the execution of a Memorandum of Understanding among the Federal Reserve Board of Governors, the Securities and Exchange Commission and the Commodity Futures Trading Commission regarding the development of CDS Central Counterparties.
The PWG announced four key policy objectives regarding the OTC derivatives market:
1) improving transparency in the credit default swaps market; 2) enhancing risk management of OTC derivatives; 3) improving the OTC derivatives market infrastructure; and 4) improving cooperation among regulators. The group’s “top near-term OTC derivatives priority is to oversee the successful implementation of central counterparty services for credit default swaps.” Accordingly, it is assessing the efforts being made in this regard.
The MOU announced by the group establishes what the PWG called “a framework for consultation and information sharing on issues related to CDS central counterparties.” The group noted that it will seek to implement its objectives over the next several months and will support legislation where appropriate.