The following guest post is by Jonathan M. Plasse and Christopher McDonald, partners at Labaton Sucharow & Rudoff LLP.

Last week the Supreme Court heard oral argument in two class action cases, Tellabs, Incorporated v. Makor Issues & Rights, Ltd. and Credit Suisse v. Billing, the outcomes of which may impact in different ways the viability of future actions to recover investor losses. If decided adversely to shareholder interests, each case may impede shareholders' ability to recover losses caused by a company's fraudulent disclosures, collusion or other illegal practices.

The Tellabs case could significantly increase the burden that investors – public pension funds, retirement funds, individuals and others – face when attempting to recover losses caused by a company’s fraudulent activity. In Tellabs, the Court will decide whether to make it easier for federal courts to dismiss securities class actions at the pleading stage.

The background on the case is fairly straightforward. Tellabs manufactures and markets broadband access and optical networking equipment. The plaintiffs allege that Tellabs and its executives concealed from investors the fact that the company was experiencing a “dramatic slowdown” in sales from mid-2000 to mid-2001. During that same time, Tellabs’ CEO was repeatedly reassuring investors that, unlike its competitors, Tellabs was experiencing “robust growth.” Also during that period, Tellabs insiders profited by selling tens of thousands of Tellabs shares for more than $8 million. As a result of the defendants’ fraudulent acts and statements, Tellabs’ share price peaked at a high of $65.38, before plunging to $16.04 after the truth about the company’s financial condition was disclosed.

In Tellabs, the Supreme Court will be reviewing the Seventh Circuit’s interpretation of “scienter,” meaning a defendant’s intent, or culpable state of mind. To succeed on a fraud claim under the securities laws, a plaintiff must allege facts that create a “strong inference” of scienter – in other words, a strong inference that the defendants knew, or should have known, that their statements to the investing public were false or misleading. The Seventh Circuit found that a securities class action can proceed if, based on the facts alleged in the complaint, “a reasonable person could infer that the defendants acted with the requisite intent” – a standard consistent with rulings by several other U.S. Courts of Appeals, including the Second Circuit. On their appeal to the Supreme Court, the defendants contend that claims of securities fraud should be dismissed at the pleading stage unless the “facts alleged in the complaint strongly show the promise or substantial merit in a plaintiff’s claim of scienter,” which includes alleging facts that “meaningfully tend to exclude the possibility of innocence.”

The standards for scienter advanced by the defendants in Tellabs would make it extremely difficult for most securities class actions to proceed. Were the Supreme Court to adopt the position advanced by the defendants in the case, the impact would be dramatic, as many meritorious lawsuits would likely not survive. This is true because investors would be required to not only allege detailed, specific facts showing that the defendants intended to violate the law, but facts that also rule out any possible non-culpable explanations for the defendants’ conduct.

This unreasonably high standard, which would have to be met before the plaintiffs are permitted to engage in discovery on the issue of the defendants’ subjective state of mind, would result in many meritorious cases being thrown at the earliest possible stage of litigation. In turn, investors would increasingly be left with little recourse in the event of fraud.

One surprising aspect of the Tellabs case is that the federal government – in a break from its past policies that encouraged protecting investors and the public, rather than protecting wrongdoers – filed amicus curiae (friend of the court) briefs in support of the defendants. That said, representatives of a majority of the states, including the attorneys general of 24 states and territories, filed amicus briefs in support of the plaintiffs in the Tellabs case. The attorneys general warn that the standard advocated by the defendants and the federal government “carries the high price of blocking many meritorious claims . . . that protect the market, well-run businesses, and investors.”

Indeed. In the wake of Enron, WorldCom and other high profile cases of corporate fraud (including, most recently, the expanding options backdating scandal), the last thing this country needs is for the Court to further shield corporate wrongdoers from liability by sharply curtailing the number of private securities lawsuits seeking redress in instances where companies and their officers have not been truthful with the investing public.

In the Credit Suisse case, the Supreme Court will decide whether antitrust laws apply to Wall Street.

Credit Suisse is one of ten investment banks named as defendants that allegedly rigged the initial public offerings (IPOs) of approximately 900 Internet and technology stocks in the 1990s. The plaintiffs allege that in the course of underwriting IPOs, the banks and certain institutional investors to which they allocated IPO shares manipulated aftermarket (stock market) share prices by tie-in arrangements such as "laddering." With laddering, institutional investors agree to purchase an allocation of IPO shares directly from the underwriter, but also agree to purchase shares in the aftermarket at pre-arranged ever increasing prices. These pre-arranged purchases create the illusion of demand in the market, which artificially drives up the share prices that ordinary investors pay. By then selling their shares at the artificially high prices, tie-in participants illegally profit because their collusion – rather than competitive market forces – is what caused share prices to skyrocket. The plaintiffs – who bought shares at the allegedly “laddered” prices – claim that the defendant banks and participating institutions used tie-in arrangements to line their pockets with billions of dollars in illegal collusive profits in violation of federal and state antitrust laws.

The question before the Supreme Court is not whether laddering violates the antitrust laws (in our opinion this is not a seriously debatable point: it does). Rather, the question is whether the antitrust laws can be used by victims of laddering to seek redress for their losses. The plaintiffs and the Second Circuit Court of Appeals say the defendants’ conduct is actionable under the antitrust laws. The State of New York and the American Antitrust Institute, both of which submitted amicus briefs in support of the plaintiffs, agree. The defendants, on the other hand, along with several securities industry and pro-business organizations submitting amicus briefs, contend that since they operate within a market closely regulated by the Securities and Exchange Commission, they should have immunity from civil antitrust liability. The United States, backtracking somewhat from a position the Department of Justice took before the Second Circuit, found fault with the standard the Second Circuit applied and advocated that the case be remanded to permit the plaintiffs the opportunity to re-plead their complaint.

The legal doctrine the defendants invoke is that of “implied repeal,” which means essentially that the regulatory scheme enforced by the SEC has supplanted, or repealed, the antitrust laws insofar as the conduct of regulated entities like investment banks is concerned. According to the defendants, because (a) the securities industry is so highly regulated, and (b) laddering is unlawful under the securities laws, any shareholder remedies ought to be pursued by application of the securities laws (which do not allow for treble damages or the awarding of attorneys’ fees to successful plaintiffs), rather than the antitrust laws (which do). Importantly, private plaintiffs are not the only ones who would be divested of the ability to pursue antitrust remedies under the defendants’ proposal. New York’s amicus brief in support of the plaintiff shareholders points out that while the defendants "purport to oppose only private class actions, the sweeping doctrinal change they advocate would equally curtail the ability of governmental antitrust enforcers, including the Justice Department and the State Attorneys General, to protect investors and businesses from anticompetitive conduct in the securities industry."

The problem with the defendants’ argument, as we see it, is that implied repeal is appropriate when the application of antitrust law to a highly regulated industry could result in regulated entities having potentially inconsistent obligations. Indeed, there are many practices permitted or encouraged by the securities laws that would be unlawful under the antitrust laws. As the defendants correctly point out, the SEC needs to balance other policy considerations – capital formation, market efficiency, investor protection and general public interest – in enforcing and interpreting the securities laws. We agree that for those practices where the SEC has allowed (or may in the future allow) anticompetitive conduct that, on balance, benefits the functioning of the Nation’s capital markets, the doctrine of implied repeal is eminently sensible.

Laddering, however, is not justifiable under any of the policies the SEC is tasked with balancing. And for all the ink spilled warning that a lack of immunity would chill capital formation and damage the Nation’s capital markets, neither the defendants nor any of their amici ever plausibly suggest how laddering could conceivably foster, rather than frustrate, the SEC’s policy goals.

Thus, in our view, application of the antitrust laws to combat laddering would not be an “end run” around the securities laws, but an instance where application of antitrust law is completely consistent with the policy goals of the SEC. The only conduct that might be “chilled” is future laddering that picks the pockets of investors.

Both the Tellabs and Credit Suisse cases may impede shareholders' ability to recover losses caused by a company's fraudulent disclosures, collusion and other illegal practices. Should these cases be decided in favor of the defendants, the impact on the investing community could be devastating.

Tuesday, March 27, 2007

Supreme Court to Address Scheme Liability

Yesterday, the Supreme Court granted certiorari to consider whether secondary actors can be held liable to shareholders under a "scheme" liability theory. Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 549 U.S. ___ (U.S. 06-43 Mar. 26, 2007).

The Supreme Court's decision comes hard on the heels of the Fifth Circuit's decision in the Enron litigation last week, which highlighted the growing Circuit split on the issue. The Fifth and Eighth Circuit Courts of Appeal have rejected scheme liability, and the Ninth Circuit has indicated that liability may be found under the theory.

The Eighth Circuit had ruled that a party cannot be liable under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5(a) and (c) for engaging in “schemes” to defraud. The Eighth Circuit held that liability under Section 10(b) is limited to those who (1) “make or affirmatively cause to be made a fraudulent misstatement or omission,” or (2) “directly engage in manipulative securities trading practices.” Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 443 F. 3d 987 (8th Cir. 2006).

The Eighth Circuit affirmed dismissal of securities fraud claims asserted by shareholders of Charter Communications (NASDAQ: CHTR) against two of Charter’s vendors, Scientific-Atlanta, Inc. and Motorola, Inc. (NYSE: MOT). Charter’s shareholders alleged that the two vendors had entered into sham transactions while knowing that Charter intended to account for the transactions improperly. Neither Scientific-Atlanta nor Motorola made or affirmatively caused to be made any allegedly misleading statements directly to Charter’s shareholders about those transactions. Charter’s shareholders had alleged that the two vendors could be liable for participating with Charter in a “scheme” to defraud Charter’s shareholders. The vendors allegedly deceived Charter’s shareholders because the “sham” transactions artificially inflated Charter’s cash flow by about $17 million in one quarter, which thereby inflated revenue forecasts and Charter’s stock price.

In rejecting scheme liability, the Eighth Circuit relied on the Supreme Court’s earlier decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994). In Central Bank, the Court held that there was no aiding and abetting liability for claims brought under Section 10(b) and Rule 10b-5. The Court in Central Bank did not foreclose all liability for secondary actors, noting that the absence of aiding and abetting liability “does not mean that secondary actors in the securities markets are always free from liability.”

A dozen years after Central Bank, the federal courts are increasingly divided on whether “scheme” claims against secondary actors are different from claims for aiding and abetting against those same actors. Although the Eighth Circuit ruled that “scheme” liability cannot be squared with Central Bank’s prohibition on aiding and abetting liability, the Ninth Circuit has ruled that it can under limited circumstances. Last year, the Ninth Circuit held that secondary actors can be liable for participating in a scheme to deceive investors if they engaged in conduct that had the “principal purpose and effect of [creating] a false appearance of revenues” even if they did not make misleading statements. Simpson v. AOL Time Warner, Inc., 452 F.3d 1040, 1048 (9th Cir. 2006). And last week, the Fifth Circuit expressly rejected the Ninth Circuit’s standard and joined the Eighth Circuit in rejecting “scheme” liability for secondary actors. Regents of The University of California v. Credit Suisse First Boston (USA), Inc., et al., No. 06-20856 (5th Cir. Mar. 19, 2007).

The actual question presented for review:

Whether this Court’s decision in Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), forecloses claims for deceptive conduct under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5(a) and (c), 17 C.F.R. 240.l0b-5(a) and (c), where Respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where Respondents themselves made no public statements concerning those transactions.

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Wednesday, February 28, 2007

Second Circuit Clarifies Primary Liability Standards for Auditors

Earlier this week, the Second Circuit held that an auditor has a duty to correct its prior certified opinions, and may be held liable under § 10(b) and Rule 10b-5 if it fails to do so. The opinion appears to be the first in the Second Circuit to squarely hold that an accountant has such a duty or may be primarily liable under the federal securities laws.

A copy of the opinion in Overton v. Todman & Co., CPAs, P.C., is available from the Second Circuit, here, or from FindLaw (reg. req'd), here.

The opinion reverses a lower court decision dismissing a securities fraud claim against the auditor, and its successor in interest, Trien, Rosenberg, Rosenberg, Weinberg, Ciullo & Fazzari, LLP.

From 1999 through 2002, Todman audited the financial statements of Direct Brokerage, Inc. (“DBI”), a broker-dealer registered with the Securities and Exchange Commission and a member firm of the New York Stock Exchange. Each year, Todman issued its “unqualified” opinion that DBI’s financial statements accurately portrayed the company’s fiscal health.

Despite its certifications of accuracy, Todman was alleged to have made significant errors that concealed DBI’s largest liability, payroll taxes. The plaintiffs alleged that Todman ignored multiple red flags that cast serious doubt on the accuracy of DBI’s financial statements, and alleged a number of facts in support of their assertion that Todman recklessly audited DBI’s affairs and recklessly evaluated whether DBI could “survive as an ongoing concern.” Plaintiffs alleged that, in 2003, DBI’s payroll tax liability led to the broker-dealer’s collapse.

The Court surveyed its prior law on primary accountant liability and concluded:

that for many years we have recognized the existence of an accountant’s duty to correct its certified opinions, but never squarely held that such a duty exists for the purposes of primary liability under § 10(b) of the 1934 Act and Rule 10b-5. Presented with an opportunity to do so, we now so hold.

The Court held that the District Court erred in dismissing the fraud claim against Todman & Co., and that an auditor may have primary liability under § 10(b) and Rule 10b-5 for a failure to correct a prior audit opinion, when the accountant:

(1) makes a statement in its certified opinion that is false or misleading when made;
(2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading;
(3) knows or should know that potential investors are relying on the opinion and financial statements; yet
(4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and
(5) all the other requirements for liability are satisfied.

The Court went on to note two limits to the holding.

First, the Court held:

that an accountant has a duty [only] to correct its prior certified statements, as opposed to a broader duty to update those statements. The duty to correct requires only that the accountant correct statements that were false when made. In contrast, the duty to update requires an accountant to correct a statement made misleading by intervening events, even if the statement was true when made.

Second, the Court noted:

that an accountant need correct only those particular statements set forth in its opinion and/or the certified financial statements. Unless an accountant exchanges its role for the role of an insider an accountant is under no duty to divulge information collateral to the statements of accuracy and financial fact set forth in its opinion and the certified financial statements, respectively.

The Court was clear to note that the Todman holding did not conflict with Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), which held that there was no aiding and abetting liability under § 10(b), as the auditor in this litigation had acted as a speaker in a primary capacity.

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Wednesday, February 21, 2007

A Fourth Circuit Judge Did What?

First, the non-newsworthy part.

Yesterday, the United States Court of Appeals for the Fourth Circuit affirmed the dismissal of the consolidated securities class action pending against Cree, Inc. (NASDAQ: CREE), and six of the corporation's officers and directors. A copy of the Fourth Circuit's opinion is available here.

The dismissal itself (and certainly the affirmance by the Fourth Circuit) is not the big news. A quick review of the SCAS database reveals that fully 50% of the federal securities class actions filed within the Fourth Circuit since the PSLRA was enacted have been dismissed.

The big news is the dissent in the Cree litigation, authored by Judge Dennis W. Shedd.

Judge Shedd takes issue with the scienter analysis performed by both the District Court and the majority. In his words:

The majority approach to testing the adequacy of the Complaint examines in isolation each individual suspect transaction in order to ascertain whether the elements of securities fraud have been adequately pled with respect to each one. However, this approach ignores the fact that this case revolves around a single securities fraud action against a single company, Cree.

Judge Shedd goes on to write:

the Complaint does not-and need not-allege an action for securities fraud with respect to all six companies with which Cree dealt. Instead, the Complaint alleges a single cause of action for securities fraud, as evidenced by many transactions with multiple companies. If even one of these transactions is pled adequately enough to meet the pleading requirements under the PSLRA and Rules 8 and 9, the cause of action must survive the motion to dismiss. Moreover, if the totality of Cree's actions reveals a larger picture of fraud sufficient to meet the necessary pleading requirements, this case must advance beyond the current stage of the proceedings

Judge Shedd also takes issue with the analysis adopted by the majority regarding the standards to be applied to so-called "confidential sources." Such information sources, typically former employees or customers of the corporate defendant are a common investigative and pleading technique used by plaintiffs to meet the pleading standard imposed by the PSLRA.

The majority adopted the standard employed by the Seventh and Second Circuits in Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir.2006) and Novak v. Kasaks, 216 F.3d 300 (2d Cir.2000), respectively. Under that analysis, a complaint which relies on confidential sources must allege facts sufficient "to support the probability that a person in the position occupied by the source would possess the information alleged."

Judge Shedd, in his dissent disagrees with the adoption of the Tellabs/Novak standard, noting:

I would resolve the issues surrounding unnamed sources differently because the approach adopted by the majority does not inhere in the plain language of the PSLRA. The plain language of the PSLRA does not subject unnamed sources to higher scrutiny than other averments made upon information and belief. Accordingly, in my view, a complaint must simply identify unnamed sources "with particularity," as required by the plain language of the PSLRA, which might include the source's job title and years of employment, or possibly, other facts sufficient to support a reasonable belief that the plaintiff did not merely invent sources. The purpose of the PSLRA's particularity requirement is to prevent the fabrication of information, not to weigh its reliability or credibility.

The Teachers' Retirement System of Louisiana is the lead plaintiff and Grant & Eisenhofer, P.A. are lead counsel in the Cree litigation.

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