“Lumpiness” insufficient When the Ship is Going Down

Class action investors recently won a partial victory against Dolan Company in the 8^th Circuit Court of Appeals.  I stress partial because, while the trial court’s dismissal was reversed, its severe limitation of the loss–causation period was sustained.

The plaintiffs alleged that Dolan Company made misleading public statements about the financial condition of one of its litigation-support subsidiaries.  Dolan allegedly knew as early as June of 2013 that the subsidiary, DiscoverReady, was on the brink of losing its primary customer, Bank of America.   Despite this knowledge, Dolan subsequently praised the subsidiary’s prior and anticipated revenue growth, only later merely cautioning that future revenues “may experience lumpiness on a quarter-to-quarter basis.”  Dolan made this statement on August 1, 2013 and apparently fell silent until November 12, 2013.  On that date it issued a press release and filed its Form 10-Q, revealing that its unexpected revenue decline was “largely due to a reduction in work from [DiscoverReady’s] largest customer.”  Dolan’s share price fell all the way to $.90 a share over the next 48 hours.  It filed a Chapter 11 bankruptcy about 6 weeks later.

Section 10(b) of the Securities Exchange Act makes it unlawful to use or employ, in connection with the purchase or sale of any security, any manipulate or deceptive device.  The implementation rule, 10(b)5, clarifies that it is unlawful to make any untrue statement of a material fact or to omit to state a material fact.  Both the statute and the rule require a showing of “scienter.”  Pursuant to the Private Securities Litigation Reform Act, scienter can be established by a deceitful or manipulative state of mind, severe recklessness, or motive and opportunity.  But without a showing of motive and opportunity, other scienter allegations need to be strong.  And since the Dolan executives did not sell their shares before they “came clean” in November, the District Court concluded that the class complaint lacked sufficient allegations of scienter.  The Court of Appeals disagreed.

On appeal the plaintiffs argued that they had “adequately pled scenter by alleging that Dolan had been ‘severely reckless.’”  Citing In re K-tel Intern, the Court of Appeals agreed, explaining in part that:

Without a showing of motive or opportunity, other allegations tending to show scienter would have to be particularly strong in order to meet the scienter standard for a securities    fraud claim.  “Severe recklessness,” for purposes of scienter requirement of a securities fraud claim, is defines as highly unreasonable omissions or misrepresentations involving an  extreme departure from the standards of ordinary care, and presenting the danger of misleading buyers or sellers which I either known to the defendant or is so obvious that the  defendant must have been aware of it.

The plaintiffs may have won that battle but then lost at least half the war, as the Court of Appeals sustained the district court’s dismissal of any claims running between November 12, 2013 and January 2, 2014.  Like the district court, it concluded that there was no “loss-causation” between those dates because the January 2, disclosures failed to correct what was said on November 12, 2013.  As such, the drop in stock prices after the November 12 disclosure could not be attributable to the earlier misrepresentations.  As such, only those individuals who purchased shares between August 1 and November 11 had actionable damages.  In other words, the drop in Dolan Company shares after the “record was corrected” on November 11 was likely caused by factors other than a revelation about the misleading nature of statements made in June.  Perhaps the Court of Appeals explained it better than I am able:

A drop in stock price is not necessarily caused by an earlier misrepresentation.  Lower stock prices “may reflect, not the earlier misrepresentation, but changed economic  circumstances, changed investor expectations, new industry-specific of firm-specific facts, conditions, or other events, which taken separately or together account for some or all of  that lower price.”  Dura Pharm., 544 U.S. at 343, 125 S.Ct. 1627.  Rand-Heart must show that Dolan’s fraud – “and not other events” – caused the price to fall after the January 2 press  release.  See Schaaf v. Residential Funding Corp., 517 F.3d 544, 550 (8^th Cir.2008).

Nothing in the January 2 press release corrects previous misrepresentations.  “Corrective disclosures must present facts to the market that are new, that is, publicly revealed for the first time, because if investors already know the truth, false statements won’t affect the price.”  Katyle v. Penn Nat. Gaming, Inc., 637 F3d. 462, 473 (4^th Cir.2011) (internal quotations omitted).  Announcing the appointment of a restructuring officer on Januar 2, does not correct a misrepresentation; it elaborates on the previously disclosed plan to restructure.  “In the financial markets, not every bit of bad new that has a negative effect on the price of a security necessarily has a corrective effect for purposes of loss causation.”  Meyer v. Greene, 710 F3d. 1189, 1202 (11^th Cir.2013).  See also In re Williams Sec. Litig.-WCG Subclass, 558 F3d. 1120, 1140 (10^th Cir.2009) (“To be corrective, the disclosure need not precisely mirror the earlier misrepresentation, but it must at least relate back to the misrepresentation and not to some other negative information about the company.”).

If you want to read the case for yourself, click here.  It is a fairly good primer on fraud in the market class action securities litigation.

Supreme Court Rules in Favor of Stanford Fraud Victims’ Ability to Bring State Law Claims

When I covered Chadbourne & Parke LLP v. Troice during oral arguments in the Supreme Court, I promised I would update you when the High Court rendered its decision.     

Yesterday, the Supreme Court decided in a 7-2 decision whether investors in a class action suit were precluded by the Securities Litigation Uniform Standards Act (“SLUSA”) from bringing state law causes of action against law firms and other third party entities for their alleged roles in the $7 billion R. Allen Stanford Ponzi scheme. SLUSA bars certain class action plaintiffs from bringing state law claims based on misrepresentations made “in connection with the purchase or sale of a covered security.”  SLUSA narrowly defines “covered security” as “[a security] listed, or authorized for listing, on a national securities exchange” such of which must be listed or authorized to be listed “at the time during which it is alleged that the misrepresentation, omission, or manipulative or deceptive conduct occurred.”

The class action at the center of this case concerned a Ponzi scheme by R. Allen Stanford involving certificates of deposits (“CDs”) sold to investors.  Part of the misrepresentations made to the investors were that the CDs were backed by a portfolio of marketable securities.  Recovery against Stanford has been unsuccessful, with investors receiving about a penny on the dollar for their losses, so the victims brought claims against various third-party entities alleging they made misrepresentations concerning the safety of the investments and that Stanford’s attorneys conspired with and aided and abetted Stanford in violating the securities laws by lying to the SEC and assisting Stanford to evade regulatory oversight.

The central question of the case was whether the purported securities-backed CDs sold to investors qualified the transactions as a covered security.  Plaintiffs argued that since SLUSA specifically exempted CDs from the definition of a covered security, they were not preempted from bringing state law claims.  Defendants, however, argued that since Stanford represented that the CDs were backed by marketable securities, a covered security under SLUSA, plaintiffs were barred from asserting state law claims. 

The test applied by the District Court, used in the Eleventh Circuit, asks “whether a group of plaintiffs premise their claim on either ‘fraud that induced [the plaintiffs] to invest with [the defendants] … or a fraudulent scheme that coincided and depended upon the purchase or sale of securities.’”  Since the District Court determined that the investors were induced to purchase the CDs under the belief that they were backed by marketable securities, it denied plaintiffs’ state law claims. 

On appeal, the Fifth Circuit reversed the decision, rejecting the test applied in the Eleventh Circuit and instead adopting the Ninth Circuit test: “A misrepresentation is ‘in connection with’ the purchase or sale of a security if there is a relationship in which the fraud and the stock sale coincide or are more than tangentially related.” The Fifth Circuit relied on public policy considerations that requires interpretation of the “in connection with” element in a manner not to preclude group claims simply because the issuer advertises that it owns covered securities in its portfolio.

In upholding the Fifth Circuit’s decision, the Supreme Court relied on several factors.  First, the basic focus of SLUSA seeks to include transactions in covered securities, not upon transactions in uncovered securities.  Second, a natural reading of SLUSA’s language supports the interpretation that a connection between the representation and a sale matters where the misrepresentation makes a significant difference to someone’s decision to purchase or to sell a covered security, not to purchase or to sell an uncovered security.  The Supreme Court noted that the plaintiffs never alleged the defendants’ misrepresentations led anyone to buy or to sell (or to maintain positions in) covered securities.  Third, the Supreme Court found that prior case law supports its interpretation because every securities case brought before the Court where fraud was “in connection with” a purchase or sale of a security has involved a covered security as defined by SLUSA. 

In its fourth point, the Supreme Court pointed out that their interpretation of SLUSA was consistent with the underlying regulatory statutes: the Securities Exchange Act of 1934 and the Securities Act of 1933.  The opinion states, “[n]ot only language but also purpose suggests a statutory focus upon transactions involving the statutorily relevant securities” and nothing in those acts or SLUSA provides a reason for interpreting its language more broadly.  Writing for the majority, Justice Breyer went on to explain that “to interpret the necessary statutory “connection” more broadly…would interfere with state efforts to provide remedies for victims of ordinary state ­law frauds.”  For instance, the Court noted that a broader interpretation would allow SLUSA to prohibit a lawsuit brought by creditors of a small business that falsely represented it was creditworthy, in part because it owns or intends to own exchange-traded stock.

Finally, the majority rejected the dissent’s argument that the Court’s ruling would significantly curtail the SEC’s enforcement powers, especially since enforcement powers are enumerated in other statutes and the dissent could not point to one example of a federal securities action—public or private—that would now be impermissible under the Court’s decision.   

While the case did not consider the merits of the plaintiffs’ claims, it allows the victims to proceed in their fight to recovery for the billions lost in the Ponzi Scheme. 

*I owe credit to this prompt update to Gerhard Petzall, an attorney here in St. Louis who started his own firm in 1963.  Meeting him for the first time last night at a high school mock trial competition, we sparked up a conversation about securities law and how technology has changed the landscape of our profession and personal lives.  I had extreme admiration for the fact that Gerhard practiced during a time where information was not readily at your fingertips the way it is now.  I couldn't even imagine.  Gerhard read about the Supreme Court decision in the financial section of the newspaper.  I told him that I believed I sat near him for a reason because I had been following this case and had been waiting for the decision to be released.  Had he not mentioned it, I might not have gotten the news right away.  We had a good laugh and I promised him that I would make sure to give him credit when I wrote my article.  Since I keep my promises, thank you Gerhard! 

U.S. Supreme Court Debates Coverage of the Securities Litigation Uniform Standards Act

The U.S. Supreme Court recently debated whether investors in a consolidated class action suit were precluded by the Securities Litigation Uniform Standards Act (“SLUSA”) from bringing state law causes of action against law firms and other third party entities for their alleged roles in the $7 billion R. Allen Stanford Ponzi scheme. SLUSA bars plaintiffs from bringing state law claims based on misrepresentations made “in connection with the purchase or sale of a covered security.” 

The Ponzi scheme at the center of the allegations involved over 21,000 investors who bought certificates of deposit from R. Allen Stanford’s bank in Antigua. Stanford promised a risk-free investment with above-market rates of return and said the CDs were backed by portfolios of liquid securities.  However, there were no securities and the money went to fund a string of failed businesses, bribe regulators, and support Stanford’s lavish lifestyle. R. Allen Stanford was convicted and sentenced to 110 years in prison in March of 2012.  The receiver, who was court appointed in 2009 to recover money from Stanford’s failed companies to return to investors, recently began mailing checks ranging from $2.81 to $110,000 to hundreds of investors.  That amounts to approximately $55 million of the $6 billion lost from the scheme – less than a penny on the dollar.

The complaints filed by investors alleged that various third party entities made misrepresentations concerning the safety of the investments and that Stanford’s attorneys conspired with and aided and abetted Stanford in violating the securities laws by lying to the SEC and assisting Stanford to evade regulatory oversight.

The District Court examined whether a covered security was applicable in the case because although the CD was not a covered security, the marketable securities purportedly backing the CD’s were a covered security.  During this analysis, the District Court used the Eleventh Circuit’s approach, which asks “whether a group of plaintiffs premise their claim on either ‘fraud that induced [the plaintiffs] to invest with [the defendants] … or a fraudulent scheme that coincided and depended upon the purchase or sale of securities.’” The District Court determined that the belief that the CD’s were backed by marketable securities induced the investors to purchase the CD’s.  Therefore, the District Court dismissed the investors’ claims.

On appeal, the Fifth Circuit reversed the decision, rejecting the test applied in the Eleventh Circuit and adopted the Ninth Circuit test: “A misrepresentation is ‘in connection with’ the purchase or sale of a security if there is a relationship in which the fraud and the stock sale coincide or are more than tangentially related.”  The Fifth Circuit relied on public policy considerations that requires interpretation of the “in connection with” element in a manner not to preclude group claims simply because the issuer advertises that it owns covered securities in its portfolio. 

In order to resolve the circuit split on the interpretation of SLUSA’s “in connection with” requirement, the Supreme Court granted certiorari. The issues considered by the highest court were the following: (1) whether the Securities Litigation Uniform Standards Act (SLUSA) precludes a state-law class action alleging a scheme of fraud that involves misrepresentations about transactions in SLUSA-covered securities; and (2) whether SLUSA precludes class actions asserting that defendants aided and abetted SLUSA-covered securities fraud when the defendants themselves did not make misrepresentations about the purchase or sale of SLUSA-covered securities.

Plaintiffs hinge part of their argument on the fact certificates of deposits were specifically excluded from Congress’s definition of “covered security” and request the Court uphold the 5^th Circuit’s ruling.  The defendants claimed that the application of federal law should be broad and because Stanford made the promise to back the CD’s with securities, the SLUSA effectively blocks the state causes of action.

During oral arguments, the nine justices gave no clear indication on how they will rule.  However, Justice Scalia’s questions and comments suggested he felt the suits could go forward because he read the statutory language “in connection with the purchase or sale of a covered security.”  Justice Alito, on the other hand, read “in connection with” broadly.  Stay tuned for and update when the court releases its ruling.   

FINRA Hearing Panel Concluded that FINRA Arbitration Rule was Preempted by Federal Arbitration Act

FINRA Department of Enforcement recently brought an enforcement action against Charles Schwab (“Schwab”) after the firm amended its customer account agreement to include provisions that would require customers to waive their rights to bring or participate in judicial class actions against the firm. The amended agreement also required customers to agree that an arbitrator would not have authority to consolidate more than one party’s claims. 

In the first two causes of action, FINRA alleged that Schwab’s pre-dispute arbitration agreements which force customers to waive rights to participate in judicial class claims violate FINRA Rules 2268(d)(1) and (d)(3) which state, “(d) No pre-dispute arbitration agreement shall include any condition that: (1) limits or contradicts the rules of any self-regulatory organization; and (3) limits the ability of a party to file any claim in court permitted to be filed in court under the rules of the forums in which a claim may be filed under the agreement.” FINRA argued that Schwab’s agreement interfered with FINRA Arbitration Rule 12204(d) which preserves a customer’s option to file claims as a part of a judicial class action. Since FINRA has separate rules that prohibit class actions in arbitrations, customers would be barred from bringing a class action against Schwab in any forum.

FINRA alleged in its third cause of action that requiring customers to agree that arbitrators lack authority to consolidate parties’ claims violates FINRA Rule 2268(d)(1). FINRA contended that such a provision limits or contradicts FINRA Arbitration Rule 12312 which covers specific circumstances in which an arbitrator may consolidate claims. 

The parties had differing opinions on how the Federal Arbitration Act (“FAA”) played a role in the matter. Enforcement argued that the FAA was irrelevant and inapplicable because the only determination that need be made when imposing sanctions is whether Schwab violated FINRA Rules. Schwab’s position was that even if the waiver violated FINRA Rules, the FAA preempts FINRA rules and bars their enforcement.

In the Hearing Panel’s order, the first two claims were dismissed. While the Panel found that Schwab’s amendments to the customer agreements did violate FINRA Rules 2268(d)(1) and (d)(3), the rules cannot be enforced in light of the FAA, as construed by the United States Supreme Court in AT&T Mobility, LLC v. Concepcion. The Panel stated that the Supreme Court disfavors rules that override agreements to arbitrate and that such hostility to arbitration is unenforceable. The Concepcion case specifically established that class actions are no exception to the general rule and that a party to an arbitration agreement cannot undermine the agreement by participating in class actions.

In regard to Enforcement’s third cause of action, the Panel found that the language which limits the         power of arbitrators to consolidates cases violates FINRA Rule 2268(d)(1) in that the agreement:

(i) “undermines the fundamental operation of rule 12312 and, in fact, the overall operation of FINRA Arbitration Rules generally, by depriving FINRA of its authority to grant and circumscribe the power of arbitrators in FINRA’s forum; and (ii) the consolidation language undermines the specific authority given to the arbitrators to join individual claims in specified circumstances.

The Panel also found that the FAA did not bar enforcement of the rules in this instance because the FAA does not govern how arbitration forums operate. 

Therefore, Schwab was ordered to take corrective action by removing the language regarding an arbitrator’s power to consolidate claims and notify customers that such language is not effective. Schwab was also ordered to pay a fine of $500,000. 

FINRA still has the option of appealing to the National Adjudicatory Council within 45 days of the hearing panel’s decision. Thus, as it stands, while pre-dispute arbitration agreements that require a customer’s waiver of class claims may be volatile of FINRA Rules, such rules cannot be enforced to allow sanctions against FINRA member firms. Essentially, firms could effectively avoid being subject to class claims in any forum. This may prompt FINRA to reevaluate class arbitration rules.

Class Arbitration: Are Investment Advisers Representatives Excluded?

Investment Adviser agreements typically contain provisions which require all disputes between the Registered Investment Adviser (“RIA”) and Investment Adviser Representative (“IAR”) to be determined in a final and binding arbitration.  These agreements also preclude class claims from being brought to arbitration.  In effect, RIAs have thereby evaded being the subject of class actions brought by IARs, at least for now. 

At the beginning of the year, the National Labor Relations Board (“NLRB”) decided a case which outlaws contract provisions in which the employer conditions employment upon signing an agreement that precludes employees from filing joint, class, or collective claims in any forum.  However, the claims must address issues such as wages, hours, or other working conditions. 

D.R. Horton v. Michael Cuda involved an employment contract where the employee was required to submit all claims to arbitration.  The agreement also prevented employees from consolidating or bringing class claims.  The NLRB determined that these agreements prohibit the exercise of substantive rights that are protected under Section 7 of the National Labor Relations Act (“NLRA”).  The NLRB’s decision specifically outlines certain limitations to its holding.  In particular, the decision is only applicable to “employees” as defined in the NLRA.  This definition specifically excludes independent contractors.

It should be noted that the US Supreme Court recently ruled in AT&T Mobility LLC v. Conception that the Federal Arbitrations Act (“FAA”) permits companies to require customers to arbitrate their complaints individually, precluding class action claims.  D.R. Horton differs in that it involved employee class actions, which is protected by statute, versus customer or consumer class actions.  However, since D.R. Horton has been appealed to the 5^th Circuit Court of Appeals, it will be interesting to see the outcome, and whether or not the Supreme Court will grant certiorari.  My guess is that it will.   

That being said, the hurdle for IARs is that they are often classified as “independent contractors” rather than employees.  Not only is this usually set forth in their investment advisor agreements, but the type of relationship between the employer and the IAR has some characteristics of an independent contractor.  However, they also have employer-employee characteristics that could be crucial in determining the type of employment relationship. 

There are various factors that determine whether one is considered an employee versus an independent contractor.  These factors include but are not limited to the following: (1) the level of control the employer has over the work performed by the individual; (2) whether the employer or worker furnishes the tools, materials, supplies, or equipment needed to perform the job; (3) whether the worker provides services for more than one firm or company at a time; (4) whether the worker can realize a profit or loss as a result of his services; (5) whether the employer set the work schedule; and (6) whether the employer hires, supervises, or pays assistants of the worker.

Perhaps one of the more determinative factors in defining an employment relationship is the level of control and supervision the employer has over an individual.  By design, RIAs are required to supervise the conduct and activities of any IAR that represents it, whether the IAR is an employee or an individual that provides investment advice on behalf of the RIA.  An RIA’s legal duty to supervise its IARs emanates from a number of sources.  For instance, Section 203(e)(6) of the Investment Advisers Act of 1940 permits the SEC to take action against an RIA for failing to supervise its IARs.  Pursuant to SEC Rule 206(4)-7 under the Advisers Act, RIAs are required to adopt policies and procedures that are reasonably designed to prevent violations of securities laws by the adviser and its supervised persons.   Furthermore, SEC Rule 204A-1 requires RIAs to adopt a code of ethics which sets forth the standard of business conduct to be exhibited by IARs. 

Generally, investment advisory agreements authorize RIAs to monitor and evaluate the IAR and subject the IAR to the supervision of the adviser.  Moreover, the duty to supervise an IAR may also stem from the fiduciary duty the RIA owes to its clients.  This supervisory duty and level of control is often implemented with periodic or annual compliance audits of each IAR.  Despite this level of control, the IAR is often contractually defined as an independent contractor.   

Therefore, as it stands, IARs could face a substantial but perhaps surmountable hurdle in bringing class arbitration claims if the investment advisor agreement defines the representative as an independent contract and precludes class actions.  Since the NLRA definition of employee precludes traditional independent contractors, there may be no statutory protection granted to some IARs. 

Federal Judge Denies Preliminary Class Action Settlement, State Securities Regulators Give Sigh of Relief

On March 18, the Federal District Court for the Northern District of Texas, refused to a $21 million partial class action settlement with Securities America, a division of Ameriprise Financial.

The case stems from the sale of hundreds of millions of dollars of private placement notes in Medical Capital Holdings, which the SEC deemed to be a fraud in 2009. After the fraud was discovered, many investors filed arbitration claims against Securities of America, others joined together in multiple class actions, and others proceeded individually. The Massachusetts and Montana securities regulators also filed enforcement actions in 2010 against the defendants, which are now in the late-stages of litigation. On February 18, Senior District Judge W. Royal Furgeson, Jr. temporarily stayed several of the arbitration actions proceeding through FINRA while the motion was pending, but refused to halt the state enforcement actions.

The settlement was proposed by representative plaintiffs in three related class actions: Billitteri et al v. Securities America et al, Toomey et al v. Hofhines et al, and McCoy et al v. Cullum & Burks Securities Inc. et al. The representative plaintiffs’ motion sought approval of a 23(b)(1)(B) limited fund settlement with two of the defendant broker-dealers, Securities America, Inc. and Securities America Financial Corporation.

The proposed settlement would have affected all investors, regardless of how they decided to make their legal claim. If granted, the settlement also could have enjoined the state enforcement proceedings. According to the North American Securities Administrators Association, “enjoining state securities regulators [could] have a far-reaching impact by undermining investor protection not only in Massachusetts and Montana, but in other jurisdictions as well.” NASAA further stated that such an effect would make citizens “more vulnerable to fraud and abuse in the offer and sale of securities.” On March 14, NASAA filed a Brief in Opposition to Plaintiff’s Motion for Preliminary Approval of Partial Class Settlement, arguing how approval of the settlement would undercut state regulators’ enforcement ability. The organization was one of many that filed briefs and memoranda with the court regarding this motion.

In his Order, Judge Furgeson, notes the large number of outside parties interested in the outcome of the proposed settlement. He also makes specific mention of the enforcement actions proceeding in the two states, which likely weighed on his decision. However, Judge Furgeson’s order explaining the reasoning behind his decision has not yet been filed.