Central Bank Can’t Save Third Party Banker Defendants

Citigroup and CSFB had best break out the Stovetop, because they are definitely staying in the Parmalat securities class action, Central Bank or no Central Bank. You see, Judge Lewis A. Kaplan (S.D.N.Y.) has largely denied their motions to dismiss (as he did with Parmalat’s foreign auditors in another opinion reported by the Nugget last month, albeit on very different grounds). This time, Judge Kaplan tackles Plaintiffs’ 1934 Act claims against the banks for “(1) structuring and participating in transactions that were hidden or mischaracterized on Parmalat’s financial statements” and (2) “making certain statements or omissions in connection with the foregoing, allegedly in violation of Rule 10b-5(b).”

The banks, hunkering down under Central Bank of Denver, N.A. v. First Interstate Bank of Denver, 511 U.S. 164 (1994) argued that “that they were at most aiders and abettors of a program pursuant to which Parmalat made misrepresentations on its financial statements.” However, Judge Kaplan found that this argument “misses the mark,” as “the transactions in which the defendants engaged were by nature deceptive” because “they depended on a fiction, namely that [certain worthless] invoices [that Citigroup purchased and securitized] had value.”

Where most opinions simply analyze violation of Rule 10b-5, Judge Kaplan’s analysis went further. He analyzed the claims under 10b-5’s subsections, namely 10b-5(a) and (c). The banks argued that “subsections (a) and (c) apply only to the narrow category of acts understood as ‘manipulative’ in a technical sense.” However, Judge Kaplan found that “this interpretation is refuted by the language of the rule as well as the case law, which make it clear that subsections (a) and (c) apply to at least some deceptive acts as much as to certain technical forms of market manipulation.”

While being careful to note that his analysis of these subsections “is not a back door into liability for those who help others make a false statement or omission in violation of subsection (b) of Rule 10b-5,” Judge Kaplan noted the “lack of precision” that many pre-Central Bank courts implemented when “dealing with primary violations as compared with aiding and abetting liability.” For example, “for decades the distinction between the conduct covered by subsections (a) and (c) on the one hand, and subsection (b) on the other was largely insignificant. A corollary is that courts for the most part found it unnecessary to consider the extent to which the phrase ‘manipulative or deceptive device or contrivance’ in Section 10(b) applied to conduct other than misrepresentations, omissions, and market manipulation.” He concluded that “it no longer is possible, however, to ignore these issues.

Thus, “the major question here is whether the banks directly or indirectly used or employed any device or contrivance with the capacity or tendency to deceive.” He then parsed and separated each bank’s activities, finding that some of their activities satisfied this test, while others did not. He concluded by holding that “the complaint alleges that the banks’ actions in connection with the relevant transactions actually and foreseeably caused losses in the securities markets. The banks made no relevant misrepresentations to those markets, but they knew that the very purpose of certain of their transactions was to allow Parmalat to make such misrepresentations. In these circumstances, both the banks and Parmalat are alleged causes of the losses in question. So long as both committed acts in violation of statute and rule, both may be liable.”

Remains to be seen how many Plaintiffs will pick up this new twist against third party defendants.

You can read the decision, issued July 13, 2005, at 2005 U.S. Dist. LEXIS 14542.

Nugget: “It is impossible to separate the deceptive nature of the transactions from the deception actually practiced upon Parmalat’s investors.”

Nugget: “This analysis is not an end run around Central Bank. If a defendant has committed no act within the scope of Section 10(b) and Rule 10b-5 — as in fact was the case in Central Bank — then liability will not arise on the theory that that defendant assisted another in violating the statute and rule. But where, as alleged here, a financial institution enters into deceptive transactions as part of a scheme in violation of Rule 10b-5(a) and (c) that causes foreseeable losses in the securities markets, that institution is subject to private liability under Section 10(b) and Rule 10b-5.”

Judge Steers Mutual Fund Investors to State Court

An investor bringing direct claims against “a number of defendants acting as mutual fund directors, advisors and affiliates of the Nuveen Family of Funds,” for failing “to ensure that the funds participated in dozens of securities class action settlements for which they were eligible” has been handed a loss (at least on his federal claims) by Judge Milton I. Shadur (N.D. Ill.). You may recall the Nugget covered another case that reached a similar result last month, although James V. Selna (C.D. Cal.) took a slightly different approach in getting there.

In evaluating Plaintiff’s 1940 Act claims under § 36(a) (alleging “personal misconduct”) Judge Shadur found that only the SEC could assert this claim, not private plaintiffs, because the Supreme Court’s recent decision in Exxon Mobil Corp. v. Allapattah Servs., Inc., 125 S.Ct. 2611 (2005) “forecloses any possibility of using Section 36(a)’s clear legislative history to create a private right of action where the unambiguous statutory language creates none.” The court also held that “Congress plainly did not create Section 36(a) as a catchall for any fiduciary breach.”

As for the Plaintiff’s 1940 Act claims under § 36(b) (for breach of fiduciary duty), Judge Shadur held that Plaintiff’s “’real complaint’ is that defendants made a poor management decision by failing to participate in dozens of settlement agreements for which some fund was eligible, and he has not alleged any inherent improprieties in the compensation agreement itself.” In addition, “the textual and legislative history arguments previously addressed as to Jacobs’ unsuccessful Section 36(a) claim have equal force as to Section 36(b).” Nailing the coffin, Judge Shadur ruled that “because the flaws identified here would not be resolved if Jacobs were to attempt to replead a derivative action, his Section 36(b) claim is dismissed without leave to replead.”

As for Plaintiff’s “state law claims of negligence and breach of fiduciary duty,” the court dismissed those “without prejudice” “so that those claims can be pursued in state court.”

Bet we haven’t seen the last of these Plaintiffs.

You can read the decision, issued July 20, 2005, at 2005 U.S. Dist. LEXIS 14762.

Nugget: “The prevailing caselaw has read ‘personal misconduct’ to require some showing of self-dealing. [Plaintiff] has advanced no such allegations, instead setting out a garden-variety fiduciary claim, which remains the domain of state law.”

Court Wields SLUSA in Tossing Mutual Fund Action

In October 2003, an investor filed a putative class action in Madison County, Illinois against the Templeton Funds, alleging that the Fund “breached a duty of care owed to investors by using stale pricing information to value securities in their open end mutual funds” (to be more specific, during the interval that elapses between when the Fund sets its share Net Asset Value (or “NAV”) and releases it to the NASD for communication to the public, securities markets in countries such as Japan, Russia, Germany, and Australia have traded for an entire session, thus making the prices stale).

Anyway, a month after the case was filed, Templeton promptly removed the action to the Southern District of Illinois. However, Judge Michael J. Reagan sent the case back to the state court, finding that his federal forum had no subject matter jurisdiction. Over a year later, Defendants again removed the case, “claiming that the Seventh Circuit’s April 5, 2005 opinion in an unrelated case, Kircher v. Putnam Funds Trust, 403 F.3d 478 (7th Cir. 2005), rendered” the action “freshly removable.” Judge Reagan noted that the Seventh Circuit’s opinion held that “SLUSA’s removal and preemption provisions are triggered when four conditions are met: (1) the underlying suit is a “covered class action,” (2) the action is based on state or local law, (3) the action concerns a “covered security,” and (4) the defendant misrepresented or omitted a material fact for employed a manipulative or deceptive device or contrivance “in connection with the purchase or sale” of that security.” Since the judge found that the four conditions had been satisfied, he held removal proper, and further found that “Kircher mandates that this Court dismiss all of Plaintiffs’ state law claims as barred by SLUSA,” as SLUSA “effectively blocks state court litigation of such claims.”

You can read the decision, issued July 12, 2005, at 2005 U.S. Dist. LEXIS 14500.

Nugget: “Plaintiffs — whose briefs focused on removal under 28 U.S.C. § 1446(b) — have not addressed the removability of the case under the above-cited SLUSA provision. Nor have Plaintiffs disputed Defendants’ argument that the allegations in this action are ‘identical’ to those examined by the Seventh Circuit in Kircher.”

KPMG Tagged as "Virtual Pushover" in Xerox Decision.

Judge Alvin W. Thompson (D. Conn.) has denied all of the motions to dismiss in the Xerox securities class action, which brings ’34 Act claims against the company, six of its executives, and KPMG. According to Plaintiffs, Xerox “was able to meet Wall Street’s earning expectations only by engaging in massive accounting fraud.” In doing so, Defendants “used a smorgasbord of methods to misstate Xerox’s earnings, revenues and margins in virtually every reporting period throughout the Class Period.” Xerox’s “improper accounting methodologies throughout the Class Period included” what its auditor “KPMG referred to” as “half-baked revenue recognition,” and rampant abuse of “Cookie Jar Reserves,” just to name a couple. In fact, “without such accounting manipulations, Xerox would not have met earnings expectations in 11 of 12 quarters during 1997-1999 . . . Moreover, by 1998, almost $ 3 of every $ 10 of annual pre-tax reported earnings and up to 37 percent of Xerox’s reported quarterly pre-tax earnings were generated through undisclosed accounting manipulations.” Internally, Xerox “approved of and expressly directed the use of ‘accounting actions’” when referring to the accounting manipulations. In fact, a former Xerox Assistant Treasurer (who was fired when he attempted to expose the fraud), “stated that many executives at Xerox had developed the attitude ‘There is no accounting standard we can’t beat.’” How’s that for a marketing slogan?

Initially, Xerox tried to blame everything on its “Mexican subsidiary,” (sounds a little like the runaway bride, doesn’t it), but eventually that ruse was exposed. By the time the dust of two restatements settled (along with what was at the time the largest SEC fine in history), Xerox shareholders were stuck with “a total reduction in profits of nearly $ 2.4 billion for the years 1997 to 1999.” Ouch.

Given these facts, the court appears to have had little trouble denying each Defendant’s motion to dismiss. The court found that the factual allegations “make it clear that this is not a case of a client innocently relying on advice from its accountants,” as the “Xerox Defendants knew the company was underperforming and used accounting manipulations to bridge the gap between actual versus desired financial results,” the CFO “informed Xerox senior management, including both the chief executive officer and the chairman of the Board of Directors, that without the benefit of the accounting actions, Xerox had essentially no growth through the late 1990s, that the directives as to the accounting manipulations emanated from Xerox senior management,” “that many of the Xerox Defendants’ accounting manipulations involved violations of simple and unambiguous accounting principles, and in specified instances, the Xerox Defendants were told by their accountants that the accounting action violated GAAP but proceeded with the action anyway,” “that the Xerox Defendants insisted that KPMG replace its senior audit engagement partner when he refused to sign off on one of their proposals,” and “filed a minimal restatement and came out with a press release saying they had cleaned everything up, knowing full well that the staff of the SEC still had serious problems with Xerox’s accounting.”

As for the six executives’ knowledge, the court said “the plaintiffs do not allege scienter on the part of the Individual Defendants simply by virtue of the positions those individuals held at Xerox, but rather by virtue of the fact that Xerox’s senior management orchestrated the scheme to disguise the company’s true operating performance and the directives as to the accounting manipulations emanated from Xerox senior management at corporate headquarters.”

Finally, the court denied KPMG’s request to dismiss the case, as “the factual allegations in the Complaint do, in fact, portray KPMG as a virtual pushover in its dealings with the Xerox Defendants, which at a minimum went along with accounting practices it knew to be clear violations of GAAP, and which, even after it was clear early in 2001 that there were very serious concerns about Xerox’s accounting practices and it was apparent that it was questionable–at best–whether Xerox took seriously its obligation to comply with applicable accounting rules, was intimidated into signing off on a minimal restatement of Xerox’s financial statements that accounted for only a small portion of Xerox’s overstatements of revenues and pre-tax earnings.”

C’mon guys, don’t be so negative. Look at the bright side. At least there should be plenty of copiers available for all those documents those pesky owners (a/k/a shareholders) will soon be subpoenaing.

You can read the decision, issued July 13, 2005, at 2005 U.S. Dist. LEXIS 14427.

Nugget: “The PSLRA does not require a plaintiff to prove his case in his complaint. And, it is appropriate to recall that the heightened standard of pleading scienter was meant simply to prevent strike suits and other abuses that had arisen in securities fraud litigation. . . . Plaintiff generally must frame the facts respecting the defendant’s mental state (i.e., the scienter element of the claim) without the benefit of discovery, and therefore, most often, allegations about a defendant’s culpable state of mind must be drawn from limited state of mind evidence augmented by circumstantial facts and logical inferences.”

Potential Minefield Awaits When Similar Securities Class Actions Settle

What’s a lead plaintiff to do when two potentially overlapping securities class actions are pending at the same time, and the other one settles? Who knows, but in the Citigroup/Global Crossing litigation we can see how one plaintiff’s choice turned out. In the action that settled, Plaintiffs alleged “that the Citigroup defendants participated in defrauding them by, among other things, issuing analytic reports on Global Crossing and Asia Global Crossing that misrepresented the defendants’ true views of the prospects of those companies.” In the other action, investors who had accounts with Salomon (n/k/a Citigroup) allege they received similar recommendations that were tainted by conflicts of interest that were undisclosed.

So when Citigroup settled with plaintiffs in the first action, the lead plaintiff in the other action objected, arguing that the release could be construed to apply to his claims against some of the same defendants. Well, that wasn’t good enough for Judge Gerard E. Lynch (S.D.N.Y.), who denied the objection, holding that if the objector “seeks, in the separate action, damages attributable to trading losses in Global Crossing securities, such damages result directly from the same alleged misconduct at issue in this case.” “The losses were incurred as a result of the same investment decision, as a result of the same alleged misconduct, resulting in the same loss to the same plaintiff. If [the objectors] have a different legal theory of liability based on these facts, which they believe is stronger, and therefore more likely to yield a larger recovery or a better settlement, than the theories being advanced by Lead Plaintiffs, they were free to opt out of the present class and pursue recovery based on that theory.” The objectors “are not free, however, to remain a part of the instant class, partake of an award of damages under the present settlement, and then pursue further damages in a separate action based on the same losses arising from the same investment decision as a result of the same misconduct. Any such result would be substantively unfair, as well as frustrating to class action settlements.”

You can read the decision, issued July 12, 2005, at 2005 U.S. Dist. LEXIS 14245.

Nugget: “A defendant can hardly be expected to settle an action based on claims of a particular wrong, pay damages to plaintiffs under that settlement, and then have to continue to defend claims by some of the same plaintiffs for further compensation based on the same harm.”

Nugget: “That is a question that can only be resolved as the facts and legal theories in his lawsuit are developed and litigated.”

Split Continues with Securities Act Claims Remanded

Further widening the split of authority on whether SLUSA allows defendants to remove covered class actions from state to federal court when the complaint only asserts federal causes of action under the 1933 Act, Judge R. Gary Klausner (C.D. Cal.) has ruled in the Salem Communications Corporation action that he will not permit it. In finding that the “plain meaning” of SLUSA prohibits removal, the court declared that “the language of the 1933 Act clearly states that removal is allowed only for class actions” “based upon the statutory or common law of any State.” “Thus, the plain language of the amended 1933 Act allows only for the removal of state claims or for federal claims brought along with state claims.”

As for Defendants’ reliance on SLUSA’s legislative history, Judge Klausner recognized that “while some pieces of SLUSA’s legislative history might, standing alone, show a desire by Congress to move many security class action claims to federal court, when taken as a whole the legislative history does not show a clearly contrary congressional intent,” because “for instance, the Senate and the House stated that SLUSA was designed to limit the conduct of securities class actions under state law,” and “these statements are consistent with Plaintiffs’ proposed interpretation.”

You can read the decision, issued June 28, 2005, at 2005 U.S. Dist. LEXIS 14202.

Nugget: “Two district courts in this Circuit have reached opposite conclusions.”

LIFO Wins the Day in Lead Plaintiff Battle

Back in the free-wheeling carefree days of late 1995, the PSLRA’s new approach for selecting the lead plaintiff in securities class actions probably seemed enticingly simple. A court merely chooses the plaintiff (or group of plaintiffs) with “the largest financial interest” to serve at the helm. Despite these lofty hopes, one of the man problems is determining exactly what each plaintiff’s losses actually are. In calculating these losses, courts have long struggled with whether to use the “first-in, first out” (“FIFO“) or the “last-in, first out” (“LIFO“) technique. They’ve gone both ways, but LIFO wins this time around.

Judge Shira A. Scheindlin (S.D.N.Y.) recognized that “the FIFO method is often used by courts,” however she noted that “more recently, courts have preferred LIFO and have generally rejected FIFO as an appropriate means of calculating losses in securities fraud cases. Moreover, in a number of instances where courts have used FIFO to calculate financial loss, they have done so reluctantly. LIFO, by contrast, has been used not only for lead plaintiff calculations, but also to determine compensation amounts for stockholders suffering losses due to securities fraud.” Also, “the main advantage of LIFO is that, unlike FIFO, it takes into account gains that might have accrued to plaintiffs during the class period due to the inflation of the stock price. FIFO… ignores sales occurring during the class period and hence may exaggerate losses.”

Judge Scheindlin also observed that the lead plaintiff applicant using FIFO “sold shares of eSpeed stock during the class period, when the price was inflated,” and therefore its “losses due to eSpeed’s alleged fraud were actually somewhat cushioned by the sales made when eSpeed’s stock price was high.” “By contrast, the other group’s utilization of LIFO reflects offsetting ‘gains’ that were attained through the sale of stock during the class period. This method matches the last purchases made during the class period with the first sales made during the class period.” This further “demonstrates why FIFO… is inferior to LIFO.”

Finally, in an unusual twist, the LIFO group (well, the group’s five individuals aren’t actually called that, they’re styled as the Adib Group) isn’t quite the lead plaintiff just yet. The court wrote that “members of the class now have the opportunity to present evidence, if they wish, in an attempt to rebut the Adib Group’s presumptive status. If no evidence is submitted or the evidence submitted is inadequate to rebut the presumption, the Adib Group will be named as the lead plaintiff.”

You can read the decision, issued July 13, 2005, at 2005 U.S. Dist. LEXIS 14104.

Nugget: “The lead plaintiff determination does not depend on the court’s judgment of which party would be best lead plaintiff for the class, but rather which candidate fulfils the requirements of the Act.”

Nugget: “[A] group of unrelated investors should not be considered as lead plaintiff when that group would displace the institutional investor preferred by the PSLRA. But where aggregation would not displace an institutional investor as presumptive lead plaintiff based on the amount of losses sustained, a small group of unrelated investors may serve as lead plaintiff, assuming they meet the other necessary requirements.”

First Circuit Reverses PSLRA Dismissal, Establishes New Clarity and Basis Test, and Restricts Safe Harbor Protections

File your appeal in the First Circuit, and a Second Circuit Judge authors the opinion? That’s what happened in Friday’s Stone & Webster decision, authored by Second Circuit veteran Judge Pierre Nelson Leval. Also serving on the Panel were District Judge Edward Francis Harrington (from the District of Massachusetts) and the First Circuit’s sole representative Judge Michael Boudin. Interestingly, Judges Boudin and Leval studied at Harvard together, and were both law clerks in the early 60’s for the Second Circuit’s legendary late pragmatic jurist Henry J. Friendly (also a Harvard alumnus). Of additional interest, of the seven First Circuit PSLRA decisions issued to date, this is the first one that was not written by First Circuit Judges Juan R. Torruella or Sandra Lea Lynch.

The Panel started its unanimous decision by noting that “the Complaint’s strongest factual allegations fall into three main categories.” “First, that S&W deliberately underbid on more than a billion dollars of contracts, which at the contract price could be performed only at a loss, and fraudulently reported anticipatory profits on these loss contracts, so as to overstate earnings; second, that S&W fraudulently concealed its loss on a huge contract in Indonesia with Trans Pacific Petrochemical Indotama (“TPPI”) by concealing the cancellation of the contract and thus reported unreceived revenues, inflating the Company’s profits or diminishing its losses; and finally, that S&W made public statements, which concealed and misrepresented its shortage of liquid reserves and its impending bankruptcy, as its finances slid into shambles.”

From there, the Panel proceeded to evaluate Plaintiffs’ argument that Judge Reginald Lindsay (yes more Crimson here too) (D. Mass.) was wrong to dismiss their claims (on 12(b)(6) and later on summary judgment) that in committing these acts, Defendants (CEO & CFO Smith and Langford and PwC) violated § 10(b), § 18, and § 20(a) of the 1934 Exchange Act.

The Panel coined a new phrase they call the “clarity-and-basis” requirement. Basically, this is a simplified method for analyzing 15 U.S.C. § 78u-4(b)(1)’s specificity, reasons for falsity, and particularity prerequisites, and the Panel says that it is “closely related to the requirement of Federal Rule of Civil Procedure 9(b)” and that “the PSLRA’s pleading standard is congruent and consistent with pre-existing Rule 9(b) pleading standards in this Circuit.”

“The central allegations in the Complaint” “can be grouped into three general categories.” “The first category of plaintiffs’ claims principally relates to the allegation that S&W underbid various projects and fraudulently reported expected profits from these projects when, in fact, the projects were expected to produce losses.” Noting the specificity of Plaintiff’s claims in this respect, the Panel said “in our view, this pleading is not the kind of vague prelude to a fishing expedition that Congress sought to bar by imposing the clarity-and-basis requirement of the PSLRA.” In addition, “with respect to clarity, the Complaint sets forth a clear and precise statement of what the alleged fraud consisted of. With respect to basis, while the sources of information on which the Complaint relies for these allegations are not overwhelmingly impressive, they include sources within the Company who might well have access to the kind of information for which they are cited.”

However, the Panel found “the Complaint deficient” with respect to these claims, because Plaintiffs provided “nothing supporting the inference that either Smith or Langford was directly involved in the detailed accounting for these ten particular contracts, or had knowledge of the alleged falsity.” In sum, “irregular financial statements which overstate estimated results to only a small degree do not support a strong inference that the Chief Executive Office or the Chief Financial Officer of the company acted with intent to defraud, or with reckless disregard for the truth of the statements.” Accordingly, the Panel affirmed the dismissal of these 10b-5 claims, but reached “a different result, however, where those claims are asserted under §§ 20(a) and 18,” because those claims do not require proof of scienter, and the Panel “vacate[d] the judgment dismissing them.”

“The second group of claims of fraud relates to the TPPI contract for construction in Indonesia, which was ultimately cancelled for lack of funding.” The Panel held that “the allegations of exaggerated revenues and failure to report an expected loss are sufficiently detailed and supported to satisfy the PSLRA’s clarity-and-basis requirement,” because “the GAAP documents cited by the Complaint specify that the propriety of reporting unreceived payments as current revenue, matched with currently incurred costs, depends on a reasonable expectation that the buyer will satisfy the obligation to make the payments” and “the Complaint clearly states its theory that TPPI’s expected failure to pay would result in very substantial losses to S&W, which it did not take as a charge against earnings.”

However, the Panel found that the Complaint again failed the strong inference test as to the CEO and CFO because the complaint lacks “sufficiently compelling and clear factual allegations concerning the culpable involvement of Smith and Langford to support a strong inference of scienter on their part,” and because “despite the Complaint’s rhetorical flourish, accusing defendants of reporting ‘phantom revenue,’ the booking of revenues before their receipt does not necessarily involve any impropriety whatsoever.”

“The Complaint’s final major area of focus is on statements allegedly concealing S&W’s financial deterioration. The Complaint contends that S&W issued false and misleading statements reassuring investors of S&W’s financial viability and its access to sufficient cash to meet its needs, even as its finances fell into shambles, and eventually into bankruptcy.” To this, the Panel found that “the allegations of financial deterioration are set forth in the Complaint at length and with specificity,” and that “a jury could reasonably find that the cumulative sum of information provided to investors by that point was still materially misleading.”
As for clarity and basis, the Panel said that “we have no doubt that these allegations pass the” test, because the “complaint paints a detailed account of the deteriorated financial conditions at S&W, replete with factual support and citations to sources likely to have knowledge of the matter.”

Turning to the Defendants’ “safe harbor” defense, the Panel observed that the statute “seems to provide a surprising rule that the maker of knowingly false and willfully fraudulent forward-looking statements, designed to deceive investors, escapes liability for the fraud if the statement is identified as a forward-looking statement and [was] accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.” To that, the Panel said “we think that the meaning of this curious statute, which grants (within limits) a license to defraud, must be somewhat more complex and restricted.” “By reason of the emphasis on “projections,” “plans,” and “statements of future economic performance,” we understand the statute to intend to protect issuers and underwriters from liability for projections and predictions of future economic performance, which are later shown to have been inaccurate.” “We believe that in order to determine whether a statement falls within the safe harbor, a court must examine which aspects of the statement are alleged to be false. The mere fact that a statement contains some reference to a projection of future events cannot sensibly bring the statement within the safe harbor if the allegation of falsehood relates to non-forward-looking aspects of the statement. The safe harbor, we believe, is intended to apply only to allegations of falsehood as to the forward-looking aspects of the statement,” and “we do not think Congress intended to grant safe harbor protection for [statements] whose falsity consists of a lie about a present fact.”

In applying this framework to the Company’s statements that it “has on hand and has access to sufficient sources of funds to meet its anticipated operating, dividend and capital expenditure needs,” the Panel held that “we do not agree with the district court that this statement is necessarily protected by the PSLRA’s safe harbor rule,” and “we reject the district court’s conclusion that the statements assuring that the Company had access to sufficient cash to cover anticipated needs were within the safe harbor.”

In remanding the action back to the District Court, the Panel noted that “we do not purport to have ruled on each of the numerous fraudulent statements alleged in the Complaint. To the extent an allegation of fraud is not discussed in this opinion, the district court should rule again on defendants’ motion to dismiss, in a manner consistent with the discussions herein.”

You can read the decision at 2005 U.S. App. LEXIS 14325.

Nugget: “The falsity of a statement and the materiality of a false statement are questions for the jury,” and “a court is thus free to find, as a matter of law, that a statement was not false, or not materially false, only if a jury could not reasonably find falsity or materiality on the evidence presented.”

Nugget: “As we understand, it was not Congress’s intention to bar all suits as to which the plaintiff could not yet prove a prima facie case at the time of the complaint, but rather to prevent suits based on a guess that fraud may be found, without reasonable basis or a clear understanding as to what the fraud consisted of, but in the hope of finding something in the course of discovery.”

Nugget: “In our view, the safe harbor of the PSLRA does not confer a carte blanche to lie in such representations of current fact.”

Nugget: “One difficulty we find with the district court’s decision is that in several instances, in ruling on defendants’ motion to dismiss under Federal Rule of Civil Procedure 12(b)(6), the court failed to read the Complaint in the light most favorable to the plaintiff and failed to give the plaintiff the benefit of inferences that could reasonably be drawn.”

Nugget: “A plaintiff has the right to plead in the alternative, and the plaintiff’s doing so does not undermine the validity of the complaint. The stronger of the conflicting allegations must be accepted as if the conflicting alternative allegation had not been included. Nor is this changed by the PSLRA’s strong-inference requirement. In assessing whether the pleading satisfies the strong-inference requirement, a court must draw all reasonable inferences in the plaintiff’s favor, and then weigh whether they satisfy the statutorily mandated strong inference.”

Nugget: “We recognize that a plaintiff must show under § 20(a) that the controlled entity committed a violation of the securities laws. If that violation was, for example, a violation of Rule 10b-5, which requires a proof of scienter, then the plaintiff under § 20(a) must prove that the controlled entity acted with “a particular state of mind.” Nonetheless, if the statute is read literally, the strong-inference requirement of the PSLRA does not apply”

Nugget: “Where the state of mind in question is the defendant’s knowledge of the fraudulent nature of the Company’s financial reports, and the PSLRA requires that facts be stated with particularity giving rise to a strong inference that the defendant acted with that state of mind, the requirement is not satisfied by a pleading which simply asserts that the defendant knew of the falsity.”

Nugget: “The Complaint alleges furthermore that throughout 1998 comprehensive internal financial reports of the Company’s current condition were regularly distributed to the Company’s top executives. Id. Although the contents of the reports are not described, we can fairly infer that they described what they purported to describe – the Company’s current financial condition.”

Judge Eyes Net Seller in Evaluating Lead Plaintiff Group

A group of investors in the Zix securities class action can claim victory over three other proposed groups in their bid for that highly coveted of all positions – Lead Plaintiff. In making their respective arguments, each competing group burst out of their bucking chutes so hard, even Little Yellow Jacket himself would be impressed. Fortunately, Judge Ed Kinkeade (N.D. Tex.) was there to score the rides.

In determining that a group of four stockholders (self titled as the Shinabarker Group) “has sufficiently shown they sustained a larger financial loss,” Judge Kinkeade first recognized that “the evidence before the Court establishes the Shinabarker Group sustained the largest loss, with approximate losses of $563,185.” However, another group (self-titled with the Siegel Group moniker), with approximate losses of $171,934, complained that the Shinabarker Group actually experienced a net gain, rather than loss.” Specifically, they said that one of the Shinabarker Group’s members “was a net seller, thereby profiting from the alleged fraud.” The judge rejected this though, finding that “the Siegel Group did not provide sufficient evidence supporting this claim” because “the Court cannot determine from the single document the Siegel Group cited… how they arrived at this conclusion.” The court also found the point irrelevant, because if the alleged net seller was eliminated from the group, “the remaining Shinabarker Group members would still have sustained larger losses than any other group.”

Moving to the limited Rule 23 inquiry, the court next found that Shinabarker Group met “the typicality and adequate representation requirements.” Again however, “in its attempt to rebut the presumption that the Shinabarker Group is the most adequate to represent the class” another competing group (this one styled as the Brody Group) argued that the Shinabarker Group has failed “to establish its cohesiveness as a group.” But the court again rejected the competing group’s position, holding that Shinabarker Group’s joint declaration (which said that the group decided to work together to prosecute this Action and, that in working together, they can fairly and adequately represent and protect the interests of the other class members) “sufficiently establish[es] for this Court the group’s cohesiveness.”

You can read the decision at 2005 U.S. Dist. LEXIS 13871.

Nugget: “Factual differences will not defeat typicality as there is no requirement the claims be identical.”

Dura Rides Again

Judge Lewis A. Kaplan (S.D.N.Y.), who enters an impressive third Nugget appearance in two weeks, bravely takes on multiple motions to dismiss in the Net Asset Value (“NAV”) actions involving several hedge funds. A hedge fund is no different than any other fund, at least with respect to the fact that one of the most important measures of its success or failure is its value. For many funds, value is an easy metric to evaluate. However, in the case of these hedge funds, the securities they owned were not traded on any exchange, so valuing them “was not a matter of looking up closing prices in the Wall Street Journal.” Instead, it was a matter of “judgment.” We’re headed for trouble now, aren’t we? Yep, you guessed it. There’s a lawsuit involved here. Basically, Plaintiffs (who were shareholders and or limited partners of the funds) sued defendants for overstating their value (again, called NAV), neglecting to use independent valuations, and misrepresenting that the NAV’s were calculated in good faith.

There’s lots of details in this case you may want to check out, but the main item of interest here is the discussion of the loss causation issue under Dura (oh, and the court accepted the group pleading doctrine too in case yuo wanted to know). But let’s stick to loss causation. The court began by citing to Dura, and noting that “if a purchaser sold his investment in the Funds before the truth about NAVs became known, the alleged misstatements would not have caused his losses.” The court then analyzed the various fraudulent schemes advanced by Plaintiffs, and held that “plaintiffs adequately allege that defendants materially overstated NAVs and concealed losses from April through September 2002, that plaintiffs purchased securities at inflated prices in reliance upon the misrepresentations, and that plaintiffs were injured when the overvaluation — the subject of the alleged misrepresentations — was revealed.”

Judge Kaplan also weighed Defendants argument “that there can be no loss causation because plaintiffs’ losses supposedly were caused by a drop in interest rates,” and “investors… [who] held short positions in U.S. Treasury securities lost money during the summer of 2002 when interest rates fell.” But he rejected this position, finding that “this assertion, even if true, would not necessarily explain all of the Funds’ losses,” and again because “plaintiffs’ allegations suggest that defendants delayed in revealing the decline in the Funds’ NAV.” The judge observed that “even if a decline in interest rates prompted that decline, defendants’ failure to disclose the decline on a timely basis caused injury to investors who purchased at inflated prices and were injured when the decline was revealed.”

Finally, Judge Kaplan recognized that “plaintiffs adequately plead loss causation for the second and third categories of misstatements — that the Beacon Hill Defendants promised to value the securities in good faith and/or using independent prices” because “they assert that the Beacon Hill Defendants misrepresented that the Funds’ NAVs were calculated in good faith and/or using repo prices, that the NAVs instead were based on the defendants’ own valuations, that defendants’ valuations fraudulently concealed losses, that plaintiffs purchased at inflated prices in reliance upon the misrepresentations, and that plaintiffs were injured when the losses were disclosed, a disclosure that caused the Funds’ collapse.” Based on this, he found that “these allegations are sufficient to show that the subject matter of the alleged misrepresentations — that prices would be valued in good faith and using independent prices — caused plaintiffs’ losses.”

You can read the decision at 2005 U.S. Dist. LEXIS 13094.

Nugget: “Although Dura was a fraud-on-the-market case, its reasoning is equally applicable here. The Court based its ruling in part on the fact that ‘the logical link between the inflated share purchase price and any later economic loss is not invariably strong . . . . If, say, the purchaser sells the shares quickly before the relevant truth begins to leak out, the misrepresentation will not have led to any loss.’ The same is true here. If a purchaser sold his investment in the Funds before the truth about NAVs became known, the alleged misstatements would not have caused his losses.”