Conclusion — Securities Class Actions: Current And Emerging Trends

In previous installments of this series, we have discussed actions taken by Congress and the courts to curtail perceived abuses in filing and litigating securities damage suits, primarily class actions. The goal of these limitations has been to weed out frivolous suits, while permitting those with merit to proceed.

Congress acted on the perception of abusive litigation in passing the PSLRA, which contains substantive and procedural limitations. A key part of those limitations is the pleading requirements. In part, those requirements were drawn from the “particularity” requirements of Federal Rule of Civil Procedure 9(b). In part, they were based on the pleading standard for scienter crafted by the Second Circuit requiring that a “strong inference” be pled. Collectively, these requirements present significant pleading requirements which must be met before a complaint can move forward in discovery.

The Supreme Court, which has long expressed concern about abuses in bringing securities class actions, has also imposed limitations on these actions. In Central Bank, for example, the Court constricted the reach of Section 10(b), the antifraud weapon of choice in most cases, by concluding that the Section does not cover aiding and abetting. In Stoneridge, the Court reaffirmed that conclusion, rejecting scheme liability for transactions it saw as more appropriately regulated by state law, rather than the federal securities laws.

The Court also bolstered pleading requirements by reinterpreting its classic decision in Conley and Federal Civil Rule 8(a) on what is required to plead a complaint. Last term’s Twombley decision added a new plausibility test which the securities law plaintiff must meet in addition to the requirements of the PSLRA. The Court also added pleading and proof requirements in Dura regarding loss causation and interpreted the PSLRA’s “strong inference” of scienter requirement in Tellabs as rewriting a portion of Federal Civil Rule 12(b)(6) regarding a motion to dismiss. Overall, these decisions have clearly tightened the already stringent pleading requirements for these cases.

There is little doubt that the actions of Congress and the High Court have had the desired impact. In 2007, fewer securities class actions were filed than the prior year. At the same time in 2007, there were more cases filed than in any other post-PSLRA year other than 2006.

Billion dollar settlements were also down in 2007. Last year, there was only one settlement over $1 billion, compared to three the prior year. However, the mean settlement amount in 2007 was the highest since the passage of the PSLRA. At the same time, there is an increasing number of settlements in the $20 million to $30 million range.

Some commentators have argued that the reduced number of cases is the result of less fraud. Others have argued that it may be the result of market volatility and less fraud. Once commentator has noted that the number of smaller cases that tend to have limited damage claims, small class periods and which are often quickly settled has diminished substantially. Those cases tend to be associated with so-called “strike suits” – the kind Congress and the courts have sought to weed out.

The reduced number of cases being filed each year, while consistent with the “less fraud” and “market volatility” theories, may also reflect the increased substantive and procedural requirements for bringing and maintaining these cases. Those limitations may be weeding out non-meritorious cases, a point consistent with the finding that there has been a substantial reduction in the number of actions which appear to be “strike suits.” At the same time, the increased settlement value of the cases suggests that those which have been brought may be more meritorious. Overall, these points suggest that the actions of Congress and the courts may be having the desired impact – weeding out non-meritorious cases, while permitting those with merit to proceed.

Deception Under Section 10(b): Stoneridge And Policy Concerns Which Can Limit SEC And DOJ Enforcement Actions

The Second Circuit handed down a significant decision last week on deception under Section 10(b) and Rule 10b-5. In U.S. v. Finnerty, Docket No. 07-1104-cr (July 18, 2008), the Court affirmed the ruling of the district court granting a post trial motion for acquittal following a jury verdict of guilty. The defendant, a New York Stock Exchange specialist, was charged with securities fraud in violation of Exchange Act Section 10(b) for “interpositioning or engaging in arbitrage of the gap between customer orders to buy and sell shares.

In 2006, Mr. Finnerty was charged with three counts of securities fraud. A superseding indictment alleged that between 1999 and 2003 he caused 26,300 instances of interpositioning, yielding profits to his dealer account of about $4.5 million. The indictment also charged defendant Finnerty with trading ahead in 15,000 instances, causing about $5 million in customer harm. This conduct, according to the indictment, violated Section 10(b) and Rule 10b-5.

The district court granted in part Mr. Finnerty’s pre-trial motion to dismiss, concluding that the allegations did not violate subsection (b) of the Section and Rule regarding omissions. Citing NYSE Rules, which require specialists to place the interests of their public customers above their own however, the court concluded that the conduct alleged may violate subsections (a) and (c) of the antifraud provisions, because the claimed practices would subordinate the interests of the public to those of the specialists, contrary to what the public would expect.

Following a trial to a jury, and after the government abandoned the trading ahead claims, the jury found Mr. Finnerty guilty. The government submitted proof which established multiple NYSE Rule violations, the trading profits, the fact that bonuses at the defendant’s firm were paid on profits from the proprietary trading account and testimony suggesting that Mr. Finnerty tried to cover up his conduct. Mr. Finnerty demonstrated that the trades on which the government relied represented about 0.94% of his trades. Following the jury’s verdict, the district court granted a post trial motion for acquittal. The government appealed.

The Second Circuit affirmed. To establish a violation of Section 10(b) and Rule 10b-5, the government must prove the use of any “manipulative or deceptive device or contrivance.” Citing the Supreme Court’s decision last term in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 128 S. Ct. 761 (2008) (discussed here), the Court concluded that conduct can violate the Section even absent a specific oral or written statement. In the end however, there must be “some act that gives the victim a false impression,” according to the Second Circuit.

In this case, the government failed to identify any way in which defendant Finnerty communicated “anything to his customers, let alone anything false. Rather, viewing the evidence in the light most favorable to the government, the government undertook to prove no more than garden variety conversion,” a simple state law claim. Invoking the Supreme Court’s reluctance to intrude into an area governed largely by state law in Stoneridge, and quoting the opinion, the Second Circuit went on to hold that “[t]o impose securities fraud liability here, absent proof that Finnerty conveyed a misleading impression to customers, would pose ‘a risk that the federal power would be used to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.'”

The Court concluded by rejecting arguments by the government that Mr. Finnerty violated Section 10(b) because may have violated NYSE Rules on which some members of the public may have relied. Even if the public relied on these rules, the Circuit Court concluded that did not constitute reliance on a statement of Mr. Finnerty. While Mr. Finnerty’s conduct may have been unfair, the Circuit Court noted that “‘not every instance of financial unfairness constitutes fraudulent activity under Section 10(b)’ quoting Chiarella v. United States, 445 U.S. 222, 232 (1980).

Finnerty is one of a number of cases brought against NYSE specialists. Other criminal cases are discussed here. The SEC also brought an administrative proceeding. In the Matter of David A. Finnerty, Adm. Proceeding File No. 3-11893 (action against 20 specialists).

The Finnerty opinion is important not just for its ruling, but for its reasoning. Here, the Second Circuit extracted conservative themes from cases like Stoneridge and Central Bank of Denver, N.A. v. First Interstate Bank, N.A., (511 U.S. 164 (1994) (discussed here) which were crafted to constrict liability in private damage actions to limit the scope of Section 10(b) in a government enforcement action. Concepts such as not intruding into areas typically governed by state law, requiring that there be an express representation on which the victim relied and that Section 10(b) is a limited remedy are notions typically invoked in cases like Stoneridge to justify limiting liability in cases where a business organization is facing a class action for damages.

While the Supreme Court may have been rendering what many call pro-business decisions in Stoneridge and other cases, it was also invoking principles and reasons for not reading Section 10(b) in an expansive fashion. Finnerty does the same – the limitations it imposes come not so much from the text of the statute as from the policy reasons decisions such as Stoneridge use to justify their conclusions. Since Section 10(b) is typically the weapon of choice in government enforcement actions – SEC civil cases and DOJ criminal cases – Finnerty suggests that going forward SEC enforcement officials and DOJ prosecutors should carefully assess the limits such principles impose on the application of Section 10(b).