Part X: Securities Class Actions: Current And Emerging Trends

One theory of Dura loss causation is the fraud on the market theory. Under this theory, the specific fraud must be revealed. This is the basic theory in Dura. The court applied this theory in Tricontinental Ind. v. PWC, 475 F.3d 824 (7th Cir. 2007). There, the complaint alleged that plaintiff sold assets to defendant for stock in reliance on the 1997 financial statements. In 2000, the defendant announced an investigation of possible accounting irregularities for the period 1998-1999. Following the announcement, the stock price dropped. The Seventh Circuit agreed with the district court that these allegations were inadequate: Dura “stresses that the complaint must ‘specify’ each misleading statement … and that there must be a causal connection … .” A general acknowledgement of “accounting irregularities” is not sufficient. See also In re Bristol-Myers Squibb Sec. Litig., 2005 WL 2007004 (S.D.N.Y. Aug. 17, 2005) (holding that it is the actual facts which are disclosed that is key, not the perception of the market).

It is critical to this theory that the truth be disclosed prior to the drop in the stop price. Conversely, it is not sufficient to plead facts demonstrating that the truth emerged after the share price drops. In Schleider v. Wendt, 2005 WL 1656871 (S.D. Ind. Jul 14, 2005), the complaint claimed that false statements were made about the operations during the class period. During the period the share price declined. After the class period, the company filed for bankruptcy and later still the truth emerged. The court held that there was a failure to plead loss causation: “The stock had long since hit bottom before these alleged misrepresentations became known.” See also In re Coca-Cola Enterprises, Inc., Sec. Litig., 2007 WL 472943 (N.D. Ga. Feb. 7, 2007) (same); Powell v. Ida Corp., Inc., 2007 WL 1498881 (D. Idaho May 21, 2007) (same).

Price inflation plus reliance on the integrity of the market also is not sufficient. Thus, the court in In re Business Objects, S.A., Sec. Litig., 2005 WL 1787806 (N.D. Cal Jul. 27, 2005) concluded that a complaint was insufficient because it alleged only that the class “suffered damages in reliance on the integrity of the market, [and that] they paid inflated prices for” the stock. See also Reding v. Goldman Sachs & Co., 382 F. Supp. 2d 1112 (E.D. Mo. 2005).

Likewise, a bankruptcy announcement has been held to be insufficient. In D.E. & J. Ltd. Partnership v. Conaway, 133 Fed. Appx. 994 (6th Cir. 2005), the stock price was alleged to have been inflated by concealing the true financial condition of the company. When the company filed for bankruptcy, the price dropped. The court rejected plaintiff’s claims that this was sufficient without more, concluding that an allegation that “a stock price dropped on a particular day, whether as a result of a bankruptcy or not, is not the same as an allegation that a defendant’s fraud caused the loss.” Indeed, under this theory, the complaint must specifically allege that the stock was sold at a loss. Knollenberg v. Harmonic, 152 Fed. Appx. 674 (9th Cir. 2005).

Next: Dura and the theory of materialization

This Week In Securities Litigation (July 3, 2008)

This week the SEC continued to focus on insider trading and option backdating. The Commission prevailed in an important decision by Ninth Circuit construing the breach of duty requirement in insider trading cases based on the misappropriation theory. It also filed another option backdating case, a portion of which is in litigation.

Foreign regulators also continued to focus on insider trading. In Canada, the Ontario Securities Commission imposed a substantial fine on a legal secretary who traded on information obtained from her law firm. In a practice which the SEC might consider, the OSC noted in the papers filed that the defendant had acted contrary to the public interest, rather than detailing her insider trading activities because of her extensive cooperation. U.K. regulators also continued to focus on insider trading, while Australian authorities released the results of a study of trading by corporate directors.

Finally, three new articles of interest discuss loss causation, springloaded options and the merits of private securities litigation.

Insider trading

In SEC v. Talbot, Case No. 06-55561 (9th Cir. June 30, 2008) the Court of Appeals reversed the dismissal of an SEC insider trading action as discussed here. The district court had dismissed the SEC’s complaint. That complaint alleged that defendant Talbot, a long time Fidelity National Financial director, purchased shares of LendingTree after learning at a Fidelity board meeting that the company was in negotiations to be acquired. Fidelity had been informed about the negotiations because it then owned 10% of LendingTree. Since the SEC failed to prove a direct, continuous link between the communication of the inside information by LendingTree and Mr. Talbot, the district court concluded there was no breach of duty as required by the misappropriation theory and dismissed the case.

The Ninth Circuit rejected the district court’s conclusion. Rather, the circuit court concluded that Mr. Talbot breached a duty to Fidelity. That breach, the circuit court concluded, was sufficient, although it admitted that other cases had the causal link the district court found lacking. This holding potentially broadens the reach of the misappropriation theory.

Backdating

The SEC filed a partially settled option backdating case on Monday (also discussed here), SEC v. Microtune, Inc., Case No. 3:08cv1105-B (N.D. Tex. June 30, 2008). The case named the company, as well as its former CEO Douglas Bartek and former CFO Nancy Richardson as defendants. The complaint alleged a years-long option backdating scheme tied to the hiring and executive compensation practices of the company covered up by fraudulently documents.

The company settled by consenting to a permanent injunction prohibiting future violations of the antifraud and books and records provisions. The individual defendants are litigating the case.

Other jurisdictions

The Ontario Securities Commission approved a settlement with former legal secretary Betty Leung under which she agreed to pay a financial penalty of $103,000 based on settlement papers which alleged that she had acted contrary to the public interest. The settlement reflected credit given to Ms. Leung for her substantial cooperation with the staff.

The underlying facts of the case established that Ms. Leung had been employed as a secretary at the law firm of Bennett Jones LLP since 1989. From April 2005 to March 2008 she traded small amounts of shares – typically 200 to 800 at a time – in eight companies based on confidential information she learned at the law firm about possible takeover deals. The trades were placed in her accounts as well as those of her husband and parent. The fine was twice her trading profits. The settlement papers did not allege insider trading or the details of the transactions in view of the fact that when contacted she immediately acknowledged her actions and fully cooperated with the staff.

The Financial Services Authority in the U.K imposed a fine of £85,000 on John Shevlin a former IT worker at The Body Shop for what it called market abuse – insider trading. The fine represented more than twice the trading profit from a short position. Mr. Shevlin obtained information that the company would miss its financial targets for the period from confidential internal e-mails. At the time, Mr. Shevlin had significant trading losses in his securities account.

The Australian Securities Exchange released a comprehensive review of disclosure of Directors’ Interest Notices (securities transactions by directors in shares of their company). According to the study, of 4,137 Notices filed over a three month period, 538 or 13% were filed late. During the same period, 795 trades were made during blackout periods, that is, between the close of the entity’s financial period and the release of the results. Approximately 7% of those trades contravened the trading policies of the entities.

Recent articles of interest

Shareholder Class Actions and The Counterfactual, by Dr. Frederick Dunbar and Dr. Arun Sen (NERA Economic Consulting). This article discusses the application of counterfactual analysis, a social science approach to causation, to the standards now required in securities damage cases by the Supreme Court’s decision in Dura (discussed here). According to the authors, this approach has significant implications for estimating damages.

Stock Option “Springloading”: An Examination of Loaded Justifications and New SEC Disclosure Rules, by William Hughes, 33 Journal of Corporation Law 770 (2008). The article discusses the concept of springloaded options. It argues that while this type of option does not fit squarely within traditional insider trading analysis, it rejects the conclusions of SEC Commissioner Atkins that they should be permitted.

The Missing Link Between Insider Trading and Securities Fraud by Professor Richard A. Booth, 30 Corporate Governance 42 (Winter 2007/2008). The author explores the frequently stated notion that private securities litigation is an indispensable tool for defrauded investors to recover their losses and that these suits are critical to the integrity of the domestic capital markets.