This Week In Securities Litigation (June 27, 2008)

This week, the Attorney Client Protection Act of 2008, pending in the Senate following passage in the House, received support from a group of former federal prosecutors.

In securities damage actions, Brooks Automation reached a tentative settlement in a class action. At the same time a decision by the Second Circuit Court of Appeals raised questions as to the pleading standards for scienter in the circuit.

Finally, as the week drew to a close, the SEC prevailed in a long-pending insider trading case where criminal charges had been dropped against the defendant. Earlier in the week, the SEC filed a settled insider trading case where the vague allegations of the complaint raise questions regarding what inside information was actually available to a defendant.

Privilege waivers

The Attorney Client Protection Act got a vote of support this week from 32 former federal prosecutors this week. In a letter to Senator Patrick Leahy, the former prosecutors argued that the Act should be passed because the “widespread practice” of requiring waivers has undercut the privilege and the constitutional rights of employees involved in corporate investigations. Former Deputy Attorney General Paul McNulty was not among those urging passage of the Act. Mr. McNulty authored a 2006 revision of DOJ’s prosecution and cooperation standards which sought to place limits on the circumstances under which prosecutors could request waivers. The revision had little impact in the view of many commentators.

The Act, previously passed by the House, is pending in the Senate. Essentially, the Attorney Client Protection Act would bar any federal prosecutor or attorney, including those at the SEC, from requesting a waiver of privilege.

What impact, if any the proposed legislation would have, is at best debatable. The Act would still permit business organizations to waive privilege and obtain cooperation credit. While there is no doubt that some business organizations would like the opportunity to consider waiving privilege under certain circumstances, the current situation presents clear difficulties.

In many instances, waivers are not the result of a direct request. Rather, they are the by-product of a pressure-packed charging system. On the one hand, prosecutors have very broad charging discretion guided by vague, almost open-ended standards. On the other, business organizations are offered little real guidance on what constitutes cooperation or what it can expect from such action. What is very clear is the potential harm to the company from being charged and the need to take any steps necessary to avoid it.

In this context, the about-to-be-charged business organization has little choice except to grasp for any desperate step that might help mitigate the potential liability. Those desperate steps frequently include privilege waivers which can undercut the rights of the organization and its ability to obtain legal advice, and which can have adverse consequences in private litigation. That waiver can also damage fundamental rights of employees who may want to cooperate with the company, but not necessarily the government. As long as there is cooperation credit to be had for a waiver born of desperation, whether it is the result of a direct request from prosecutors or it is a so-called voluntary waiver is of little moment: the result is the same. The Act may have some impact on waivers resulting from prosecutorial requests, but not on those compelled by the process.

Securities damage actions

Brooks Automation, Inc. tentatively settled a securities class action based on allegations of option backdating. Under the tentative settlement, $7.75 million will be paid into a settlement fund by the liability insurers for the company.

Previously, the company settled an option backdating case with the SEC. A separate enforcement action filed by the SEC against a company executive is still pending. Both are discussed here.

A decision this week by the Second Circuit raised questions concerning the pleading standards being followed in the circuit in securities damage actions. In Bay Harbour Management LLC v. Carothers, Case No. 07-1124-cv (2nd Cir. June 24, 2008), the court affirmed the dismissal of a securities damage action in part for failing to properly plead scienter under Section 21D(b)(2) of the PSLRA. The Supreme Court crafted a new “equipoise” standard in Tellabs v. Makor Issues & Rights, Ltd., 128 S.Ct. 61 (2007) last year for determining when a “strong inference” of scienter has been pled under the Section. Yet, Bay Harbour failed to cite the High Court’s decision or even mention its test. Rather, the Circuit Court used a test it first created prior to the passage of the PSLRA, raising questions about what pleading standards are being followed in the circuit.

Insider trading

The SEC obtained a jury verdict in its favor in a long pending insider trading case, SEC v. Patton, Civil Action No. 02 cv 2564 (E.D.N.Y. April 30, 2002). Following the verdict, the court entered a final judgment against defendant Constantine Stamoulis, enjoining him from violating Section 10(b) and Rule 10(b)-5 and directing him to disgorge his trading profits and prejudgment interest and to pay a fine equal to three times the amount of his gain.

The SEC’s complaint, filed in April 2002, named fourteen individuals as defendant. It alleged insider trading in the securities of WLR Foods, Inc. prior to a September 27, 2000, announcement that the company was being acquired by Pilgrim’s Pride Corporation. Among those named as defendants were Eric Patton, the former Director of Manufacturing for the Turkey division of the company, his brother Steve Patton, the owner of a Pennsylvania trucking company, Michael Nicolaou, Steve Patton’s former registered representative, Mr. Nicolaou’ friend Dimitrios Kostopoulos, also a former representative, and several others. The other defendants have settled with the SEC, consenting to injunctions prohibiting future violations and orders requiring the payment of disgorgement and penalties.

Criminal insider trading charges were also filed in 2002 against Eric and Steve Patton, Mr. Stamoulis, and several other defendants. Three of the defendants pled guilty to conspiracy and securities fraud charges while another defendant pled guilt to a perjury charge. The criminal charges were dismissed as to three defendants including Mr. Stamoulis.

Finally, the SEC also filed a settled insider trading case this week against a Williams-Sonoma, Inc. employee who held the position of manager for financial planning and analysis. The complaint claimed that defendant Di Vita learned inside information about the downward financial trend of the company at a management meeting and traded while in possession of that information prior to its release.

Although Mr. Di Vita settled the action by consenting to an injunction and agreeing to pay disgorgement, prejudgment interest and a penalty, the SEC’s complaint was, at best vague about what information was available at, and transpired during, the key meeting where the financial information was discussed. The case is discussed in more detail here. SEC v. Di Vita, Civil Action No. 1:08-cv-01060 (D.D.C. June 20, 2008).

Does Tellabs Have Any Impact In the Second Circuit?

Part IV of the series Securities Class Actions: Current and Emerging Trends discusses the impact of the Supreme Court’s decision in Tellabs. That decision construed the “strong inference” of scienter requirement of PSLRA Section 21D(b)(2). That part of the series concluded that at least in some circuits Tellabs appears to be having little impact. A recent decision by the Second Circuit Court of Appeals confirms that conclusion for that circuit.

In Bay Harbour Management LLC v. Carothers, Case No. 07-1124-cv (2nd Cir. June 24, 2008), the court reviewed the dismissal of a securities fraud complaint for failure to comply with the pleading requirements of Federal Civil Rule 9(b), which requires that fraud be pled with particularity, and the PSLRA. In discussing the adequacy of the complaint with respect to pleading scienter, the circuit court did not cite or discuss the Supreme Court’s decision last year in Tellabs v. Makor Issues & Rights, Ltd., 128 S.Ct. 761 (2007). Rather, the court relied on one of its own pre-Tellabs decision, applying the two-prong test crafted prior to the passage of the PSLRA: “We have held that a securities fraud plaintiff’s scienter allegations must ‘give rise to a strong inference of fraudulent intent,’ and that such a plaintiff may establish the requisite intent either ‘(a) by alleging facts to show that defendants had both motive and opportunity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness,” quoting Learner v. Fleet Bank, N.A., 459 F.3d 273, 290-91 (2d Cir. 2006).

In analyzing the scienter allegations in the Bay Harbour complaint, the circuit court applied its traditional two-prong test of scienter rather than Tellabs. There is no mention of Tellabs or the Supreme Court’s directives to consider: 1) all the allegations in the complaint; 2) assess whether there was a strong, cogent inference of scienter; or 3) determine whether that inference is at least as strong as any competing inference. Indeed, in discussing scienter, the court did not even cite its own decision applying Tellabs which incorporated the teachings of the Supreme Court and the circuit’s traditional two-prong test. See ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87 (2nd Cir. 2007). Rather, the test the court applied is the same one it has used since the passage of the PSLRA. Indeed, it is the same test the court has used since prior to the passage of that Act. Compare Press v. Chem. Inv. Serv. Corp., 166 F.3d 529 (2nd Cir. 1999) with In re Time Warner, Inc., Sec. Litig., 9 F.3d 1049 (2nd Cir. 1993).

Perhaps the Second Circuit concluded that only half of its ATSI Communications analysis was required to affirm the dismissal of what it apparently viewed as a weak complaint. Yet, it would seem that any analysis of this question should start with Tellabs, not omit the Supreme Court’s newly minted test. In fact, Bay Harbour, like some others decisions discussed in the earlier post analyzing circuit court decisions following Tellabs, suggests that at least in some circuits the Supreme Court’s teachings are having little impact.