News & Developments
Second Dismissal for American Express in the Southern District of New York
In one of the first ostensible subprime securities fraud cases, Judge William Pauley III of the U.S. District Court for the Southern District of New York has for the second time rejected a securities class action lawsuit brought against American Express Co. and certain of its current and former executives. See In re American Express Co. Sec. Litig., 02 Civ. 5533 (S.D.N.Y. Sept. 26, 2008).
Plaintiffs claimed that the company "misrepresented Amex's high yield investments as conservative when, in fact, they were high risk; concealed the extent of Amex's high-yield exposure; failed to disclose the lack of risk management controls; and failed to disclose the fact that Amex's accounting was not in accordance with GAAP." On remand, after an earlier dismissal on statute of limitations grounds was reversed by the Second Circuit, Judge Pauley granted defendants' motion to dismiss, ruling that plaintiffs failed to adequately plead scienter in light of the U.S. Supreme Court's recent decision in Tellabs Inc. v. Makor Issues & Rights Ltd., 127 S. Ct. 2499 (2007).
In weighing competing inferences of fraudulent intent, the court rejected plaintiffs' generalized allegations of insider knowledge and recklessness and refused to find a compelling inference of scienter based upon the allegations of confidential witnesses. The Second Amended Complaint failed to allege that any of these confidential witnesses "had any contact with the Individual Defendants or . . . knowledge of what they knew or should have known during the Class Period." Moreover, "none of the confidential witnesses state[d] that any Individual Defendant ha[d] information or access to information indicating that Amex was not properly valuing the High Yield Debt, that its risk control policies were inadequate, that Amex was violating GAAP, or that contradicted the Company's statements in 2001." Judge Pauley also held that the more compelling inference was that the executives were finding out about the extent of the losses as they were incurred, and thus did not hide any information from investors.
Defendants in future securities class actions will likely cite this new decision as the correct application of Tellabs and a guide for judges evaluating competing inferences of scienter in securities fraud cases.
Second Circuit Rules on the Doctrine of “Collective Scienter”
On June 26, 2008, the Second Circuit Court of Appeals issued an eagerly anticipated opinion addressing the use of the doctrine of "collective scienter" in securities fraud cases. In Teamsters Local 445 Freight Division v. Dynex Capital, Inc., No. 06-2902-cv, 2008 WL 2521676 (2d Cir. June 26, 2008), the Second Circuit reversed the district court and held that the plaintiffs failed adequately to allege scienter against corporate defendants Dynex Capital and Merit Securities. In February 2006, Judge Harold Baer of the Southern District of New York had held that plaintiffs had adequately alleged scienter against the corporate defendants, despite finding that plaintiffs insufficiently pleaded scienter against individual defendants Stephen Benedetti and Thomas Potts—two high-ranking officers at Dynex—or any other officer or employee of either company. The complaint alleged that Dynex had misrepresented the credit worthiness of loans and the value of collateral underlying certain Dynex bonds. But the lower court held that although Teamsters adequately pleaded "a pattern of reckless corporate behavior," there were insufficient allegations that Benedetti and Potts directly supervised or were personally involved in wrongdoing.
In vacating the decision and remanding the case, the Second Circuit clarified that the Public Securities Litigation Reform Act of 1995 (the "PSLRA") and Rule 12(b)(6) mandate dismissal of a securities fraud claim absent allegations demonstrating a "strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter." Id. at *4 (emphasis added). Apart from the inadequate allegations against individual defendants Benedetti and Potts, Teamsters failed to allege that Dynex's management knew about or had access to "information showing that the primary cause of the bonds' poor performance was not the general weakness in the mobile homes market," or that "anyone at Dynex or Merit had a compelling motive to mislead investors." Id.at *6. Consequently, the Second Circuit held that plaintiffs' proffered inferences of scienter were not "at least as compelling" as the competing inferences – that Dynex's statements were either not misleading, or were simply the result of "careless mistakes at the management level" – a pleading requirement under Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499, 2504-05 (2007). Notably, the court found that the stronger inference to be drawn from the poor performance of certain mortgage-backed securities issued by a Dynex subsidiary was that of general market weakness, rather than fraud.
With respect to the viability of the "collective scienter" doctrine, the Second Circuit declined to go so far as to accept the defendants' contention that Teamsters' pleading against Dynex failed as a matter of law because Teamsters failed to adequately allege scienter against any of the individual defendants. The court reasoned that the PSLRA's strict requirements for securities fraud pleadings did not foreclose the possibility that a plaintiff may raise the requisite "strong inference" of scienter against a corporate defendant without successfully pleading against any of its named officers. Id. at *3. Plaintiffs have thirty days leave to re-plead.
Second Circuit Expands Federal Jurisdiction over Securities-Related Class Actions
On May 13, 2008, the Second Circuit expanded federal jurisdiction over securities-related class action suits, deciding a question of first impression concerning the removal provisions of the Class Action Fairness Act (CAFA), 28 U.S.C. §§ 1332(d), 1453, 1711-1715 (2005). Pew v. Cardarelli, No. 06-5703-mv, 2008 WL 2042809, at *1 (2d Cir. May 13, 2008). This decision is noteworthy for two reasons. First, the Second Circuit exercised its authority under CAFA to hear the defendant's appeal even though district court remand orders traditionally are not reviewable. Id. at *3. Second, the court narrowly interpreted CAFA's securities exception by ruling that a district court had original jurisdiction based on diversity over a suit that did not involve nationally-traded securities and appeared to be rooted in state law.
Plaintiffs brought the complaint under state consumer fraud law, alleging that defendant Agway Inc. failed to disclose its insolvency while issuing money market certificates to the plaintiff class of purchasers. After defendants removed pursuant to CAFA, the district court remanded, holding that the action was not properly removed because it fell within an exception to CAFA's removal provisions that excludes from federal jurisdiction actions which solely involve the "rights, duties … and obligations related to or created by … any security." 28 U.S.C. § 1332(d)(9)(c) (2005). Defendants petitioned the Second Circuit to appeal the district court's remand order.
Exercising its discretionary power under CAFA, the Second Circuit elected to hear the appeal because the action raised an "important and consequential" question requiring clarification in the district courts. Pew, at *3. The court held that the case had been properly removed under CAFA's relaxed diversity requirements (and thus the federal courts had jurisdiction), and that the securities exception did not apply. The court concluded that Congress intended to reserve the exception for disputes over terms contained within securities, such as those that determine "how interest rates are to be calculated," in order to keep cases of primarily local significance in state courts. Id. at *6-7. Because this consumer fraud action alleging defendant's concealment of insolvency is not covered by the court's narrow interpretation of the exception, the court ruled the suit properly fell within the realm of federal jurisdiction. Plaintiffs are petitioning for a rehearing en banc.
Sub-Prime Plaintiffs Defeat Countrywide Motion to Dismiss
On May 14, 2008, Judge Pfaelzer of the Central District of California denied Defendants' motion to dismiss the shareholder derivative and class action suit brought against Countrywide and fourteen of its officers and directors. In re Countrywide Financial Corp. Deriv. Litig., No. CV-07-06923, 2008 WL 2064977 (C.D. Cal. May 14, 2008). The Court sustained the Plaintiffs complaint which alleges violations of Section 10(b) of the Securities Exchange act among other claims. The Court found that "Plaintiffs' allegations create a cogent and compelling inference that the Individual Defendants misled the public with regard to the rigor of Countrywide's loan origination process, the quality of its loans and the company's financial situation – even as they realized that Countrywide had virtually abandoned its own underwriting process." In re Countrywide, slip op. at 15.
The Countrywide Complaint may be noteworthy to prospective sub-prime plaintiffs with respect to its use of confidential witnesses. The court in Countrywide relied heavily on confidential witnesses from various levels in the corporate hierarchy and different satellite offices to "paint a compelling portrait of a dramatic loosening of underwriting standards in Countrywide branch offices across the United States." Id. at 16. This decision stands in contrast to the recent sub-prime dismissal, Tripp v. IndyMac Financial Inc., No. CV07-1635, 2007 WL 4591930, at *4 (C.D. Cal. Nov. 29, 2007), where confidential witness allegations were not sufficiently probative of scienter and generalized allegations such as "[t]he Company's policy of 'pushing through' unqualified loans evidences a Company-wide knowledge of IndyMac's underwriting problems" were insufficiently particularized.
Countrywide may also garner attention because of the court's willingness to impute knowledge of facts relevant to the scienter of certain individual defendants because of their participation on particular board committees. See In re Countrywide, slip op. at 22. As the Court stated, "it is difficult to believe that the Individual Defendants were unaware of the implications of the meteoric rise in negative amortization, especially when the overwhelming majority of these loans were approved with little documentation by the borrower." Id. The Countrywide court drew these conclusions even though other courts considering scienter have required specific factual allegations showing that the directors either wholly failed to put systems in place, or had actual knowledge of the wrongdoing. See, e.g., Guttman v. Huang, 823 A.2d 492, 494 (Del. Ch. 2003) (refusing to infer that members of audit committee must have known of accounting problems); DeSimone v. Barrows, 924 A.2d 908, 938 (Del. Ch. 2007) (rejecting the plaintiffs' allegations that members of the compensation committee must have known about options backdating because the committee administered the stock option plan).
It is unclear what broader impact Countrywide will have on sub-prime litigation, but it is likely to attract careful scrutiny from securities litigators across the nation.
Second Circuit Set to Hear Oral Arguments in Collective Scienter Case
On January 30, 2008, the Second Circuit will hear oral arguments in the case Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital Inc., et al, 06-2902-cv. The central question is whether a claim under 10 (b) of the Securities Exchange Act may proceed against a corporation on a theory of collective scienter. In other words, in the absence of viable claims against individual employees of the corporation due to lack of scienter, could a claim against the corporation be sustained, nonetheless, based on the theory that the combined knowledge of employees sufficiently established corporate scienter.
In the district court, Dynex Capital Inc., along with its subsidiary Merit Securities Corp. and two officers of the corporation, faced a putative class action for alleged violations of Section 10(b) of the Securities Exchange Act of 1934 in connection with the sale of asset-backed bonds. In June of 2006, Judge Harold Baer of the Southern District of New York dismissed the case against the individual defendants, finding that the plaintiffs did not adequately plead the requisite "scienter" for a §10(b) claim. Notably, however, Judge Baer did not dismiss the claims against the corporate entities. Applying what is known as the "collective" or "corporate" scienter theory, the court held that a plaintiff "may … allege [] scienter on the part of a corporate defendant without pleading scienter against any particular employees of the corporation." Recognizing that "there is substantial ground for difference of opinion" with respect to pleading collective scienter, Judge Baer subsequently certified the case for immediate appeal to the Second Circuit.
Over the past year, the Dynex appeal has garnered considerable attention, with over a dozen amicus curiae briefs filed by individual states, banks, pension funds, and other interested parties. Oral Argument is scheduled for January 30, 2008, before Judges Walker, Calabresi and Pooler.
High Court Ruling Reaffirms Limits on Private Right of Action under Section 10(b)
The U.S. Supreme Court, in a 5-3 decision written by Justice Anthony Kennedy, ruled that investors do not have a private right of action under Section 10(b) of the Securities Exchange Act of 1934 against third parties in corporate-fraud cases unless they relied on statements or representations by those parties when making investment decisions.
The high court affirmed a lower court ruling that had barred an investor lawsuit against Scientific-Atlanta, Inc., now a unit of Cisco Systems, Inc., and Motorola, Inc. The companies, vendors for cable company Charter Communications Inc., were alleged to have participated in a cable control box sales scheme that inflated Charter's revenue by $17 million in a much larger accounting scheme. The defendants, however, had no role in preparing or disseminating the alleged misleading financial statements to investors.
At issue in this case was whether a secondary actor could be liable under Section 10(b) if it engaged in deceptive conduct that was never disclosed to the investing public but had the purpose and effect of creating a false appearance of fact to further a scheme to misrepresent an issuer's financial statements. Corporations, as well as the U.S. Justice Department, which appeared at the oral arguments, argued that allowing 10(b) liability for this type of conduct would dispense with the critical element of reliance and that a secondary actor that did not actually make or participate in the making of a false statement was at most guilty of "aiding and abetting," conduct, which the Court already ruled could not form the basis of a 10(b) claim in Central Bank v. First Interstate Bank, 511 U.S. 164 (1994).
Kennedy's opinion said investors must rely on deceptive acts in order for a civil lawsuit to succeed under federal securities laws: "Reliance by the plaintiff upon the defendant's deceptive acts is an essential element." Because the defendants did not have an affirmative duty to disclose information to the public and did not participate in the deceptive acts communicated to the public, no reliance could be demonstrated.
Kennedy was joined in the majority by Chief Justice John Roberts Jr., Antonin Scalia, Clarence Thomas and Samuel Alito. Justice John Paul Stevens authored the dissent, in which Justices David Souter and Ruth Bader Ginsburg joined. Justice Stephen Breyer took no part in the consideration or decision of the case.
CEO Found Guilty of Fraud in SEC Action
On November 19, 2007, a jury in the U.S. District Court for the District of Massachusetts found Brian Adley, a former CEO of transportation-leasing equipment company Chancellor Corp., liable for fraudulent accounting.
The action, commenced by the SEC in 2003, alleged that Adley caused Chancellor to file false financial statements in 1999 and 2000. The complaint alleged that Adley directed the fabrication of corporate documents; instructed that the fabricated documents be given to the company's auditors; and coordinated the filing of false financial statements with the SEC.
The jury found Adley liable for violating the antifraud and record-keeping provisions of the federal securities laws, for making false statements to its accountants, and for aiding and abetting Chancellor's violation of reporting and recordkeeping provisions of the securities laws.
The SEC previously settled with 10 other defendants, including Chancellor's former chief financial officer, chief operating officer, audit committee and outside auditor.
A hearing will be held on December 7 to determine the penalty in the case.
Amaranth Decision Highlights Blurred Jurisdictional Lines of U.S. Regulatory Agencies
A New York judge has denied hedge fund Amaranth Advisors’ request to prevent the Federal Energy Regulatory Commission (FERC) from pursuing an administrative enforcement proceeding against it while Amaranth is simultaneously being sued by the Commodity Futures Trading Commission (the "CFTC"), based on the same alleged misconduct.
Defendant Amaranth traded in the natural gas futures market. Brian Hunter, also a defendant, was a natural gas trader and portfolio manager at Amaranth. In April 2006, FERC observed anomalies in the prices of the March and May 2006 natural gas futures contracts on the New York Mercantile Exchange ("NYMEX"). In response, FERC and the CFTC to conducted coordinated investigations of Amaranth. On July 25, 2007, CFTC commenced its action in the SDNY against Amaranth claiming that Amaranth violated the Commodity Exchange Act by engaging in market manipulation and making false statements to the NYMEX, concerning the March and May futures trades. On July 26, 2007, FERC commenced an administrative action, based on the same conduct alleged by CFTC, and claiming violations of FERC’s Anti-Manipulation Rule.
Faced with a near identical lawsuit and administrative proceeding, Defendant Hunter, asked the Southern District of New York, to enjoin FERC—a non-party to the CFTC action—from proceeding with its administrative action pending the outcome of CFTC’s suit. Although Judge Denny Chin "agree[d] that it would be prudent for FERC to defer to this lawsuit" he declined to stay FERC’s administrative action. Specifically, Judge Chin looked to his powers to preliminary enjoin proceedings of an non-party federal administrative agency under FRCP 65 and the All-Writs Act (28 U.S.C. 1651), and determined that neither granted him the authority to enjoin the FERC proceeding. Judge Chin found that (1) FRCP 65 only applies to parties (or officers, agents, servants, employees, or attorneys of parties) to an action, and FERC, as a non-party to the SDNY proceeding could not be enjoined pursuant to the Rule; and (2) the FERC proceeding in no way threatened the jurisdiction of the Court, and thus a preliminary injunction granted pursuant to the All-Writs Act would be improper.
Hunter further argued that the CFTC has exclusive jurisdiction to prosecute Amaranth’s trading activities in the commodity markets, and thus the FERC proceeding should not go forward. The Court rejected this argument finding that under the statute, the circuit courts and not the district courts are the proper fora for defendants to challenge FERC’s jurisdiction.
This latter argument, whether the CFTC’s holds primacy over FERC as the regulator of futures markets, has been the subject of some debate.
SEC to Weigh Effect of Securities Litigation on U.S. Companies
The U.S. Securities and Exchange Commission intends to hold public hearings next spring in an attempt to gauge the effect shareholder litigation is having on U.S. companies, and specifically to evaluate whether such litigation is making companies less competitive. The roundtable was spurred by recent studies suggesting that litigation has had a detrimental effect on the U.S. market.
New Mortgage Bill Could Create Liability For Bankers and Lenders
On October 23, 2007, the chair of the House Committee on Financial Services introduced a bill aimed at restricting abusive lending that could result in a surge of litigation by borrowers against banks that package mortgage securities.
The legislation, introduced by Rep. Barney Frank (D-Mass.) and titled “The Mortgage Reform and Anti-Predatory Lending Act of 2007,” was drafted in response to the sudden surge in mortgage defaults and foreclosures., and is specifically designed to protect future borrowers. Among other things, the bill would:
- bar mortgage lenders and brokers from receiving incentive payments to sign up borrowers for overly expensive loans;
- force lenders to give borrowers a range of suitable loan options and to make sure the consumer has a reasonable ability to repay the loan;
- make banks that package mortgage securities into investments explicitly liable for violations of lending laws under certain conditions;
- require mortgage brokers and bank loan officers to be licensed by state or federal authorities; and
- enact strict limits, but not an outright ban, on penalty charges made to borrowers who make their payments early.
Under the bill, banks that package mortgage securities would be legally responsible for loans that violate minimum standards, and borrowers would be granted the right to file a lawsuit to get any such loan nullified.
According to Frank, the bill reflects a common sense principle: "People should not be lent money that’s beyond what they can be expected to pay back."
There are, however, many concerns related to the bill including the increased regulatory burden on federally insured depository institutions, the proposals failure to establish a uniform underwriting standard as states could still pass more aggressive rules, and the extension of liability to the secondary market – i.e., investment banks that fund loans.
Stoneridge v. Scientific-Atlantic, Inc.: Supreme Court Revisits Aiding and Abetting Liability Under the Securities Laws
On October 9, 2007, eight justices of the United States Supreme Court (Justice Stephen Breyer had recused himself) heard oral argument in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., No. 06-43. The potentially significant impact of the case on the securities laws of the United States was evidenced by the more than two dozen amici submissions and a courtroom packed with spectators. At issue is whether two vendors of cable television boxes, who participated in transactions with Charter Communications, Inc. ("Charter") that allegedly were improperly accounted for in Charter’s financial statements, are subject to claims under § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5(a) and (c) when the vendors neither made nor caused to be made direct statements to Charter’s shareholders. The scope of any scheme liability calls into sharp focus the Supreme Court’s ruling in Central Bank v. First Interstate Bank, 511 U.S. 164 (1994), where the Court held that "a private plaintiff may not maintain an aiding and abetting suit under § 10(b)" id. at 191, finding that § 10(b) "prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act" and "does not include giving aid to a person who commits a manipulative or deceptive act." Id. at 177.
Petitioner alleged that Respondents participated in a scheme whereby Charter deliberately overpaid for the vendors’ products. The vendors purportedly used these overpayments to purchase advertising from Charter. Charter then allegedly booked the "advertising" funds as additional revenue. Petitioner’s counsel Stanley Grossman argued that Respondents conduct enabled Charter to misrepresent its financial statements. Grossman stated that a § 10(b) claim was cognizable because Respondents 1) directly engaged in deceptive conduct, creating documents falsely suggesting that there was a legitimate reason for the increased payments for their cable boxes, and 2) did so, either knowingly or recklessly in furtherance of the scheme to defraud its shareholders by improperly inflating Charter’s revenues. Grossman asserted that in the context of scheme liability, "[i]t’s not enough just to have the deceptive act. The deceptive act for scheme liability has to be with the purpose of furthering a scheme to defraud its investors." (Transcript of Oral Argument ("Tr.") at 8.)
Justices Scalia, Alito and Chief Justice Roberts focused on the issue of whether the Court should expand aiding and abetting liability in light of Congress’s active role in passing relevant legislation since the Court’s Central Bank opinion. Chief Justice Roberts offered, "Why shouldn’t we be guided by what Congress did in the action to the Central Bank case? There we said there’s no aiding and abetting liability, Congress amended the statute in 20(e) to say yes, there is, but private plaintiffs can’t sue on that basis. Why shouldn’t that inform how we further develop the private action under 10b-5?" (Tr. at 11-12.) The Chief Justice suggested that "we should get out of the business of expanding [private right of action] because Congress has taken over and is legislating in the area in the way they weren’t back when we implied the right of action under 10(b)." (Tr. at 7.) Justice Souter questioned whether the test propounded by Petitioner was "making a distinction that in the real world is not a distinction?" (Tr. at 20.)
Respondents argued that Petitioner was asking the Court "to expand an implied [private] cause of action by diluting traditional requirements such as the reliance requirement and by eroding this Court’s precedent in the Central Bank case." (Tr. at 26.) Respondents’ counsel, Stephen Shapiro, continued, "The Court has said in the past that it must be very cautious about expanding implied causes of action, but here there are special reasons for caution. … Congress wanted cases like this one to be handled by an expert and disinterested administrative agency." (Tr. at 26.)
Justice Ginsberg asked Respondents’ counsel whether there is "a ’middle category’ between Charter, who is clearly primarily liable, and Central Bank, that didn’t do anything deceptive." (Id.) Respondents asserted that "[i]ndependent actors that don’t speak to the markets and cause direct reliance on their statements are aiders and abettors. And they are supposed to be dealt with by the SEC, an expert agency." (Tr. at 41.) The government’s counsel, Deputy Solicitor General Thomas G. Hungar, amplified this point, stating that creation of a new private right of action was not necessary to hold such actors responsible. Both Respondents’ and the government contended that Congress had determined that the SEC was in best position to evaluate whether such conduct should be prosecuted. Mr. Hungar maintained that the SEC could prosecute theses claims and investors would be able to recover monetarily under the fair funds provision of the Sarbanes-Oxley Act.
Justice Souter also questioned Respondents whether it was possible for an overlap to exist between a primary actor and an aider and abettor which would permit a middle category of (presumably liable) actors. Respondents countered that there are only two separate categories as Central Bank itself provided: a primary violator makes a statement to the market upon which investors rely and an aider and abettor does not. But Justice Ginsburg observed that Respondents’ failure to make any statement was the very "essence of the scheme." (Tr. at 35.) She stated that Respondents did not need to say anything because "they set up Charter to make those statements, to swell its revenue – revenue that it in fact didn’t have." (Id.)
During Respondents’ argument, Justice Kennedy asked whether liability would attach to an outside attorney or accountant who deliberately prepares a false statement intended for investors and gives it to the primary actor to disseminate to the market. Respondents distinguished that situation by observing that if an outside accountant or lawyer prepared such a statement and it was attributable to him or her, then liability would attach because such conduct is made to the market and induced investor reliance.
The Court is expected to issue a decision in the first half of 2008.
