The Supreme Court recently granted certiorari in Leidos, Inc. v. Indiana Public Retirement System. The case has the potential to resolve a circuit split between the Second and Ninth circuits regarding whether a company can be liable for securities fraud claims initiated by third parties for failure to make disclosures pursuant to Item 303 of the Securities and Exchange Commission’s Regulation S-K. Item 303 requires that companies provide information in certain SEC filings regarding any “known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.” The Second Circuit previously ruled in this case that failures to comply with Item 303 provide a basis for private investor suits under Section 10(b) of the Securities Exchange Act of 1934. Leidos argued in its petition for certiorari that the Second Circuit’s ruling was a dramatic expansion of the scope of “omissions liability under Section 10(b)” and has fueled forum shopping in Section 10(b) litigation. The Ninth Circuit has taken the position that the duty to make disclosures under SEC regulations does not give rise to a duty under Section 10(b) because of the differences between the SEC’s and the Exchange Act’s materiality standards. In seeking certiorari, petitioner Leidos argued that “an omission may be fraudulent only if the omitted information is necessary to make an affirmative statement ‘not misleading.’” In favor of the Ninth Circuit’s interpretation, the petitioner requested that the Supreme Court “right the ship that the Second Circuit has taken off course” which is also at odds with “clearly expressed Congressional intent.” The Supreme Court’s ultimate ruling in this case could resolve an issue of importance due to the “sheer volume of securities litigation in the United States, particularly in the Second and Ninth Circuits.”
FIRST CIRCUIT AFFIRMS NO FRAUD BY HINDSIGHT IN CLINICAL TRIAL ADVERSE EVENT DISCLOSURES
In Brennan, et al. v. Zafgen, Inc., et al., the First Circuit affirmed the district court’s dismissal of a securities class action based on plaintiffs’ failure to allege a strong inference of scienter under the Private Securities Litigation Reform Act’s heightened pleading standard. Zafgen, a clinical-stage biopharmaceutical company, was developing a drug product candidate, Beloranib, for the treatment of severe obesity and complex metabolic disorders. On October 14, 2015, Zafgen announced that it had learned of a patient death in an ongoing Phase 3 clinical trial of Beloranib and, two days later, the company disclosed that the FDA had placed Beloranib on partial clinical hold. When Zafgen’s stock price fell by more than 50 percent, investors filed suit against the company and its CEO, asserting claims under Sections 10(b) (and Rule 10b-5) and 20(a) of the Securities Exchange Act of 1934. Plaintiffs alleged that defendants knew from scientific articles that Beloranib increased the risk of thrombotic adverse events (“AEs”) and that defendants materially misled investors by failing to disclose two superficial AEs in a clinical trial that the company had conducted more than one year before the 2015 patient death. The First Circuit held that the complaint lacked specific facts that, at the time of the allegedly deceptive disclosures, defendants knew that (or recklessly risked that) they were misleading investors by not disclosing the two superficial adverse thrombotic events. The complaint’s allegations did not give rise to a strong inference of scienter because, as the Court held, the superficial AEs became significant in hindsight “only after the patient death” in 2015, and Zafgen’s robust risk disclosures—including the disclosure of two serious thrombotic AEs in the earlier trial—“at the very least support a strong competing inference that the defendants disclosed what they considered to be, at the time, the most relevant information about Beloranib’s clinical trials.” Goodwin securities litigators represented Zafgen in the shareholder action and before the First Circuit.
CIRCUITS CONTINUE TO WEIGH WHETHER DODD-FRANK PROTECTIONS APPLY TO INTERNAL WHISTLEBLOWERS
Circuit courts remain divided on the question of whether whistleblowers who only report issues internally and not to the Securities and Exchange Commission are protected by the anti-retaliation provisions of the Dodd-Frank Act. The Supreme Court recently denied a writ of certiorari in Verble v. Morgan Stanley Smith Barney, LLC, thereby declining to resolve a circuit split on the issue. The Sixth Circuit had affirmed the district court’s dismissal of Mr. Verble’s claim that he was improperly terminated in retaliation for being a confidential informant (and whistleblower) to the FBI. However, the Sixth Circuit did not reach the issue regarding the scope of Dodd-Frank’s anti-retaliation provision, finding instead that Mr. Verble failed to meet the threshold pleading requirements to state a plausible claim for relief. In an amicus curiae brief filed in support of the plaintiff’s position in that case, the SEC argued that “internal reporting of violations of law and other misconduct ‘play an important role in achieving compliance with the securities laws’” and that despite the statute’s ambiguous language, its anti-retaliation protections “extend to, among others, employees of public companies who make certain disclosures internally.” In contrast, on March 8, 2016, a divided panel of the Ninth Circuit ruled in Somers v. Digital Realty Trust Inc. that Dodd-Frank’s anti-retaliation protections extend to whistleblowers who only internally reported. Somers widened the split caused by the Second Circuit’s decision in Berman v. Neo@Ogilvy LLC, which found that an employee can receive anti-retaliation protections without reporting to the SEC, and the Fifth Circuit’s decision in Asadi v. G.E. Energy (USA), LLC, which found Dodd-Frank only offers protection to SEC whistleblowers. The issue could potentially be raised to the Supreme Court again soon, in Danon v. Vanguard Group, Inc., which has been pending in the Third Circuit since October 2016.
BITCOIN MARKET IN EARLY STAGES PROMPTS SEC TO REJECT PROPOSALS
The Securities and Exchange Commission recently rejected a proposal by NYSE Arca, Inc., an electronic exchange, to list and trade shares in a bitcoin-based trust. The SEC reviewed the proposal to determine its compliance “with the statutory provisions, and the rules and regulations that apply to national securities exchanges.” The SEC rejected the proposal because it did not find it to be “consistent with Section 6(b)(5) of the Exchange Act” which requires “that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.” To do so, the SEC stated, an exchange should have “surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity” and “those markets must be regulated.” This was the second rejection by the SEC of this nature recently. A few weeks earlier, the SEC rejected a similar application by Tyler and Cameron Winklevoss to create a bitcoin-based exchange traded fund. In the most recent order, the SEC hinted at what it would need to see in order to reverse its rejection of such proposals. The SEC stated that “bitcoin is still in the relatively early stages of its development” and noted that if the market develops, the SEC “could consider whether a bitcoin [exchange-traded product] would, based on the facts and circumstances then presented, be consistent with the requirements of the Exchange Act.” The SEC’s decision can be found here.
UTAH DISTRICT COURT FINDS THAT CERTAIN SECURITIES CLAIMS CAN BE BROUGHT EXTRATERRITORIALLY PURSUANT TO DODD-FRANK
On March 28, 2017, a district court in Utah released a precedential opinion in SEC v. Traffic Monsoon, LLC, et al. The opinion held that United States courts could hear claims regarding “activity related to foreign [securities] transactions.” In reaching its decision, the court reviewed the holding of Morrison v. National Australia Bank and a Dodd-Frank provision which have been labeled as being at odds with each other. Morrison “held that Section 10(b) and Rule 10b-5 [only apply] in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.” While Morrison was pending, Dodd-Frank was being drafted. Since then, Dodd-Frank has been interpreted as clarifying “that [U.S.] district courts have jurisdiction over a Section 10(b) action or a Section 17(a) action brought by the [Securities and Exchange Commission] if the conduct and effects test has been satisfied.” The parties in Traffic Monsoon disputed whether the conduct and effects test that had been “repudiated in Morrison” was revived by Dodd-Frank. The court found that Dodd-Frank “did not explicitly overturn the core holding of Morrison” because Dodd-Frank “addresses only the jurisdiction of the courts.” The result of the court’s holding was that Sections 10(b) and 17(a) apply extraterritorially “to the extent that the conduct and effects test can be satisfied.” Thus, Traffic Monsoon provides guidance on how to interpret the scope of U.S. laws applying outside of the country when securities claims are at issue. From Traffic Monsoon, it is clear that Sections 10(b) and 17(a) apply to “foreign transactions” where there is a U.S. connection pursuant to the conduct and effects test. In Traffic Monsoon, the court turned to the test as laid out in Section 929P(B) of Dodd-Frank. Despite clarifying the tension between Morrison and Traffic Monsoon, the court certified its order for interlocutory appeal on the basis that it contained legal issues “to which there is a substantial ground for difference of opinion.”
DELAWARE COURT ADVANCES CLASS COERCION CLAIMS IN SABA MERGER DISPUTE
In its recent decision in In re Saba Software, Inc. Stockholder Litigation, the Delaware Chancery Court demonstrated the limits of the application of the business judgment rule under Corwin v. KKR Financial Holdings LLC, in declining to dismiss a stockholder suit involving Saba Software, Inc. that alleged that the company’s board of directors breached its fiduciary duties by coercing the shareholders into approving a depressed-price merger. The Securities and Exchange Commission had investigated the company’s subsidiary for years for overstating “its pre-tax earnings by $70 million.” Although the company reassured the SEC that it would restate its financials, it never did, which resulted in the delisting of the company’s stock, a revocation of its registration, and drops in stock price preceding the company’s sale. The Saba board allegedly pressed the sale plan without disclosing material information related to its failures to meet the SEC’s restatement requirements. The “choice presented to stockholders was to either accept the $9 per share Merger consideration, well below its average trading price over the past two years, or continue to hold their now-deregistered, illiquid stock.” The defendants argued that the stockholder vote was uncoerced and therefore subject to the business judgment rule. In Corwin, the Delaware Supreme Court clarified that, in situations where entire fairness review does not apply, a transaction that is approved by a fully-informed, uncoerced vote of disinterested stockholders, even where statutorily required, will invoke the business judgment rule. However, Vice Chancellor Slights found that the complaint supported a reasonable inference that the vote was coerced and not fully informed. The Vice Chancellor also clarified that affirmative action is not required to demonstrate coercion, nullifying the defendants’ argument that “the court must identify some affirmative action by the fiduciary in connection with the vote  that reflect[s] some structural other mechanism for or promise of retribution that would place the stockholders who reject the proposal in a worse position than they occupied before the vote.” While decided on unique facts, the Saba decision appears to demonstrate the limits of the Corwin doctrine.
INVESTORS BANCORP DODGES SHAREHOLDER SUIT FOR COMPENSATION AWARDS
In In re Investors Bancorp, Inc. Stockholder Litigation, the Delaware Chancery Court dismissed a shareholder derivative action challenging $50 million in equity incentive awards to directors and executives of Investors Bancorp Inc., ruling that the awards complied with a compensation plan already approved by company shareholders. The action was the result of a mutual holding company completing a mutual-to-stock conversion, which led to the company becoming a public stock holding company. After the conversion, the directors presented a compensation plan to stockholders for approval. With shareholder approval, the directors gave themselves “substantial restricted stock and stock options.” Stockholders brought suit, “alleging that the compensation awards were excessive and unfair to the corporation.” The question presented to the court was “whether the stockholder approval of the equity compensation plan” extended to the board’s “subsequent decision to authorize grants of awards under the plan such that the propriety of [the] awards should be reviewed under a waste standard.” Vice Chancellor Slights found that the stockholder vote was fully informed and that the approved “plan extended to the awards themselves” because they “indisputably fell within the limits set by the plan.” After making this determination, the Vice Chancellor reviewed the “propriety of [the] awards” under the business judgment rule “which defaults to a waste standard.” The court held that the plaintiffs failed to plead waste, satisfy the requirements for demand futility, and state an independent claim for unjust enrichment because it was a “recast of their breach of fiduciary duty claim[,]” thus failing to “state a viable claim under either theory of recovery.”
Jennifer L. ChuniasPartner