Securities Snapshot
August 29, 2017

Seventh Circuit Upholds First-Ever Conviction For “Spoofing” Market Manipulation Tactic

Seventh Circuit upholds first-ever “spoofing” conviction; First Circuit affirms dismissal of shareholder action against biopharmaceutical company for failure adequately to plead scienter; Fifth Circuit opens door for pre-indictment public access to search warrant materials; Minnesota Supreme Court allows shareholders to bring direct claims over inversion-related tax liabilities; Delaware Chancery Court dismisses shareholder action for failure to show board’s bad faith in merger approval; Northern District of California dismisses shareholder action for failure to identify corporation’s misleading statements; Southern District of New York rejects statistical sampling as method to establish liability in RMBS cases; Central District of California dismisses shareholder suit for failure adequately to plead scienter and loss causation. 

In U.S. v. Coscia, the Seventh Circuit recently upheld the conviction of Michael Coscia for “spoofing,” a market manipulation tactic defined by Section 6c(a)(5)(C) of the Commodity Exchange Act as “bidding or offering with the intent to cancel the bid or offer before execution.”  In so doing, the Seventh Circuit became the first federal appellate court to provide guidance on the crime.  Coscia was convicted on spoofing and commodities fraud charges under 18 U.S.C. § 1348(1) after he used pre-programmed algorithms to place large, high-frequency orders that artificially moved the price of commodities to favor his positions and then cancelled many of those orders before execution.  Coscia appealed, arguing that the anti-spoofing statute is void for vagueness and that the evidence did not support his conviction.  The Seventh Circuit affirmed the conviction in full, rejecting Coscia’s vagueness challenge and holding that the anti-spoofing “statute, standing alone, clearly proscribes the conduct” as “defined in the statute.”  The court reasoned that “even if [Coscia’s] behavior were not well within the core of the anti-spoofing provision’s prohibited conduct, the statute’s intent requirement clearly suggests that the statute does not allow for ad hoc or subjective prosecution.”  The court then found that Coscia’s spoofing conviction was well supported by the evidence, which included a record of the high frequency with which Coscia cancelled his orders before execution, testimony by the designer of the trading algorithms that they were “designed to inflate prices through illusory orders,” and expert testimony concerning Coscia’s unusually high order-to-trade ratios.  The Seventh Circuit also found that Coscia’s commodities fraud conviction was supported by evidence that Coscia never intended to fill his orders, and that the trial court properly found Coscia’s conduct “material” where it was “reasonably calculated to deceive” and played a role in other investors’ trading decisions.  Finally, the Seventh Circuit approved the trial court’s calculation of Coscia’s sentence using a fourteen-point loss enhancement based on his gains, noting that the time required to analyze actual losses based on the relevant trading logs “imposed an insurmountable logistical burden on the prosecution.”


In Corban v. Sarepta Therapeutics, Inc., the First Circuit affirmed the dismissal of a putative class action asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Sarepta Therapeutics, Inc., a biopharmaceutical company that develops gene therapies for the treatment of rare neuromuscular diseases, and certain of its officers and directors.  Plaintiffs alleged that Sarepta overstated the significance of test data and exaggerated in public statements the likelihood that its latest drug, eteplirsen, would receive accelerated approval from the Food and Drug Administration.  In a fifth amended complaint, plaintiffs argued that the FDA eventually declared Sarepta’s new drug application for eteplirsen “premature,” despite Sarepta’s rosy statements that it was “very encouraged by the FDA feedback” and viewed the drug’s progress as “a tremendous achievement.”  A unanimous panel of the First Circuit Court of Appeals (including Associate Justice David H. Souter (Ret.), sitting by designation) affirmed the district court’s dismissal of the complaint for failure to allege a strong inference of scienter.  The court found that the challenged statements provided “poor material for building a fraud claim” because they “convey[ed] opinion more than fact,” and “came with caveats.”  For example, Sarepta offered a “mix of optimism and caution” when it made clear that the FDA had requested additional information related to the methodology and verification of the drug, and declined to offer any guarantee that the eteplirsen NDA would be accepted.  The court found that “[e]ven if these and other caveats could have been more fulsome, they cut against the inference of scienter,” so that, at worst, “there was a positive spin that put more emphasis in tone and presentation on the real signs of forward movement with the NDA than it did on causes for wondering if the journey would prove successful.”  Although plaintiffs alleged that Sarepta withheld certain important information about the drug’s approval process, the court found that “defendants had no legal obligation to loop the public into each detail and very communication with the FDA.”  The court also noted that Sarepta’s hopes “ultimately proved correct,” as the FDA did eventually accept Sarepta’s NDA for filing for eteplirsen, albeit later than expected.


The Fifth Circuit, in U.S. v. Sealed Search Warrants, held that requests for access to pre-indictment search warrant materials must be assessed by courts on a case-by-case basis, balancing the public’s right of access with interests favoring nondisclosure.  The decision followed motions filed by Justin Smith, the subject of an IRS criminal tax investigation, seeking to unseal the probable cause affidavits supporting three search warrants executed at Smith’s properties.  A magistrate judge initially granted Smith’s motions in part, ordering the government to unseal the affidavits and redact any sensitive confidential information.  The government objected, and a district court reversed the magistrate judge, ordering the affidavits to remain fully sealed during the government’s investigation.  By reversing the district court’s order, the Fifth Circuit effectively “extend[ed] the case-by-case approach previously used by [the Fifth Circuit] for assessing the common law qualified right of access to judicial records to situations involving an individual’s request to access pre-indictment warrant materials.”  However, the court noted that although there is a common law right to inspect judicial records and documents, “this right is not absolute.”  Therefore, “the decision of whether access should be granted must be left to the discretion of the district court, upon the court’s consideration of the relevant facts and circumstances of the particular case.”  The Fifth Circuit remanded the matter to the district court with the instructions that the lower court “must generally articulate its reasons to support sealing the affidavits with a level of detail that will allow for this Court’s review.” Although the Fifth Circuit did not rule on whether Smith should be allowed to view the affidavits, it stated that granting the public access to judicial documents “promotes the trustworthiness of the judicial process, curbs judicial abuses, and provides the public with a better understanding of the judicial process, including its fairness.”


In In re Medtronic, Inc., Shareholder Litigation, the Minnesota Supreme Court held that corporate shareholders may file direct claims, as opposed to derivative claims, concerning certain tax liabilities imposed on them by a corporate merger.  In this case, Medtronic, a Minnesota corporation, acquired Covidien, PLC, in an inversion transaction whereby both companies became subsidiaries of a newly-formed Irish holding company.  As a result, Medtronic shareholders incurred a capital gains tax on Medtronic shares (but received no offsetting compensation from the company), while the company’s officers and directors incurred an excise tax liability for which they were reimbursed by Medtronic.  A Medtronic shareholder filed a direct suit against the company alleging three types of harm: (1) injury due to the capital gains tax liability imposed on certain shareholders; (2) injury due to the excise tax reimbursement made to Medtronic officers and directors; and (3) injury due to the dilution of shareholders’ interest in Medtronic.  Finding that the harms alleged by the claims were direct to Medtronic and derivative to its shareholders, the Minnesota district court dismissed the claims for failure to make a demand on the Medtronic board.  The court of appeals agreed with the lower court that the excise tax claim constituted a derivative claim, but concluded that the remaining claims were direct in nature.  The Minnesota Supreme Court clarified that the proper test under Minnesota law for distinguishing between direct and derivative claims focuses on “the nature of the injury alleged to determine to whom any recovery would belong.”  Therefore, “where shareholders are injured only indirectly, the action is derivative; when shareholders show an injury that is not shared with the corporation, the action is direct.”  Employing this standard, the Minnesota Supreme Court concluded that the plaintiff’s claims asserting injuries due to the excise tax reimbursement to Medtronic officers and directors were derivative “because corporate reimbursement of an excise-tax liability resulting from the transaction is at bottom an alleged waste of corporate assets.”   However, the court held the claims asserting injuries due to the capital gains liability were direct “because the tax liability is imposed on [plaintiffs] solely in their status as shareholders.”  Finally, the court held that claims concerning the dilution of shareholders’ interests were direct as well, as the injuries alleged arose from  reductions in shareholders’ ownership, and not a reduction in the value of shares.  Having found some of the shareholders’ claims to be direct (and, therefore, not subject to the demand requirement), the Minnesota Supreme Court remanded the case for further proceedings consistent with its opinion.


The Delaware Chancery Court, in In re MeadWestvaco Stockholders Litigation, recently dismissed a shareholder class action alleging that the board of directors for MeadWestvaco Corporation, a packaging company, acted in bad faith by approving a merger with the company’s competitor, Rock-Tenn.  According to plaintiffs, the MeadWestvaco directors approved the merger knowing that the company’s assets were undervalued by at least $3 billion.  The plaintiffs also alleged that the board approved the merger while “flying blind” under pressure from an activist investor, Starboard Value LP.  The court rejected these claims, holding that plaintiffs’ allegations fell “far short of pleading the ‘extreme set of facts’ necessary to establish a reasonably conceivable bad-faith claim . . . .”  Chancellor Andre Bouchard noted that plaintiffs faced a difficult task in pleading bad faith under the applicable business-judgment rule based on the following undisputed facts: eight of the nine directors who approved the merger were outside directors; the board was actively engaged in the merger discussions and held at least six meetings to consider the potential transaction; the directors received numerous valuations of the company; the board was advised by prominent legal counsel and three nationally recognized financial advisers; the directors rejected Rock-Tenn’s initial proposal and held out for a higher, 9.1% premium for MeadWestvaco’s shareholders; and the merger agreement included a fiduciary-out and a reasonable break-up fee of less than 3%.  Accordingly, the Chancery Court granted the company’s motion to dismiss the shareholders’ complaint.


In In re SolarCity Corporation Securities Litigation, the U.S. District Court for the Northern District of California dismissed a putative class action asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against SolarCity, a provider of solar-energy systems, and certain of its current and former officers.  Shareholders alleged that SolarCity concealed the declining demand for its services by making false or misleading statements concerning the company’s “key operating metrics,” including the number and quality of SolarCity’s customer contracts.  The complaint also alleged that SolarCity ceased releasing certain operating metrics to the public once its financial health began to falter in 2016.  The court rejected the shareholders’ allegations because they failed to identify any false or misleading statements made by SolarCity or its officers.  In a thorough review of the company’s public statements, Judge Lucy H. Koh found that each alleged misstatement either was protected by the Private Securities Litigation Reform Act’s safe harbor for forward-looking statements, constituted a non-actionable statement of corporate optimism, or that plaintiffs failed to allege falsity with particularity.  Notably, the court found unpersuasive the testimony of numerous confidential witnesses, because such testimony failed to identify key information, such as how the total number of contracts was calculated, why certain contracts were allegedly unlikely to be fulfilled, the number of contracts obtained through alleged deception, and how these allegedly tainted contracts affected the key operating metrics.  The court also held that, even assuming the defendants’ statements were misleading, the plaintiffs had failed adequately to plead scienter.  Finally, the court held that SolarCity’s chief revenue officer could not be held liable for any allegedly false or misleading statements under the U.S. Supreme Court’s decision in Janus Capital Group, Inc. v. First Derivatives Traders.  In so holding, the court rejected the Southern District of New York’s reasoning in City of Pontiac General Employees’ Retirement System v. Lockheed Martin Corp., which held that Janus does not apply to corporate officers and insiders, and instead joined numerous other district courts in the Ninth Circuit that regularly apply Janus to corporate officers.


In BlackRock Allocation Target Shares Series Portfolio v. Wells Fargo Bank, N.A., the U.S. District Court for the Southern District of New York adopted a magistrate judge’s recommendation to deny plaintiffs’ motion to use statistical sampling as a method to establish defendant Wells Fargo’s liability.  Plaintiffs were certificate-holders of residential mortgage-backed securities trusts degraded by the financial crisis of 2008.  Wells Fargo, as trustee of the RMBS trusts, was required under the trust agreements to enforce loan-sellers’ obligations to repurchase their loans upon “discovery” of a breach of the loan agreements, and to perform an investigation upon “discovery” that service agreements had been breached.  Plaintiffs alleged that Wells Fargo deliberately ignored signs that it was allowing low-quality mortgages into the trusts and failed to administer its duties upon discovery of the underlying contractual breaches.  The current dispute focused on whether “discovery” required Wells Fargo’s “constructive knowledge” or “actual knowledge” of a breach.  Judge Katherine Polk Failla adopted a compromise, holding that plaintiffs could “demonstrate ‘discovery’ through a showing of conscious avoidance or implied actual knowledge, both of which would impose a higher burden than ‘constructive knowledge,’ but both of which are different than ‘actual knowledge.’”  The parties also disagreed about the method for proving the underlying contractual breaches: plaintiffs argued that breaches could be demonstrated by statistical sampling of a portion of the thousands of mortgages at issue, while Wells Fargo contended that proof of a loan-specific breach could be shown only through a complete loan-by-loan review.  Judge Failla sided with Wells Fargo and agreed with Magistrate Judge Sarah Netburn’s conclusion that “sampling could not help [plaintiffs] identify the loans in breach, demonstrate that any material breaches adversely affected material loans, or ascertain the loan-specific cure and repurchase remedy.”  Moreover, “[b]ecause ‘discovery’ here required more than a showing of constructive knowledge . . . sampling could not help [plaintiffs] to demonstrate that any ‘discovery’ occurred.”  The decision is a setback for RMBS purchasers seeking to assign liability and calculate damages by reviewing a fraction of the thousands of loans at issue and extrapolating the results of those sampling efforts to entire loan pools.


In Knox v. Yingli Green Energy Holding Company Limited, the U.S. District Court for the Central District of California recently dismissed for the third time a putative class action asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Yingli Green Energy Holding Company Limited, a provider of solar energy products, and certain of its officers and directors.  Between 2010 and 2013, Yingli made public statements attributing much of its success to its participation in a program run by the Chinese government to subsidize the cost of solar power projects in China.  Plaintiffs alleged that Yingli’s public statements were false and misleading because they failed to disclose the risk that the program might be terminated due to widespread fraud by subsidy recipients.  The court dismissed these claims on scienter grounds, finding that plaintiffs failed to allege facts giving rise to a strong inference that Yingli executives intended to defraud investors by touting the subsidy program.  Specifically, Judge Otis D. Wright, II, found that plaintiffs could not rely exclusively on the “core operations” theory to establish scienter, which posits that “facts critical to a business’s core operations or an important transaction generally are so apparent that their knowledge may be attributed to the company and its key officers.”  Instead of showing that Yingli’s officers could not conceivably have lacked knowledge of the pervasive fraud in the subsidy program, plaintiffs’ allegations contained only “vague quantifiers” and “majestic generalities.”  The court also dismissed plaintiffs’ claim that Yingli committed accounting fraud by failing to timely disclose a write-off of debt owed by another solar energy company.  According to the court, plaintiffs failed to establish the element of loss causation because “simply recognizing that an account has become uncollectible does not imply that it was uncollectible at some earlier point.  Because the market could not have reacted to a fact that it did not know, Plaintiffs cannot establish loss causation.” Finally, the court denied plaintiffs another opportunity to amend their complaint, noting plaintiffs’ multiple prior complaints and stating that it did not see how plaintiffs could cure the identified deficiencies.