Securities Snapshot
October 24, 2017

Leidos Settlement Likely Forecloses Supreme Court Decision on Scope of Item 303 Liability

Proposed Leidos settlement likely forecloses Supreme Court decision on scope of Item 303 liability; Delaware Chancery Court dismisses fiduciary duty suit against Fortress affiliate; Massachusetts superior court finds demand rejection not protected by business judgment rule; Boston federal jury finds F-Squared’s former CEO liable under the Investment Advisers Act for misrepresenting investment product; Minnesota district court dismisses securities class action against Polaris amidst recalls. 

On October 6, 2017, the parties in Leidos, Inc. v. Indian Public Retirement System, et al., announced their proposed settlement of the securities fraud action, thereby hitting pause on a determination by the United States Supreme Court as to whether a company can be held liable for securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 for failure to disclose “known trends and uncertainties,” as required by Item 303 of SEC Regulation S-K. The case was first filed in 2012 against Leidos’s predecessor, SAIC, Inc., alleging that SAIC failed to control an employee who ran a kickback scheme via the municipal timekeeping system, City Time. Although the complaint was dismissed in the Southern District of New York in January 2014, the Second Circuit revived it in March 2016, finding that investors had valid claims against the company for allegedly failing to disclose an ongoing criminal investigation in their 2011 regulatory filings as required under Item 303. Leidos petitioned to appeal the Second Circuit’s decision, arguing that Item 303 does not create a duty to disclose “known trends and uncertainties” that can be privately enforced by investors under Section 10(b) and Rule 10b-5. The United States Supreme Court granted certiorari on March 27, 2017 and scheduled oral argument for November 6, 2017 to decide this issue. But on October 6, 2017, after briefing before the Supreme Court was complete, the parties filed a Joint Motion To Recalendar Argument And Stay Proceedings “to allow the parties to seek district court approval of the parties’ agreement in principle to settle this litigation.” The parties’ decision to settle this case leaves pending the hotly debated circuit split between the Second Circuit, on the one hand, and the Third and Ninth Circuits, on the other hand, as to whether Item 303 of Reg. S-K creates a duty to disclose “known trends and uncertainties” that is actionable under Section 10(b) and Rule 10b-5. That is, unless the district court refuses to approve the proposed settlement pursuant to Federal Rule of Civil Procedure 23(e).


On October 6, 2017, the Delaware Chancery Court in Chester County Employees’ Retirement Fund v. New Residential Investment Corp., et al., dismissed a suit by shareholders alleging that New Residential Investment Corp.’s board of directors, management, and others breached their fiduciary duties by allowing NRIC’s $1.5 billion purchase of Home Loan Servicing Solutions Ltd. The plaintiff, Chester County Employees’ Retirement Fund, argued that the NRIC board engaged in self-dealing and acted irrationally by not securing a better price and terms for the purchase of HLSS, especially in light of HLSS’s ongoing litigation and regulatory investigations. The complaint also alleged that NRIC board members had conflicting duties to NRIC and Fortress Investment Group, an affiliate of NRIC that stood to benefit from the asset purchase. Vice Chancellor Tamika R. Montgomery-Reeves rejected these arguments as “Monday morning quarterbacking,” dismissing the case because the plaintiff failed to plead demand futility under Court of Chancery Rule 23.1. The court specifically found that there was insufficient evidence to: (1) “raise a reasonable doubt as to the impartiality of a majority of the board” for purposes of demand futility; and (2) to show that NRIC’s payment for HLSS was “so far beyond the bounds of reasonable judgment” as to only be explained by bad faith. The Chancery Court concluded that this was not one of those “rare cases” that was “so egregious on its face” to warrant overruling the business judgment rule.


On September 14, 2017, a Massachusetts superior court in Brining v. Donovan denied dismissal of SendLater, Inc.’s motion to dismiss a minority shareholder’s derivative suit alleging claims for corporate waste. The plaintiff, Jennifer Brining, sent a demand letter to SendLater’s board of directors, asking the company to sue John J. Donovan, a director of the company, who allegedly diverted money that had been invested in the company for his own personal affairs. Although the board conducted an investigation resulting in a report, it ultimately rejected the plaintiff’s demand. The plaintiff argued that the three-member board that rejected her demand was comprised of new members that Donovan invited to join the board after the demand was received and was not independent of Donovan’s influence. Judge Mitchell Kaplan of the Suffolk Superior Court Business Litigation Session considered whether the evidence that the directors breached their duty of independence through self-interest was sufficient to rebut the business judgment rule, which would otherwise protect the board’s demand rejection. The court determined that, although personal friendship and business relationships are not alone sufficient evidence of self-interest, the plaintiff had presented other “confounding factors,” which raised a reasonable doubt that the board had acted in good faith. These factors included, inter alia, the transition of the board membership at Donovan’s request, evidence of self-interested loans that were memorialized later in time, regularly modified documents, and the board’s decision not to pursue claims now or in the future despite the likelihood of substantial recovery from Donovan. The court concluded that this case presented “a situation in which the Board’s conduct is so different from what an independent Board would be expected to do when confronted by the Report that it can raise reasonable doubt concerning the Board’s good faith.” Accordingly, the court denied SendLater’s motion to dismiss, allowing the suit to move forward.


On October 6, 2017, a Boston federal jury found Howard Present, the founder and former CEO of F-Squared Investments Inc., civilly liable under the Investment Advisers Act of 1940 for misrepresenting the record of one of its leading investment products, AlphaSector, in advertising materials and SEC filings. F-Squared, which had been a registered investment adviser since 2008, was at one time the largest marketer of index products using exchange-traded funds. The SEC alleged that Present represented that AlphaSector had a sterling history dating back to 2001 when, in reality, it was largely developed from an algorithm created in 2008 by a college intern at Morton Financial. Present argued that he believed in good faith that he had licensed an entire investment strategy from Morton Financial, which dated back to 2001, and not just the algorithm itself. Additionally, AlphaSector’s results were represented to be based on actual investments rather than calculated, hypothetical results or backtesting, when in fact they were the result of backtesting. The jury ultimately sided with the SEC, finding Present liable under Sections 206(1), 206(2), 206(4) and 207 of the Advisers Act. The SEC has indicated that it will seek the forfeiture of earnings and penalties totaling at least $22.2 million.


On October 17, 2017, a Minnesota district court in In re Polaris Industries, Inc. Securities Litigation dismissed with prejudice a securities class action against Polaris Industries, Inc., a manufacturer of off-road vehicles, alleging violations of Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 because the amended complaint failed to plead any actionable misstatements or omissions or scienter. The plaintiffs, a pension fund and individual investors, alleged that Polaris and some of its current and former executives made false and material misleading statements about its vehicles, including allegations that: (1) the quarterly reports stated that there were “no material changes or additions to [its] risk factors” not stated in its 10-K’s generic warning of product liability risks despite Polaris’s alleged knowledge of customer complaints in 2012 before its vehicle recalls in 2015-2017; (2) Polaris’s earnings reports were misleading and timed to “obscure bad news” regarding recalls; (3) Polaris’s warranty disclosures “failed to reflect the true extent of the financial risks”; (4) Polaris falsely overstated the safety of its products; and (5) Polaris falsely understated the impact of the product recalls. Judge Paul A. Magnuson disagreed, holding that the plaintiffs did not satisfy the heightened pleading standard applied to Section 10(b) claims because they did not show that the statements were false when made or materially misleading. Specifically, the court held that the statements regarding safety were “mere puffery,” that Polaris’s low warranty reserves might evidence bad business acumen but not fraud, and that the plaintiffs failed to allege evidence that Polaris’s warnings in its 10-K filing, recall statements and earnings reports were false at the time they were made. Moreover, Judge Magnuson ruled that the plaintiffs failed to allege scienter because they did “not establish that Defendants knew about the serious safety issues and concealed that knowledge from investors.”