Securities Snapshot
March 13, 2018

Fourth Circuit Reverses Dismissal of Securities Class Action Based on Concealment of Fraudulent Reimbursement Scheme

Fourth Circuit reverses dismissal of securities class action based on concealment of fraudulent reimbursement scheme; E.D.N.Y. rules that cryptocurrencies are subject to CFTC oversight, paving way for federal regulation; S.D.N.Y. differentiates between statutes of repose and limitation in analyzing relation-back principles; California federal court follows Second Circuit in limiting use of alleged omissions to overcome lack of reliance; Virginia federal court allows claim to proceed against company where scienter only adequately alleged as to lower level employees; Massachusetts federal court allows state law claims to proceed following merger of brothers’ companies, while dismissing federal securities claims; Illinois federal court rejects argument that explanation of increased insurance claim frequency was nonactionable opinion; and Delaware Chancery Court uses new "Dell-compliant" shorthand for when courts may defer to deal price in post-merger appraisal actions.

On February 22, 2018, the U.S. Court of Appeals for the Fourth Circuit in Singer v. Reali, et al. vacated the previous dismissal of a securities fraud class action brought against medical device company TranS1, Inc., which the plaintiffs alleged had “convince[d] surgeons to engage in improper reimbursement practices in direct violation of” various statutes, including the False Claims Act. As background, a healthcare provider submitting a reimbursement claim for surgery is obligated to use certain codes promulgated by the American Medical Association divided into Categories I, II, and III. A Category I code indicates a traditional procedure subject to full reimbursement, while Category III procedures are more experimental and are not eligible for any reimbursement. The plaintiffs alleged that the defendants carried out a scheme enabling surgeons to use TranS1’s AxiaLIF system to treat degenerative disc disease in the lower lumbar spine and receive reimbursement from private insurers and government-funded healthcare programs by entering the Category I code, even though the AxiaLIF system had been classified as Category III and was not eligible for reimbursement. In an October 2011 SEC filing, the company disclosed a subpoena issued by the Department of Health and Human Services under authority of “the federal healthcare fraud and false claims statutes,” and the next day, an analyst report was published opining that the subpoena “could be due to reimbursement communications” and noting that half of the company’s revenues came from physicians using a Category I rather than Category III code. Following those events, the company’s stock price fell by more than 40%, and the plaintiffs sued, asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The district court dismissed the case based on the plaintiff’s failure to plead a material misstatement or scienter. On appeal, the Fourth Circuit reversed, holding that the plaintiffs had adequately pleaded a securities fraud claim. According to the court, by choosing to discuss its reimbursement practices, the company “possessed a duty to disclose its alleged illegal conduct,” which it violated by “omitt[ing] the fraudulent reimbursement scheme.” The Fourth Circuit also agreed with the district court that the plaintiffs had adequately pleaded loss causation arising from the October 2011 public disclosures “pursuant to an amalgam of the corrective disclosure and materialization of the concealed risk theories,” in contrast to other courts who have expressed skepticism that plaintiffs may use disclosure of government investigations or subpoenas as evidence of loss causation. The Fourth Circuit’s decision, which also relied on other factors to establish loss causation in addition to the mere disclosure of the subpoena, may signal an increased willingness by courts to allow plaintiffs to use such disclosures to establish loss causation.


On March 6, 2018, the U.S. District Court for the Eastern District of New York in CFTC v. McDonnell, et al. awarded a major win to the Commodity Futures Trading Commission in a case involving oversight of cryptocurrencies. The CFTC had sued Patrick McConnell and his company, Coin Drop Markets, for allegedly operating “a deceptive and fraudulent virtual currency scheme … for purported virtual currency trading advice” and misappropriating investor funds. The issue before the court was whether the CFTC had authority to regulate cryptocurrencies as a commodity in the absence of federal level rules, and whether its jurisdiction extended to “fraud that does not directly involve the sale of futures or derivative contracts.” The court held that “[u]ntil Congress clarifies the matter, the CFTC has concurrent authority, along with other state and federal administrative agencies, and civil criminal courts, over dealings in virtual currency.” According to the court, “[v]irtual currencies are ‘goods’ exchanged in a market for a uniform quality and value” and “fall well within the common definition of ‘commodity,’” and therefore “CFTC may exercise its enforcement power over fraud related to virtual currencies sold in interstate commerce.” The court further granted a preliminary injunction barring the defendants from engaging in cryptocurrency investment as the case progresses and allowing the CFTC to access the defendants’ business records and ordered the defendants to submit to an accounting of their finances. The case is a significant milestone in determining the extent to which cryptocurrencies and other similar products may be subject to federal regulation and enforcement.


On March 1, 2018, the U.S. District Court for the Southern District of New York ruled in FDIC v. First Horizon Asset Securities Inc., et al. that newly-added federal and state law securities claims were barred by the applicable statutes of repose, but that other newly-added state law claims, not subject to a statute of repose, related back to the original complaint and were timely. The decision arises out of an August 2012 lawsuit that the Federal Deposit Insurance Corporation brought against various entities including First Horizon Asset Securities, Inc. and First Horizon Home Loan Corporation, on behalf of the now-defunct Colonial Bank, of Montgomery, Alabama, alleging misrepresentations by the defendants in connection with Colonial’s 2007 purchase of residential mortgage backed securities issued or underwritten by the defendants. The FDIC alleged that the SEC disclosures contained misrepresentations regarding the loans in the collateral pools backing the securities, many of which defaulted during the housing market collapse. Colonial Bank incurred heavy losses from the defaults, and in August 2009 Alabama regulators closed Colonial Bank and appointed the FDIC as receiver. The lawsuit was amended in June 2017, nearly five years after it was originally commenced, to add one federal claim under Section 12(a)(2) of the Securities Act of 1933, two securities claims under Nevada law, and two claims under Alabama law. The defendants moved to dismiss the amended complaint, alleging that the new claims were time-barred under applicable statues of limitations and repose. The FDIC argued in response that because the claims were added as amendments to an existing and timely lawsuit, the claims were not time-barred under the terms of the statute. Judge Louis L. Stanton ruled that the securities violations brought under both federal and Nevada law were indeed barred by a five- and three-year statute of repose, respectively, holding that the FDIC’s argument for treating amendments differently than original claims “cannot be reconciled with the Supreme Court’s recent holding in California Public Employees’ Retirement System v. ANZ Securities, Inc. that ‘the purpose of a statute of repose is to create an absolute bar on a defendant’s temporal liability,’” and that the relation-back doctrine could not save the claims. By the time the time the FDIC discovered evidence of the violations under federal and Nevada law through discovery on other cases, according to the court, the “defendants’ liability was already extinguished by the express provision of the statute of repose.” Judge Stanton declined to dismiss the claims brought under Alabama law, however, as those claims were only subject to a statute of limitations, which are subject to tolling, and were thus saved by the relation-back doctrine and timely brought under Fed. R. Civ. P. 15(c)(1)(B).


On March 2, 2018, the U.S. District Court for the Northern District of California dismissed bondholders’ class action claims against Volkswagen AG in In re: Volkswagen “Clean Diesel” Marketing, Sales Practices, and Products Liability Litigation. The claims were brought in June 2016 with the bondholders, led by the Puerto Rico Government Employees and Judiciary Retirement Systems Administration, alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 arising from their purchase of more than 4,100 bonds in a May 2014 offering from Volkswagen Group of America Finance LLC. The bondholders alleged that the bond offering documents failed to disclose Volkswagen’s emissions fraud, thus causing the bonds to sell at inflated prices. In a July 2017 ruling, relying on the Supreme Court precedent in Affiliated Ute Citizens of Utah v. United States, the court had previously allowed the plaintiffs to rely on a presumption of reliance by primarily “alleging fraudulent omissions as opposed to misstatements,” and finding that bondholders had “plausibly alleged that the relevant offering memorandum was misleading, and that at last some (but not all) defendants made statements and omissions therein with scienter.” In its March 2 ruling, however, Judge Charles R. Breyer relied on an intervening November 2017 decision out of the Second Circuit, Waggoner v. Barclays PLC, which held that the principle in Affiliated Ute does not apply when the only omission alleged is of “the truth that an affirmative misstatements misrepresents.”  Relying on Waggoner and similar holdings, Judge Breyer dismissed the claims, holding that if the bondholders did not rely on the allegedly misleading statements, they cannot “overcome this shortfall by characterizing their claims as primarily alleging omissions.” However, the court allowed the bondholders leave to amend their complaint to properly allege an alternative theory of reliance, such as fraud on the market or direct reliance based on an acknowledgment clause in the bond offering memoranda. The decision shows that courts may be less receptive to plaintiffs’ attempts to circumvent the reliance element by attempting to characterize straightforward misstatements as omissions.


On March 2, 2018, the U.S. District Court for the Eastern District of Virginia ruled in Knurr v. Orbital ATK Inc. that plaintiffs bringing suit for violations of the Securities Exchange Act of 1934 failed to allege facts supporting a “strong inference” of scienter with respect to a corporate officer defendant, but did adequately state a Section 10(b) claim against the corporation itself, Orbital ATK Inc., by sufficiently alleging scienter by lower-level employees. The plaintiffs had alleged that individual defendant corporate officers, and by extension Orbital ATK, made a series of false and misleading statements in various SEC filings, conference calls, and investor meetings with respect to merger synergies, the performance of a major contract, and alleged accounting-related misstatements regarding GAAP compliance. The court had previously dismissed the Section 10(b) claims in the original complaint for failure adequately to plead the required strong inference of scienter, but granted the plaintiff leave to amend those claims, and also held that the Section 14(a) claims passed muster.  On review of the amended complaint, the court held that the additional allegations were sufficient to state a claim against Orbital ATK. Specifically, Judge T.S. Ellis, III held that “common law principles of agency, the purposes of the Exchange Act, and precedent from this circuit and elsewhere warrant the conclusion that the scienter of a lower-level employee can be imputed to the corporation for the purposes of corporate liability under [Section] 10(b) where, as here, that lower-level employee fraudulently furnishes information for a public statement and in so doing, intends to cause, and causes, a corporate officer to make a misrepresentation to investors.” In this case, the plaintiffs relied on public information regarding the findings of an Audit Committee investigation at the company to adequately allege that lower-level employees in the company acted “with the requisite fraudulent intent” when they furnished false information on certain cost overruns and profit rates to corporate officers for inclusion in SEC filings and other public reports. The decision highlights that companies should be careful to take a holistic view of scienter in securities actions and recognize that liability may attach even if fraudulent intent only exists outside of executive management and the individuals making the actual disclosures.


On March 2, 2018, the U.S. District Court for the District of Massachusetts in Vardakas v. ADGE allowed a proposed class of investors led by Lee Vardakas to proceed with state law contractual claims against American DG Energy Inc., Tecogen, ADGE Acquisition Corp., and Cassel Salpeter & Co., LLC, along with individual officer and director defendants including brothers George and John Hatsopolous, arising from the merger of ADGE and Tecogen, two ultra-efficient hearing and cooling technology companies allegedly controlled by the Hatsopolous brothers. The claims brought included violations of Section 14(a) and 20(a) of the Exchange Act, as well as common law breach of fiduciary duty claims against individual directors alleging breaches of their duties owed to ADGE shareholders. The plaintiffs alleged that the merger was the result of a conflicted sales process which undervalued the common stock of ADGE. According to the plaintiffs, the Hatsopolous family had a $5.6 million stake in ADGE and a $17.9 million stake in Tecogen, and thus had a “huge financial incentive to protect the value of their Tecogen shares in the merger, even at the expense of the value of their ADGE shares.” The plaintiffs also alleged that the independent review committees of the companies that approved the merger were tainted by the Hatsopolous brothers’ involvement and oversight, resulting in a “tainted sales process” which did not shop ADGE to anyone other than Tecogen and did not run a competitive auction or market check. The plaintiffs further alleged that in seeking approval of the merger, the defendants disseminated a misleading Form S-4 Registration Statement which contained material omissions regarding the procedural history of the merger in order to convince ADGE’s unaffiliated shareholders to vote in favor of the “unfair” transaction, which left Tecogen shareholders with approximately 81 percent of the combined company and ADGE shareholders with just 19 percent, even though ADGE contributed approximately half of the assets and equity. Judge Leo T. Sorokin dismissed the federal securities claims, characterizing the plaintiffs’ allegations of material omissions concerning the merger process as “purely conjectural”, and ruling that disclosures regarding valuation analyses and unfavorable contract liability did not contain material omissions. Despite dismissing the federal claims, however, the court allowed the common law claims to proceed in federal court under the supplemental jurisdiction doctrine, stating that the case was a “rare” instance “where ‘the interests of fairness, judicial economy, and convenience’ counsel in favor of exercising supplemental jurisdiction.”


On February 27, 2018, the U.S. District Court for the Northern District of Illinois, in City of St. Clair Shores Police and Fire Retirement System v. The Allstate Corporation, et al., declined to dismiss a proposed class action alleging that The Allstate Corporation made misleading statements regarding the reasons for an uptick in insurance claim frequency in order to benefit from an increased stock price. The plaintiffs asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, alleging that Allstate made misleading factual statements that its claim frequency trends were favorable compared to previous years, and that any increase in auto claims frequency was attributable to factors outside Allstate’s control, such as miles driven and bad weather, which were “everybody’s problem,” while concealing the fact that Allstate had lowered its underwriting standards. In its motion to dismiss, Allstate argued that the defendants’ statements regarding the reasons for an increase in auto claims frequency were opinions, not determinable facts, citing the Supreme Court’s 2015 decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund. Judge Robert W. Gettleman rejected Allstate’s contention that the statements on the cause of the uptick in claim frequency were couched in terms such as “we believe” and “we think,” indicating that the statements were uncertain matters of opinion as to the cause and therefore not misleading, noting that “[e]ven if a reasonable investor understood defendants’ conclusions to be uncertain, that understanding would have been based on incomplete information because defendants did not disclose that Allstate decreased its underwriting standards while simultaneously asserting that the increase in claims frequency was attributable to external factors.” The court’s decision cautions companies to be careful not to avoid discussing alternative explanations for circumstances that affect a company’s stock price, even if the disclosed explanation or conclusion is reasonable, arguably “uncertain,” and phrased as an expression of belief.


On February 23, 2018, the Delaware Court of Chancery in In re Appraisal of AOL Inc. rejected investors’ arguments in a post-merger appraisal lawsuit that AOL’s $50-per share, $4.4 billion sale to Verizon in 2015 was undervalued. While the plaintiffs had argued for a 28 percent increase in the fair value of the shares, the Chancery Court instead calculated a fair value of $48.70 per share, a roughly 3 percent decrease from the merger price. In so doing, the Chancery Court declined to defer to the merger price because it said the negotiations process was not “Dell Compliant”, referring to 2017’s seminal Delaware Supreme Court decision in Dell Inc. v. Magnetar Global Event Driven Master Fund Ltd. According to the Chancery Court, “[a] transaction is Dell Compliant where (i) information was sufficiently disseminated to potential bidders, so that (ii) an informed sale could take place, (iii) without undue impediments imposed by the deal structure itself.” In the Chancery Court’s view, a deal price resulting from a transaction satisfying those criteria would be the best evidence of fair value, while a transaction that does not would not be entitled to deference, as it may not represent “an unhindered, informed, and competitive market valuation.” In the case of Verizon’s purchase of AOL, the Court of Chancery concluded that the circumstances surrounding the deal created “a considerable risk of information and structural disadvantage that would dissuade any prospective bidder.” Those circumstances included AOL’s CEO publicly announcing his intention to close the deal and prospect of future employment with Verizon, which in the Chancery Court’s view “signaled to potential market participants that the deal was ‘done,’ and that they need not bother making an offer,” as well as Verizon’s three-day matching rights and data room access.  Declining to defer to the deal price in determining fair value, the Chancery Court instead applied a discounted cash flow analysis, using AOL’s expert’s model as a “starting point” to determine fair value, which it noted did “not deviate grossly from the deal price.” The decision continues a line of decisions showing a willingness of Delaware courts to deviate from deal price in post-merger appraisal actions based on independent fair value analyses.