Securities Snapshot
April 24, 2018

Second Circuit Reverses SLUSA Dismissal, Holding Alleged Misrepresentation Was Not Made “In Connection With” the Sale of a Security

Second Circuit reverses SLUSA dismissal, ruling that annuity holders' claims were not brought “in connection with” the purchase of a covered security; S.D.N.Y. dismisses securities class action against pharmaceutical company, finding no material misstatements or scienter; S.D.N.Y. dismisses legacy financial crisis securities fraud class action against Nortel executives; and Southern District of Florida denies motion to dismiss securities fraud action, while limiting reach of Section 17(a)(2) liability.

On April 10, 2018, the U.S. Court of Appeals for the Second Circuit in O’Donnell v. AXA Equitable Life Insurance Company, reversed the dismissal of a putative class action lawsuit alleging a breach of contract claim against AXA Equitable Life Insurance. The breach of contract suit alleged that AXA failed to comply with the terms of the variable annuity policy that it sold to the plaintiff and the other class members when it implemented a new volatility management strategy (referred to as the ATM Strategy) without obtaining prior approval from state regulators. Central to the breach of contract allegation was the fact that AXA entered into a consent order with the New York Department of Financial Services in March 2014, in which the NYDFS criticized AXA for “misleading it as to the scope and potential effects of the strategy” based on the “absence of detail and discussion in [AXA’s] filings regarding the significance of the implementation of the ATM Strategy.” The plaintiff originally filed suit in Connecticut state court, but AXA, citing to the alleged misrepresentations to the NYDFS, removed the action to federal court and later moved to dismiss the complaint as precluded by the Securities Litigation Uniform Standards Act of 1998. The district court held that the putative class action complaint was precluded by SLUSA and dismissed the action. Under SLUSA, a class action is properly removed to federal court and thereafter summarily dismissed when the state action is: (i) a “covered class action;” (ii) brought under state or common law; (iii) involving a covered security; and (iv) the alleged misrepresentation or omission was made “in connection with the purchase or sale of that security.” The Second Circuit held that the alleged misrepresentation to the NYDFS regarding the ATM Strategy was not made “in connection with the purchase or sale” of a covered security. In reaching this conclusion, the Second Circuit found that the complaint was “bereft of any allegations that an actual securities transaction ever occurred,” and that “the complaint does not plausibly allege—nor support a reasonable inference—that any decision to hold by [plaintiff] was made that was related in any way to any misstatements to the [NY]DFS.” Rather, the court found that the alleged misrepresentation was made by AXA to the NYDFS, not to the plaintiff or other putative class members. Accordingly, because the court found “no link” between AXA’s disclosures to the NYDFS and the plaintiff’s decision to hold the security, it held there was no SLUSA preclusion. The decision demonstrates that courts are continuing to closely scrutinize the “in connection with” requirement when assessing SLUSA preclusion.


On March 30, 2018, the U.S. District Court for the Southern District of New York granted Goodwin litigators’ motion to dismiss a securities class action lawsuit in In re Rockwell Medical, Inc. Securities Litigation. The suit, which asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Michigan-based pharmaceutical company Rockwell Medical, Inc., its CEO and CFO, alleged that Rockwell and its officers violated the 1934 Act by failing to disclose that Rockwell was developing an improved powder packet formulation of Triferic—a iron compound used during dialysis treatment—to replace its FDA-approved liquid formulation as the primary product offering because they allegedly knew that the liquid formulation would not be commercially viable. The suit also alleged that Rockwell made no real effort to commercialize the liquid formulation, supposedly knowing that the powder formulation would cannibalize any market for the liquid formulation. Judge Richard Sullivan dismissed the plaintiffs’ second amended complaint with prejudice, agreeing with Goodwin litigators that the complaint failed to allege actionable misstatements or omissions, and scienter. The court rejected the plaintiffs’ argument that Rockwell was “duty bound” to disclose the development of the powder packet formulation of Triferic once the company spoke about the scientific studies supporting their plans and beliefs that the liquid Triferic would be successful. The court explained that the plaintiffs “really have no theory” as to why this omission “in the uncertain event of its approval by the FDA” rendered any of the company’s public statements misleading. The court further explained that the plaintiffs’ “failure is not surprising; companies often have new products in development that will eventually update or replace older models, and remaining silent about those still-developing products does not make discussion of the current product offering misleading. . . . Such a broad theory of omissions liability would paralyze corporate spokespersons and likely yield less, rather than more, information for investors—not to mention chill innovation across a range of industries.” Furthermore, the court found Rockwell’s statements regarding its motivation to launch liquid Triferic non-actionable, as the plaintiffs failed to offer particularized allegations indicating Rockwell was not committed to marketing its product. The court further reasoned: “To state the obvious, vigorously promoting a current product is not at all inconsistent with simultaneously innovating and developing new products. To hold otherwise would risk chilling the development of new products and technologies across all fields. That is certainly not the goal of the federal securities laws.” In its concluding remarks, the court noted that “to the extent any party could be accused of being reckless, it is Plaintiffs, who have essentially embraced a theory of securities fraud that would punish corporations merely for developing new products on their own timetable.” The decision demonstrates that courts should be skeptical of alleged misstatements and omissions when a company is simply continuing to develop and compete in an ever-evolving market. As the court explained: “At this very moment, pharmaceutical companies are undoubtedly working tirelessly to develop new drugs and medicines that will make current treatments—including their own offerings—obsolete. That is a good thing, and something that is essential to a dynamic economy and social progress.”


On April 11, 2018, the U.S. District Court for the Southern District of New York in Lucescu, et al. v. Zafirovski, et al., dismissed a securities fraud class action asserting claims against two Nortel executives for activities undertaken in 2008, during the height of the global financial crisis. The action was commenced in 2009, that same year Nortel filed for bankruptcy protection. The bankruptcy stay was lifted in 2017, and this action was allowed to proceed. The suit asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Nortel’s CEO and former CFO, alleging that they made materially false statements in 2008 about the company’s relationship with key customers and failed to timely write down over $2.3 billion of goodwill that the defendants allegedly knew was impaired as of May 2, 2008. Specifically, the plaintiffs claimed that the CEO’s statements regarding the company’s first and second quarter results were false and misleading because he did not specifically disclose certain Nortel consumers’ capital investment reductions. Additionally, the plaintiffs claimed that the statements contained in company’s statements that Nortel’s financial results complied with GAAP, which were signed by the former CFO, were false. In support of their claims, the plaintiffs included allegations from thirteen confidential witnesses, none of whom were alleged to have had any direct contact with either defendant; and only one of whom was even alleged to have worked in Nortel’s headquarters. Ultimately, Judge Denise Cote found that neither set of alleged misstatements supported the plaintiffs’ claims for securities fraud. The court found that the CEO’s statements regarding the company’s relationships with customers were not actionable because: (i) his statements were no more than general statements about the goals and process of the company; (ii) Nortel had already disclosed, and emphasized, that the company’s financial success was dependent on customer capital investments which were “uncertain given the overall financial climate”; and (iii) the public was aware that Nortel customers, like all customers during the global financial crisis, were cutting back on their capital expenditures. Additionally, the court found that the plaintiffs’ allegations regarding the company’s goodwill impairment amounted to “nothing more than a disagreement about Nortel’s subjective accounting judgments.” The court further noted that even if the former CFO had known of facts that “cut against the representation of Nortel’s goodwill, that does not make the statements, which are statements of opinion, false or misleading,” especially in light of the “very particular circumstances of this company and the economic climate of 2008.” The court also rejected the plaintiffs’ efforts to plead conscious or reckless misbehavior, in part because the confidential witnesses relied upon to support such allegations did not report to the defendants or have any discussions with the defendants surrounding the alleged misstatements at issue. In fact, the court noted that while “the apparent absence of such direct access to Zafirovski [the CEO] is not controlling, the lack of such access underscores the paucity of the [complaint’s] allegations regarding Zafirovski’s scienter.” Lastly, the court remarked that an “expectation that Nortel’s new management would be able to rebuild the company’s fortunes does not constitute an intent to deceive or defraud investors.” This decision demonstrates how the courts should assess securities class actions in the economic context in which they arise and scrutinize the substantive relationships between the confidential witness and the alleged conduct at issue.


On April 11, 2018, the U.S. District Court for the Southern District of Florida, in Securities and Exchange Commission v. Sandoval Herrera, et al., denied the defendants’ motion to dismiss a securities fraud action asserting claims against two GCC ROW executives for purportedly taking part in a scheme to defraud investors as to the financial health of the company. GCC is an international manufacturer of copper, aluminum and fiber optic wires and cable products; GCC ROW is a “segment” of GCC that includes the company’s Brazilian operations. The suit, which, in relevant part, brought counts under Section10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and Section 17(a)(2) of the Securities Act of 1933, against Mathias Sandoval Herrera, GCC ROW’s CEO, and Maria Cidre, GCC ROW’s Senior VP for Latin America, alleged that the defendants submitted false certifications to the individuals responsible for GCC’s financial statements, knowingly failed to report inventory accounting errors to GCC executives, directed their reports to destroy evidence of the inventory accounting errors; directed their reports not to disclose the inventory accounting error to GCC’s internal or external auditors, and instructed the CFO for GCC’s operations in Brazil to submit a false sub-certification. Beginning in 2011, the Controller for GCC’s operations in Brazil discovered “significant inconsistencies between its general ledger and the supporting documentation for intercompany sales.” The discrepancies were investigated and revealed that the value of the Brazilian inventory was “vastly overstated” due to the manipulation of the Brazilian accounting system and inventory theft by Brazilian personnel. It was later discovered that the magnitude of the accounting error amounted to approximately $40 million. It was not until around September 2012 that the defendants informed GCC executives of the overstatement of inventory in the Brazilian accounting records and an internal investigation ensued. The defendants argued that the Section 10(b) claim must be dismissed because the SEC was attempting to plead a “back door” misrepresentation and omission claim to circumvent the Supreme Court’s holding in Janus Capital Group, Inc. v. First Derivative Traders. Judge Joan A. Lenard rejected the defendants’ argument, finding instead that Janus did not pertain to claims based on schemes to defraud because “such illegal schemes do not focus on the making of an untrue statement.” The court found that the complaint sufficiently alleged that the defendants made “deceptive contributions to an overall fraudulent scheme” rather than mere misstatements or omissions by participating, and ordering subordinates to participate, in a cover up of the inventory theft. Accordingly, the court found that the claims under Rule 10b-5 survived the defendants’ motion to dismiss. With respect to the Section 17(a)(2) claim, the court was called to resolve whether liability could only be imposed when the defendants themselves obtained money or property, rather than when the defendants obtained money or property for either themselves or their employers. While acknowledging disagreements in the case law, the court found that the statutory provision, “on its face,” only imposes liability when a defendant personally obtained money or property. Accordingly, the court found that the defendants could not be held liable for any money or property GCC obtained as a result of the defendants’ alleged misstatements and omissions. However, the court found the allegation that the defendants each received a bonus as part of their compensation, which was directly linked to the financial performance of GCC and/or GCC ROW, was sufficient to impose liability under Section 17(a)(2). This decision represents the growing view among the federal courts that to impose liability under Section 17(a)(2), the defendant must personally gain from the conduct at issue, and demonstrates the flexibility that courts will apply in finding such personal gain at the motion to dismiss stage.