Securities Snapshot
July 31, 2018

Ninth Circuit Breathes New Life Into Toshiba Accounting Securities Suit

Ninth Circuit breathes new life into an accounting securities suit, finding that over-the-counter market purchases of Toshiba ADRs may be domestic purchases under Morrison; Ninth Circuit affirms that the Investment Company Act does not establish a private right of action for challenging the continued validity of a registration exemption; Third Circuit returns another win for defendant advisers and administrators in Section 36(b) “excessive fees” litigation; Massachusetts federal court streamlines an investor stock-drop suit against biopharmaceutical company; the SEC unanimously enacts new rules to further protect investors in dark pools while expanding equity compensation limits before requiring additional disclosures; and the Department of Justice extends its application of FCPA corporate enforcement policy to successor companies in mergers and acquisitions.

On July 17, 2018, the U.S. Court of Appeals for the Ninth Circuit, in Stoyas, et al. v. Toshiba Corporation, reversed and remanded a lower court ruling that dismissed a proposed investor class action based on Toshiba’s allegedly fraudulent accounting practices. The securities class action, brought on behalf of purchasers of Toshiba American Depository Shares or Receipts, alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, based on the now-admitted fraudulent institutional accounting practices and accompanying restatements of pre-tax profits that caused hundreds of millions of dollars in loss to U.S. investors. The U.S. District Court for the Central District of California, applying the test set forth in the U.S. Supreme Court’s decision in Morrison v. Nat’l Australia Bank, concluded that the Exchange Act, which does not apply extraterritorially, did not apply to the purchase of Toshiba ADRs because “the over-the-counter market by which the Toshiba ADRs are sold was not a ‘national exchange’ within the meaning of Morrison, and that there was not any domestic transaction between ADR purchasers and Toshiba” and dismissed the action with prejudice. Accordingly, the heart of the plaintiffs’ appeal was the question of: (1) the nature of ADRs and their transactions; and (2) whether Toshiba ADRs are covered by the Exchange Act through either (a) registry on a national exchange, or (b) through domestic sales and purchases. The Ninth Circuit disagreed with the district court, finding that it misapplied Morrison, and instructed it to allow the plaintiffs to amend their complaint. However, in doing so the court declined to resolve the question of whether, under Morrison, the Exchange Act applied to “domestic exchanges” or only “national securities exchanges,” because the over-the-counter market was not an “exchange” within the meaning of the Exchange Act. Nonetheless, the Ninth Circuit concluded that the Toshiba ADRs were “securities” within the meaning of the Exchange Act and, therefore, the Exchange Act could apply to the Toshiba ADR transactions under the theory that the transactions were domestic transactions in securities not registered under the exchange. The Ninth Circuit then adopted the “irrevocable liability” test employed by the U.S. Courts of Appeals for the Second and Third Circuits —which assesses where purchasers incurred the liability to take and pay for securities, and where sellers incurred the liability to deliver securities—and further concluded that the plaintiffs must be allowed to amend their complaint to allege that the purchase of Toshiba ADRs on the over-the-counter market was a domestic purchase, and that the alleged fraud was “in connection with” such purchase. While it remains to be seen whether the plaintiffs will be able to sustain their claim, the Ninth Circuit’s decision is yet another move by American courts to protect American investors against international malfeasance.  

Ninth Circuit Finds ICA Does Not Provide a Private Right of Action to Challenge Continued Validity of Registration Exemption

On July 12, 2018, the U.S. Court of Appeals for the Ninth Circuit, in UFCW Local 1500 Pension Fund v. Mayer, et al., affirmed the district court’s dismissal of a derivative lawsuit against Yahoo!’s board of directors and certain corporate officers, as well as a direct claim against Yahoo! under the Investment Company Act of 1940. The plaintiff alleged that Yahoo! violated the conditions of its exception, granted by the Securities and Exchange Commission, from the registration requirements of the ICA when it invested in—a Chinese retail website. The plaintiff sought to: (1) rescind the executives’ employment contracts; (2) enjoin the company from further violating the ICA and selling any material assets; and (3) recover damages for unjust enrichment. While the U.S. District Court for the Northern District of California acknowledged that exempted companies must comply with the conditions of their ICA exceptions, it concluded that the ICA provides “no role for the courts to find, in the first instance, that a company should be stripped of its exemption and therefore deemed an unregistered investment company,” so that the plaintiff’s claims “all fail as a matter of law.” On appeal, plaintiff conceded and acknowledged that its claims rely solely on the allegation that Yahoo! violated the conditions of its ICA exemption by investing in Alibaba. The Ninth Circuit, agreeing with the district court, held that plaintiff failed to state a claim because the ICA does not establish a private right of action for challenging the continued validity of an ICA exemption, such that the plaintiff’s “claim fizzle[d] faster than” While the Ninth Circuit’s opinion is wildly entertaining with its Hollywood and dot-com era references, its holding is uncontroversial.  Like many of its sister courts, the Ninth Circuit continued the practice of limiting judicially-created private rights of action, deferring to the SEC or Congress to create such a remedy.

Third Circuit Upholds Dismissal of Claims Against Mutual Fund Managers, Continuing Defendants’ Successes in SECTION 36(b) “Excessive Fees” Litigation

On July 10, 2018, the U.S. Court of Appeals for the Third Circuit, in Sivolella, et al. v. AXA Equitable Life Insurance Company and AXA Equitable Funds Management Group LLC, affirmed the district court’s dismissal of the plaintiffs’ Section 36(b) claim with prejudice. The plaintiffs, parties to variable annuity contracts with AXA, alleged that the defendants breached their fiduciary duty under Section 36(b) of the ICA, because the investment management and the fund administration fees were “excessive” given the responsibilities designated to the funds sub-administrator and sub-advisers. Following the 25-day bench trial, the U.S. District Court for the District of New Jersey issued a 146-page opinion in which it concluded that the plaintiffs had failed to meet their burden of proof, finding that none of the six factors in Gartenberg v. Merrill Lynch Asset Mgmt., Inc., a Second Circuit case which set forth the standard for assessing whether an investment adviser breached its fiduciary duty under Section 36(b), favored the plaintiffs. The trial court also explained that it did not find the plaintiffs’ experts credible, as compared to defendants’ expert and fact witnesses.  On appeal, the plaintiffs’ arguments “boil[ed] down to assertions that [the court] should overturn the District Court’s factual findings and credibility determinations.” The Third Circuit refused to do so, instead reviewing the district court’s findings of fact for clear error and its conclusions of law de novo.  After a brief discussion of each of the Gartenberg factors, the Third Circuit concluded that “[o]verall, the District Court wrote a thorough and comprehensive opinion that [plaintiffs] have failed to undermine.” The Third Circuit’s ruling is yet another win for defendants in Section 36(b) litigation. Recently, Goodwin successfully secured dismissal for J.P. Morgan’s investment adviser and administrator in two separate actions: (1) winning a motion to dismiss in the U.S. District Court for the Southern District of New York; and (2) winning a motion for summary judgment in the U.S. District Court for the Southern District of Ohio. Though the barrage of defensive wins has yet to completely thwart plaintiffs seeking redress under Section 36(b), the Third Circuit’s decision represents another reminder of how favorably courts treat those advisers and administrators who deliver value.

District of Massachusetts Streamlines Shareholder Stock-Drop Suit

On July 20, 2018, the U.S. District Court for the District of Massachusetts, in Karth, et al. v. Keryx Biopharmaceuticals, Inc., et al., rejected Keryx’s attempts to dodge a proposed shareholder class action which claims the company inflated its stock price by hiding a drug’s supply chain. However, Judge Denise J. Casper did agree to trim an allegation regarding the company’s financial prospect statements. Keryx is a biopharmaceutical company which sells Auryxia—a drug approved for the treatment for elevated phosphorus levels in patients with chronic kidney disease—the only compound the company has received FDA approval to market. The plaintiffs allege that, throughout the relevant time period, Keryx and certain of its officers and directors made three types of false or misleading statements in connection with Auryxia, namely that: (1) the defendants purportedly repeatedly referred to plural contract manufactures or third parties even though it had contracted with only one firm to convert the product into tablets; (2) the defendants allegedly indicated in an April 2016 filing that it obtained FDA approval for a second contract manufacturer, even though, during that period, Keryx only had one firm converting the product into tablets; and (3) the defendants supposedly continued to provide positive forward guidance despite being aware of production problems with its lone contract manufacturer. Accordingly, the plaintiffs brought suit against the defendants under Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5, promulgated thereunder, in connection with the foregoing purported material misstatements. The defendants argued that the first two types of statements were not misleading—because “contract manufacturer” refers not only to the entity that converts the product but also the one that manufactures the product itself—and that the plaintiffs failed to adequately allege scienter with respect to the third category of alleged misstatements. Scrutinizing the language used in connection with the first two types of alleged misstatements, the court concluded that the plaintiffs “adequately alleged that a reasonable investor could have concluded…from the ambiguous language in the subsequent filings regarding the number of contract manufacturers that Keryx had engaged multiple contract manufacturers to convert the API into tablets when in fact Keryx had not, rendering the statements in the subsequent filings misleading.” Furthermore, the court found that the allegations adequately supported plaintiffs contention that the defendants understood the important of this information to its investors. With respect to the third category of alleged misstatements, however, the court agreed with the defendants that the complaint failed to adequately allege that any of the defendants who made the forward-looking statements “were aware at the time of the production problems” with Keryx’s lone manufacturer.  The court denied the plaintiffs request to amend these claims, noting that amendments with respect to the forward-looking statements “would be futile.” This case, one of many securities class action lawsuits recently brought against life sciences companies, shows that while courts are generally willing to entertain plaintiffs allegations at the motion to dismiss stage, the heightened requirements for pleading scienter can be a formidable bar to recovery. 

SEC Adopts New Rules on Dark Pool and Equity Compensation Disclosures

On July 18, 2018, the SEC unanimously approved new rules on dark pool and equity compensation disclosures. With respect to dark pools, the SEC adopted a series of new rules designed to increase transparency for investors who trade stocks on dark pools. The new rules require alternative trading systems, including dark pools, that trade stocks listed on national securities exchanges to file “more stringent public disclosure forms” which will include, for example, more information related to their business model and potential conflicts of interest. With respect to equity compensation disclosures, the SEC adopted a series of new rules doubling the amount of equity-based compensation employers can grant their employees, to $10 million annually, before necessitating increased disclosure. The rules are intended to make it easier for start-up companies to recruit and retain employees through equity-based compensation schemes. SEC Chairman Jay Clayton stated that the Commission’s actions are in response to the evolution of the American economy and corresponding compensatory instruments. The new rules signal the SEC’s continued focus on responding to the rapidly-changing American economy.

The U.S. Department of Justice Extends The Application Of FCPA Corporate Enforcement Policy to Successor Companies in Mergers and Acquisitions

On July 25, 2018, at the American Conference Institute’s Eighth Global Forum on Anti-Corruption Compliance in High-Risk Markets in Washington, D.C., Deputy Assistant Attorney General Matthew S. Miner of the Criminal Division of the Department of Justice announced the DOJ’s intent to apply the tenets of its Foreign Corrupt Practices Act Corporate Enforcement Policy to successor companies that uncover wrongdoing in connection with mergers and acquisitions. This is yet another step by the DOJ as it continues its efforts to entice companies to self-report violations of the FCPA. Under this application, successor companies that (1) voluntarily disclose misconduct to the DOJ, (2) cooperate with its investigation of the wrongdoing, and (3) adopt meaningful remedial measures, will benefit from the FCPA Corporate Enforcement Policy, including, for example, the presumption of eligibility for a declination of prosecution. The announcement was explicit that the policy will apply to companies that uncover wrongdoing in advance of or subsequent to an acquisition. This extension of the FCPA Corporate Enforcement Policy to mergers and acquisitions is discussed more fully in a Goodwin client alert dated July 26, 2018.