Securities Snapshot June 20, 2017

Supreme Court Refuses to Revive Lawsuit Seeking Tax Refund on Forfeited Insider Trading Profits


Supreme Court refuses to revive former Qwest CEO’s lawsuit seeking refund of taxes paid on forfeited insider trading profits; Third Circuit holds FBI agent did not violate Constitution by leaking details of impending search to media; Second Circuit rules FINRA registrant cannot be forced to arbitrate claims of non-customers; Massachusetts federal court dismisses stockholder suit for failure to meet heightened PSLRA pleading standard; and Delaware Chancery Court holds that DGCL “safe harbor” cannot be invoked to ratify deliberately unauthorized corporate acts.

In Nacchio v. United States, the U.S. Supreme Court declined to revive a lawsuit filed by Joseph Nacchio, the former CEO of Qwest Communications, who sought an $18 million refund of taxes paid on $44.6 million of trading profits that Nacchio was later ordered to forfeit to the SEC following his conviction for insider trading.  By denying review, the Court left in place the Federal Circuit’s June 2016 decision holding that Nacchio could not pursue a deduction because the criminal forfeiture fell within the terms of Section 162 of the Internal Revenue Code, which prohibits deductions for “any fine or similar penalty paid to the government for the violation of any law.”  In 2012, following his forfeiture order, Nacchio filed suit in the Court of Federal Claims, seeking to deduct $18 million, the amount he had paid in taxes on his disgorged profits, as a loss under I.R.C. § 165.  The court ruled in Nacchio’s favor.  Rejecting the government’s argument that Section 162(f) barred such a deduction, the Court of Claims held that Nacchio’s forfeiture was not a “fine or similar penalty” but rather was “compensatory” in nature because it had ultimately been returned to victims of Nacchio’s crimes through remission.  On appeal, the Federal Circuit disagreed.  Reversing the Claims Court’s decision, the Federal Circuit held that, even if Nacchio’s forfeiture constituted a “loss,” it was not deductible under I.R.C. § 165 because the forfeiture was, in fact, a “fine or similar penalty” and “allowing [its] deduction would contravene public policy, as codified in § 162(f).”  While the Attorney General may have decided to use the forfeited funds for remission, the Federal Circuit opined, that post hoc decision “did not transform the character of the forfeiture so that it was no longer a ‘fine or similar penalty’ under § 162(f).”  Ultimately, allowing Nacchio to deduct his forfeiture because the Attorney General chose after-the-fact to distribute it to victims “would mean that whether two people convicted of the same crimes could deduct their criminal forfeiture would turn not on their actions,” but rather on the “discretionary decisions of a third party.”  This, the Federal Circuit held, “is not the law.”  With the Supreme Court’s refusal to grant Nacchio’s petition for certiorari, the Federal Circuit’s decision remains intact.


In United States v. Fattah, the Third Circuit held in a precedential ruling that the government did not violate Chaka “Chip” Fattah Jr.’s constitutional rights when, in advance of executing search warrants at Fattah’s home and office in 2012, an FBI agent disclosed to the media, “in exchange for information pertinent to the [FBI’s] investigation,” the time, location, and target of the searches.  So informed, press was on hand to report the story even though the warrants were sealed and Fattah was not indicted until two years later on charges of fraud and tax evasion (for which he is now serving a five-year prison sentence).  Fattah argued that the agent’s conduct violated his Sixth Amendment rights because the pre-indictment press rendered him unable to retain the counsel of his choice.  To make this argument, Fattah principally relied on the Second Circuit’s 2008 decision in United States v. Stein, where the court held that prosecutors unjustifiably interfered with KPMG employees’ right to counsel by pressuring the company to cease advancing their legal fees in connection with a criminal tax fraud investigation.  Fattah argued that, as in Stein, the agent’s conduct in his case ran afoul of the Sixth Amendment in that it caused him to lose his job, in turn depriving him of funds necessary to mount a legal defense.  The Third Circuit disagreed.  Unlike in Stein, the court observed, “the government here undisputedly lacked any…purpose to deliberately interfere with counsel.”  Any loss of income, therefore, was merely an “unintended and incidental consequence of the agent’s conduct.”  The court thus refused to extend the boundaries of Sixth Amendment protection further than what it characterized as the “outer limits” tested by Stein.  Fattah also argued that the agent violated his Fifth Amendment due process rights.  Rejecting that argument as well, the Third Circuit held that while the agent’s conduct was “unquestionably wrongful,” it did not meet the “high bar of the outrageous misconduct” that would entitle Fattah to constitutional relief.  Notwithstanding this precedential ruling, however, the Third Circuit emphasized that its opinion “should by no means be construed as an approval of the government’s conduct.” 


 In Deutsche Bank v. Roskos et al., the Second Circuit issued a summary order affirming a  2016 ruling by the Southern District of New York that Deutsche Bank Securities Inc. could block a $15 million FINRA arbitration demand by individuals whose loan-based tax shelters were rejected by the IRS.  In the early 2000s, Thomas Roskos and six others participated in tax shelter transactions known as custom adjustable rate debt structures (CARDS).  Deutsche Bank AG, a non-FINRA member, extended credit and executed loan agreements for the CARDS transactions, which were designed to generate tax losses to offset the participants’ taxable income.  The IRS later concluded, however, that the transactions lacked economic substance, and required the investors to pay their back taxes, penalties, and interest.  Twelve years later, seeking to recoup the damages they had allegedly suffered, the CARDS participants filed a FINRA arbitration demand, naming DBSI —a FINRA-registered affiliate of Deutsche Bank AG —as party to the claim.  In response, DBSI filed suit in the Southern District of New York, seeking to enjoin the arbitration on the grounds that the participants were not DBSI’s “customers” under FINRA Rule 12200, which only requires a FINRA member to arbitrate disputes with a “customer.”  The district court sided with DBSI on summary judgment.  Second Circuit precedent, Judge Laura Taylor Swain opined, established a “bright-line rule” for defining the “customer” relationship pursuant to Rule 12200: a “customer” is one who either “purchases a good or service from a FINRA member,” or “has an account with a FINRA member.”  Here, any CARDS-related loans were extended by non-FINRA member Deutsche Bank AG, and any collateral accounts were held by non-FINRA member Deutsche Bank Private Bank.  In turn, Judge Swain held, because the participants “were not account holders of DBSI and purchased no goods and services from DBSI,” they were not “customers” subject to mandatory arbitration within the meaning of FINRA Rule 12200.  Thus, “they are not entitled to arbitrate their claims.”  In its June 5 summary order, the Second Circuit affirmed, holding that the district court properly adhered to the “bright-line rule” for determining when a FINRA member can be forced to arbitrate, and “appropriately held that the claims are not arbitrable in FINRA.” 


In Sousa v. Sonus Networks, Inc., the District of Massachusetts dismissed a putative securities class action against software company Sonus Networks, its CEO, and its CFO, holding that the plaintiff stockholder failed to meet the heightened pleading standard for alleging securities fraud under the Private Securities Litigation Reform Act. After Sonus earned $50 million in revenue in the first quarter of 2015, stockholder Richard Sousa filed suit against the company and its two officers, alleging that they violated Section 10(b) of the Securities Exchange Act of 1934, and related Rule 10b-5, by forecasting Q1 2015 revenue at $74 million despite knowing that the company would fall short.  The plaintiff claimed that Sonus made materially misleading statements regarding the revenue forecast on two occasions.  First, Sonus’s CFO stated on an October 2014 earnings call that the company was “comfortable” with “consensus” Q1 revenue estimates of $74 million, despite allegedly knowing that the projection was inaccurate.  The plaintiff countered that the statement was actionable pursuant to the Supreme Court’s 2015 Omnicare decision, holding that an opinion statement may be misleading if the speaker did not in fact hold the stated opinion, or omitted material facts about how the opinion was formed.  The defendants, the plaintiff argued, were not truly “comfortable” with analysts’ projection, because—according to former employees—Sonus knew by October that its sales team would fail to meet “stretch” targets included in the Q1 revenue forecast.  Judge George O’Toole disagreed, holding that “the allegations of these former employees are not enough to meet the PSLRA’s heightened pleading standard,” which requires a plaintiff to “specify each statement alleged to have been misleading, [and] the reason or reasons why the statement is misleading.”  Here, the complaint included only “generalized,” “sweeping” allegations too vague to support an inference that the defendants’ expressed “comfort” with the analyst consensus was disingenuous.  The plaintiff also alleged that Sonus misled investors in a February 2015 press release and earnings call by reiterating the $74 million revenue forecast, This statement was misleading, the plaintiff contended, because ex-Sonus personnel had expressed doubts about achieving sales numbers included in the revenue forecast.  Dismissing claims based on this statement, Judge O’Toole held that the alleged facts on which the complaint relies (including allegations that the defendants closely monitored Sonus’s sales) “are too general to support the [PSLRA’s] requisite strong inference” of scienter.  Ultimately, Judge O’Toole refused to “find fraud by hindsight,” holding that while “the defendants erred with respect to the Q1 2015 projection…general allegations that defendants knew earlier what later turned out badly are not sufficient to plead scienter.”


In Nguyen v. View, Inc., the Delaware Chancery Court held that a deliberately unauthorized corporate act does not constitute a “defective corporate act” under 8 Del. C. § 204, a “safe harbor” provision enabling companies in certain situations to retroactively ratify defective corporate actions not properly approved as an initial matter.  View, Inc., a smart glass manufacturer, had previously sought stockholder consent to pursue a round of Series B preferred stock financing.  Paul Nguyen, View’s founder and then-owner of 70% of the company’s common stock, initially consented to the financing, but he revoked his consent before the transaction closed.  Contesting Nguyen’s revocation rights, View moved forward with the financing as if he had agreed.  Nguyen then pursued claims against View in arbitration, seeking a declaration that his revocation was valid and thus the Series B transaction was void.  The arbitrator ruled in Nguyen’s favor.  Because View had undertaken several subsequent financing rounds resting in large part on the Series B financing, the arbitrator’s ruling voiding that financing effectively “blew up” the company’s capital structure.  Thereafter, in an effort to restore the Series B financing, View took a series of corrective steps, attempting to cure the defective act pursuant to 8 Del. C. § 204.  Specifically, View’s Series A preferred stockholders converted their shares to common stock, thereby displacing Nguyen as majority stockholder and rendering his consent unnecessary to effect the transaction.  In February 2016, with these changes in place, View filed certificates of validation with the Delaware Secretary of State pursuant to Section 204, in which the company purported to ratify the Series B financing.  In May, Nguyen filed an amended complaint, challenging the certificates of validation.  Denying View’s motion to dismiss, Vice Chancellor Joseph R. Slights held that the company could not rely on Section 204 to cure its action.  View’s decision to proceed with the Series B financing after Nguyen revoked his consent, the Chancery Court opined, did not constitute a “defective corporate act” eligible for later validation under the remedial provisions of Section 204.  This decision was, to the contrary, an “unauthorized corporate act”:  an act that the majority stockholder explicitly “declined to authorize, but that the corporation nevertheless determined to pursue.”  This type of deliberately unauthorized corporate act, the Chancery Court held, could not be cured pursuant to the Section 204’s safe harbor, as the statute “is not a license to cure just any defect.”