Securities Snapshot February 27, 2018

Supreme Court Restricts Definition of Whistleblower under Anti-Retaliation Provisions of Dodd-Frank Act

Summary
The Supreme Court restricts the definition of “whistleblower” under the anti-retaliation provisions of the Dodd-Frank Act; Third Circuit vacates a 46-month prison sentence for insider trading, finding the sentence unfairly based on trading of which the defendant was not aware; Southern District of New York dismisses mutual fund excessive fee lawsuit; Central District of California denies motion to dismiss securities class action lawsuit; and Delaware Chancery Court finds a company’s pre-merger trading price to be the “most persuasive evidence” of fair value in appraisal action. 

On February 21, 2018, the United States Supreme Court ruled in Digital Realty Trust, Inc. v. Somers in favor of petitioner Digital Realty Trust, holding that employees who bring securities law complaints against their company must bring their allegations to the U.S. Securities and Exchange Commission in order to be protected by the anti-retaliation measures afforded by the Dodd-Frank Wall Street Reform Consumer Protection Act. Passed in 2010, Dodd-Frank expanded the whistleblower protections established by the 2002 Sarbanes-Oxley Act. Dodd-Frank defined whistleblowers as “any individual who provides . . . information relating to a violation of the securities laws to the [Securities and Exchange] Commission, in a manner established, by rule or regulation, by the [Securities and Exchange] Commission.” Following Dodd-Frank’s passage, a split had emerged among the federal circuit courts as to whether the Act’s anti-retaliation protections applied to employees who reported wrongdoing internally but not to the SEC. The Fifth Circuit ruled in Asadi v. G.E. Energy that whistleblowers must bring their complaints to the SEC to be protected by Dodd-Frank. The Ninth Circuit, however, held that Digital Realty executive Paul Somers was entitled to Dodd-Frank protections after being fired for complaints to upper management regarding elimination of internal corporate controls in violation of Sarbanes-Oxley. In an opinion written by Justice Ruth Bader Ginsburg, which was joined by Chief Justice Roberts and Justices Kennedy, Breyer, Sotomayor and Kagan, the Supreme Court strictly adhered to the statutory definition and reversed the Ninth Circuit decision. The Court held that under Dodd-Frank’s anti-retaliation provision, a person must first “provid[e] . . . information relating to a violation of the securities laws to the Commission.” The Court further held that this reading was consistent with the “core objective” of Dodd-Frank’s robust whistleblower program, which is “to motivate people who know of securities law violations to tell the SEC.” By enlisting whistleblowers to “assist the Government [in] identify[ing] and prosecut[ing] persons who have violated securities laws,” the Court held, “Congress undertook to improve SEC enforcement and facilitate the Commission’s “recover[y] [of] money for victims of financial fraud.” The Court rejected a contrary reading of the statute advanced by the United States, which had argued that Dodd-Frank’s whistleblower definition applies only to the statute’s award program, not to its anti-retaliation provision. The Court agreed that its plain-text reading of the statute undoubtedly shields fewer individuals from retaliation than the United States’ proffered reading, but it went on to note that the Act nonetheless provides significant protections to internal whistleblowers. Additionally, because it held that “Congress has directly spoken to the precise question at issue,” the Court declined to award Chevron deference the contrary view of the statute advanced by the SEC. Justice Sotomayor filed a concurring opinion joined by Justice Breyer, and Justice Thomas filed an opinion concurring in part and concurring in the judgment joined by Justices Alito and Gorsuch. Following this ruling, employees who report complaints internally, as opposed to the SEC, are now excluded from Dodd-Frank’s anti-retaliation protections, which may incentivize employees to forego internal reporting and instead bring complaints directly to the SEC.  

THIRD CIRCUIT VACATES INSIDER TRADING DEFENDANT’S 46-MONTH PRISON SENTENCE, FINDING THAT SENTENCE WAS UNFAIRLY BASED ON TRADING OF WHICH HE WAS NOT AWARE

In United States v. Metro, the U.S. Court of Appeals for the Third Circuit recently vacated a 46-month prison sentence for a former Simpson Thacher & Bartlett LLP clerk convicted in connection with his role in a $5.6 million insider trading scheme. Steven Metro, a former managing clerk at Simpson Thacher, pleaded guilty in federal court in Trenton, New Jersey in September 2015 to one count of insider trading and one count of conspiracy to commit securities fraud. Metro admitted giving his friend, former Citibank NA broker Frank Tamayo, information regarding mergers and acquisitions and tender offers in matters involving his firm, but Metro argued he was unaware that Tamayo shared this information with former Morgan Stanley Smith Barney LLC broker, Vladmir Eydelman.  Eydelman traded on this information for himself, family, friends and clients. Metro was sentenced to forty-six months in prison, three years of supervised release and a $10,000 fine in his criminal case, and a $2 million penalty by the SEC in a civil case. The district court judge adopted the government’s position by holding Metro responsible for the actions of Edyelman, an unknown third party. On appeal, the Third Circuit rejected the government and lower court’s position, concluding that “[b]ecause ‘the attribution of gains to a defendant can be critical in a guidelines sentencing range calculation,’ the ‘strict liability’ position now taken by the government runs the risk of sentences being imposed on defendants that are excessive in relation to their criminal conduct.” On the same day, Judge Michael A. Shipp of the District of New Jersey, who had imposed the initial sentence on Metro, separately found the SEC’s $2 million fine served to punish Metro for the other conspirators’ actions, and accordingly reduced the civil penalty to $25,000. The Third Circuit and District of New Jersey decisions demonstrate that courts must look beyond a defendant’s guilty plea to a conspiracy charge to assess a defendant’s role in the gains of co-conspirators, and instead must conduct some additional fact-finding in setting appropriate sentences for co-conspirators. 

FEDERAL DISTRICT COURT DISMISSES MUTUAL FUND EXCESSIVE FEE LAWSUIT

On February 14, 2018, the U.S. District Court for the Southern District of New York dismissed the complaint in Pirundini v. J.P. Morgan Investment Management Inc., which alleged that an investment adviser had violated its fiduciary duties by charging excessive advisory fees to a mutual fund.  In April 2017, the plaintiff investor accused J.P. Morgan Investment Management Inc. of charging “eye-popping” and excessive investment advisory fees to a mutual fund under Section 36(b) of the Investment Company Act of 1940. Section 36(b) lawsuits are governed by the so-called Gartenberg factors adopted by the Supreme Court in Jones v. Harris, under which liability turns on whether the fee the adviser charged “is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.” In this case, Judge George B. Daniels determined that the plaintiff failed to allege facts sufficient to support such an inference. The court rejected the plaintiff’s fee comparison argument, holding that “merely because one or two mutual funds pay lower investment advisory fees than what the Fund pays does not suggest that the fee rate [the adviser] charges the Fund is necessarily outside the ‘range of what would have been negotiated at arm's length.’” The court further noted that “charging a fee that is above the industry average does not violate Section 36(b),” and that allegations of underperformance do not suffice by themselves to state a claim under Section 36(b). The court also rejected the complaint’s allegations about the care and conscientiousness of the fund’s board in approving the fees, criticizing the allegations as focused on the merits of the board’s conclusions as opposed to addressing the board’s process. The decision is the first since 2011 where a court has granted a motion to dismiss on a Section 36(b) complaint alleging excessive mutual fund fees. More than 20 other mutual fund excessive fee complaints have been filed since 2011, and virtually all have proceeded to discovery rather than being dismissed at the pleadings stage.  

FEDERAL COURT DENIES MOTION TO DISMISS IN CAPSTONE TURBINE SECURITIES CLASS ACTION LAWSUIT 

On February 9, 2018, the U.S. District Court for the Central District of California held in In re Capstone Turbine Corp. Sec. Litig. that shareholders had pleaded falsity and scienter with sufficient particularity to survive a motion to dismiss. Capstone Turbine Corporation develops, manufactures, markets, and services microturbine technology, utilizing a network of distributors to sell the turbines. Capstone’s primary distributor in Russia is BPC Engineering. Capstone’s financial reporting included projections of backlog signifying the amount of sales orders received by Capstone that had yet to be fulfilled, completed, or fully paid for. After Capstone removed from backlog more than $50 million of BPC’s purported sales orders, some of which were almost a decade old, the plaintiff filed claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, claiming that Capstone and two of its senior officers wrongfully concealed backlog issues and misrepresented significant revenue from sales of its products to BPC. Judge Dolly M. Gee denied the defendants’ motion to dismiss, holding that the plaintiffs had adequately pleaded their securities fraud claims. The plaintiffs’ allegations regarding the downsized backlog rested predominantly on statements by a confidential witness, which the court accepted because: (1) they were described with sufficient particularity to establish their reliability and personal knowledge; and (2) the statements themselves were indicative of scienter. Because the company’s executives were actively involved in Capstone’s sales efforts and were in consistent communication with BPC both prior and during the class period, the court accepted the plaintiffs’ argument that the most reasonable inference was that the defendants had knowledge of, or were reckless in not knowing, the nature and terms of its transactions with BPC, and that their decision not to remove such orders from the backlog was deliberately reckless or fraudulent.

DELAWARE CHANCERY COURT FINDS COMPANY’S PRE-MERGER TRADING PRICE THE “MOST PERSUASIVE EVIDENCE” OF FAIR VALUE

On February 15, 2018, the Delaware Court of Chancery in Verition Partners Master Fund Ltd., et al., v. Aruba Networks, Inc., a statutory appraisal proceeding arising out of Hewlett-Packard Company’s May 2015 acquisition of Aruba Networks, Inc. for $24.67 per share, concluded that the “most persuasive evidence” of Aruba’s fair value was its 30-day average unaffected market price of $17.13, “at least for a company that is widely traded and lacks a controlling stockholder.” In reaching this conclusion, Vice Chancellor J. Travis Laster considered: (1) discounted cash flow analyses submitted by the competing parties’ experts; (2) the merger price; and (3) the company’s unaffected market price. The Chancery Court relied on the Delaware Supreme Court’s recent decision in DFC Global Corporation v. Muirfield Value Partners, L.P. to reject using the discounted cash flow analyses as indicators of fair value, finding such models helpful only for non-public companies not sold in an open market. The Chancery Court also rejected using the merger price as a determinant of fair value, finding it to be a “ceiling for fair value” but not sufficient as a standalone estimation. Citing the Delaware Supreme Court’s recent decision in Dell, Inc. v. Magnetar Global Event Driven Master Fund Ltd., the Chancery Court observed that “[t]he issue in an appraisal is not whether a negotiator has extracted the highest possible bid [but rather] whether the dissenters got fair value and were not exploited.” Finally, the Chancery Court noted that the “ultimate goal in an appraisal proceeding is to determine the ‘fair or intrinsic value’ of each share on the closing date of the merger” and found the market to be the most reliable determination of fair value. The court suggested that “future appraisal litigants [] retain experts on market efficiency” to help “consider subtler aspects of the efficient capital markets hypothesis.” This decision underscores the importance of the unaffected market price in light of the Delaware Supreme Court’s recent decisions in DFC and Dell, serves as a reminder that the goal of appraisal proceedings under Delaware law is fair value, not highest possible value, and suggests that valuation experts should consider their theoretical approaches within the context of real market data.