On March 20, 2018, the Supreme Court decided the closely watched case Cyan, Inc. v. Beaver County Employee Retirement Fund, holding that the Securities Litigation Uniform Standards Act of 1998 does not strip state courts of jurisdiction over securities class actions alleging violations of only the Securities Act of 1933 or permit defendants to remove such actions to federal court. As background, in an effort to stem the tide of “abusive and meritless” securities class actions, Congress enacted a number of procedural reforms that apply to securities class actions filed in federal court through the Private Securities Litigation Reform Act of 1995. Later, in response to plaintiffs’ efforts to circumvent the PSLRA’s procedural reforms by filing cases alleging misstatements and omissions in connection with the purchase or sale of securities in state court, Congress enacted SLUSA with the intent to make “[f]ederal court the exclusive venue for most securities class action lawsuits.” At issue in Cyan was whether SLUSA’s amendments to the 1933 Act’s jurisdictional provision eliminated concurrent state court jurisdiction over class actions alleging only claims under the 1933 Act. In a unanimous opinion authored by Justice Kagan, the Court ruled that “[b]y its terms,” SLUSA “does nothing to deprive state courts of their jurisdiction to decide class actions brought under the 1933 Act.” Rather, the Court explained, the purpose of the SLUSA is to “completely disallow (in both state and federal courts) sizable class actions that are founded on state law and allege dishonest practices respecting a nationally traded security’s purchase or sale,” and to ensure “the dismissal of a prohibited state-law class action even when a state court ‘would not adequately enforce’ [SLUSA]’s bar.” These cases must be brought under the 1934 Act and in federal court. The Cyan decision may encourage plaintiffs to file more class actions under the 1933 Act in state court, where they can now be assured such actions will likely remain. Because securities class actions filed in state court may not be subject to the procedural reforms of the PSLRA, including provisions requiring detailed disclosures by the named plaintiff of its transactions in the issuer’s securities, securities issuers and underwriters may face greater challenges in defending such cases than they would in federal court. A more detailed analysis of the decision can be found here.
Fifth Circuit Strikes Down DOL’s “Fiduciary Rule”
On March 15, 2018, in a 2-1 opinion, the U.S. Court of Appeals for the Fifth Circuit struck down the U.S. Department of Labor’s “Fiduciary Rule” in Chamber of Commerce of the U.S.A., et al. v. U.S. Dep't of Labor, et al. The much-debated rule, promulgated under the Obama administration, was set to take effect in April 2017 before the new Trump administration delayed its implementation until July 2019. The rule would have expanded who is a “fiduciary” under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code, imposing significant new obligations on the hundreds of thousands of financial service providers and insurance companies in the trillion-dollar markets for ERISA plans and individual retirement accounts. The U.S. Chamber of Commerce and other leading trade associations challenged the rule on the basis that the Department of Labor had exceeded its rulemaking authority. The Fifth Circuit agreed, reasoning that the rule’s expanded definition of “fiduciary” was inconsistent with the plain text of ERISA and the Internal Revenue Code, as well as with the common law meaning of “fiduciary,” which depends on “a special relationship of trust and confidence between the fiduciary and his client.” Thus, the court held that the Fiduciary Rule was arbitrary, capricious, and unlawful under the Administrative Procedure Act, and vacated it “in toto.” The Court’s judgment will go into effect on May 7, 2018 and will render the rule inapplicable nationwide. The Fifth Circuit’s decision came down just two days after the Tenth Circuit rejected a challenge to a discrete aspect of the Fiduciary Rule, specifically, its amendment to a DOL Rule known as Prohibited Transaction Exemption 84-24. Under PTE 84-24, insurance agents were exempted from regulations prohibiting fiduciaries from receiving third-party compensation on sales of fixed indexed annuities (those that grow at the rate of a specified market index) and other annuities. The Fiduciary Rule, however, amended PTE 84-24 to specifically exclude fixed indexed annuities from the exemption. The Tenth Circuit rejected the challenge, but expressly declined to address the more fundamental concerns—whether the DOL exceeded its authority in adopting the rule or impermissibly defined the term “fiduciary”—at issue in Chamber of Commerce. Thus, the Tenth Circuit’s decision is moot and the two decisions do not present a circuit split.
NINTH CIRCUIT AFFIRMS DISMISSAL OF TESLA SOLAR UNIT INVESTOR SUIT FOR FAILURE TO ADEQUATELY PLEAD SCIENTER
On March 8, 2018, the U.S. Court of Appeals for the Ninth Circuit in Webb v. SolarCity Corp., et al. affirmed the dismissal of a putative securities fraud class action brought against SolarCity (now doing business as Tesla Energy Operations Inc.) and its former CEO and CFO, concluding that the complaint’s allegations failed to adequately plead scienter. The suit, which asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, alleged that the defendants changed SolarCity’s accounting formula prior to its IPO in order to misrepresent the company’s profitability. Specifically, the plaintiffs alleged that SolarCity failed to adhere to its GAAP-compliant accounting protocols, allowing it to amortize the costs associated with its sales of solar energy systems over the 20-year lease term instead of recognizing them all at once. The complaint included a number of allegations that the plaintiffs argued gave rise to a strong inference that the defendants acted with scienter. Relying on the core operations doctrine, the plaintiffs argued that the notion that the former CEO and CFO were unaware of the accounting change “strain[ed] credulity,” given that the company followed the GAAP-compliant procedures in 2010 and 2011 before changing to a formula that permitted it to “realize a sudden, dramatic increase of over 100% in gross margins for solar energy sales in fiscal year 2012.” This argument was bolstered by allegations attributed to eleven former SolarCity employees acting as confidential witnesses, which described the former CEO and CFO as hands-on managers who generally understood the company’s accounting obligations. The plaintiffs also argued that the defendants had a motive to commit fraud because the officer defendants were incentivized to maintain the company’s stock price both for their own benefit and for that of co-founder Elon Musk, who had put up 18,849,991 of his own shares as collateral for $275 million in loans from Goldman Sachs. The Ninth Circuit credited the allegation that the defendants had a strong incentive to keep stock prices high and agreed that the confidential witness statements demonstrated that the individual defendants were hands-on managers. Nevertheless, the court found that the alleged facts did “not give rise to an inference of scienter that is at least as compelling as the inference of an honest mistake.” In reaching this decision, the court noted that the defendants’ behavior during the class period was inconsistent with scienter—they were not alleged to have sold any SolarCity stock at artificially inflated prices and, in fact, both the former CEO and Musk had purchased additional stock during the purported class period. The court also held that the allegations concerning the defendants’ motive to boost the company’s stock price were the kind of “routine corporate objectives” held by all corporate actors and therefore were not sufficiently “specific” or “particularized” to give rise to a strong inference of scienter. Finally, the court rejected the plaintiffs’ core operations argument on grounds that the company’s sales division was a relatively minor portion of the company’s overall business, and because “the accounting error was so subtle that it appears that even the company’s specialized accounting division and professional auditors missed it.” The decision further illustrates the difficulty securities plaintiffs face in pleading scienter following the Supreme Court’s 2007 decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., absent allegations showing personal benefit to the defendants.
DELAWARE DISTRICT COURT DISMISSES SECURITIES SUIT CONCERNING ADEQUACY OF INFORMATION DISCLOSED TO FINANCIAL ADVISOR
On March 13, 2018, the U.S. District Court for the District of Delaware dismissed a putative securities class action lawsuit in Laborers’ Local #231 Pension Fund v. Cowan, et al. Following the acquisition of Lionbridge Technologies, Inc. by private equity firm HIG Capital LLC, stockholders filed suit against Lionbridge, Lionbridge’s board, and HIG, alleging that the proxy statement filed in connection with the transaction was materially misleading and therefore violated Sections 14(a) and 20(a) of the Securities Exchange Act of 1934. The proxy in question disclosed financial projections that were developed by an independent financial advisor “under the assumption of [Lionbridge’s] continued standalone operation as a publicly-traded company and did not give effect to any changes or expenses as a result of the merger or any effects of the merger.” These projections, according to the plaintiffs, were inaccurate and misled investors into approving the sale of the company at a price that allegedly did not reflect its true value. Specifically, the plaintiffs argued that the assumptions underlying the projections, which the company provided to the advisor, were false and failed to account for both the anticipated growth through Lionbridge’s aggressive acquisition strategy and the financial impact of Lionbridge’s acquisition of Exequo completed days after the sale. The defendants countered that the plaintiffs were wrong to interpret the projections as a statement of fact regarding management’s expectations; rather, Lionbridge included the projections “solely to give the Lionbridge stockholders access to certain financial projections that were made available to the Special Committee, [the] Board of Directors and [Lionbridge’s financial advisor]” in assessing the sale, “and [was] not included in th[e] proxy statement to influence a Lionbridge stockholder’s decision whether to vote for the merger agreement or for any other purpose.” Relying on the Third Circuit’s holding in OFI Asset Mgmt. v. Cooper Tire & Rubber, Judge Mark A. Kearney dismissed the claims, noting that “[w]hether the projection incorporated the acquisition strategy does not negate Lionbridge’s representation it provided the same projection to others involved in assessing the merger,” and declined “to transform the disclosure of the information given to the advisor and the advisor’s resultant projections reported in the [proxy] into a fiduciary obligation of disclosing all aspects of the assumptions which possibly should or could have been given to the advisor.” At bottom, the court said, the plaintiffs improperly sought to transform Section 14(a)’s disclosure requirements “into a second shot at a fiduciary duty claim for failing to disclose information to the financial advisor.” The decision makes clear that merger litigation focused on the completeness of information provided to a financial advisor is the province of state fiduciary duty law and not the federal securities laws.
S.D.N.Y. REVIVES DISMISSED INVESTOR SUIT FOLLOWING SCOTUS’ OMNICARE RULING, NEWLY-DISCOVERED INFORMATION
On March 19, 2018, the U.S. District Court for the Southern District of New York revived a putative securities class action in Pearlstein v. Blackberry Limited et al., three years after the claims were initially dismissed. The earlier complaint, which asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, alleged that Blackberry Limited and three of its officers artificially inflated the value of the company’s stock by hiding poor performance of its recently-launched Z10 smartphone. Relying on the Second Circuit’s decision in Fait v. Regions Financial Corp., which held that a statement of opinion could only be misleading when it was “both objectively false and disbelieved by the defendant at the time it was expressed,” the court dismissed the case in March 2015 for failure to plausibly allege that defendants made misrepresentations or omissions of material fact, and for failure to adequately plead scienter. Two important events followed that dismissal: the Supreme Court issued its ruling in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, and information supporting the plaintiffs’ claims came to light during the criminal prosecution of James Dunham, Jr., a former executive at national Verizon retailer Wireless Zone. Omnicare altered the Fait standard, ruling that statements of opinion can be misleading even when a defendant believes a statement at the time it was made if the statement “omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from the statement itself.” In light of these developments, the plaintiffs amended their complaint, and Judge Colleen McMahon ruled that the defects in the misrepresentation and scienter allegations had been cured. Specifically, the court found that information uncovered in the Dunham action tended to show that Blackberry Limited was in possession of Wireless Zone’s sales and returns data for the Z10 that contradicted the rosy outlook that the company communicated to the public. Thus, even if the individual defendants actually believed their public statements were truthful, their alleged withholding of the adverse sales and returns data could plausibly have mislead investors, the court ruled. Similarly, the court found that the newly discovered Wireless Zone sales and returns data was sufficient to establish an inference that the defendants had acted recklessly (i.e., with scienter) because they were alleged to have “knowledge of facts or access to information contradicting their public statements” or that they “failed to review or check information that they had a duty to monitor.”