Securities Snapshot July 03, 2018

U.S. Supreme Court Holds That SEC ALJ Must Be Constitutionally Appointed

Summary

U.S. Supreme Court holds that SEC ALJs are subject to the Appointments Clause of the Constitution; Southern District of New York holds that investors adequately pleaded loss causation in shareholder fraud class action; Southern District of Texas dismisses securities class action against Anadarko on materiality and scienter grounds; Northern District of Illinois dismisses securities law claims against IPO underwriters as time-barred, holding that Merck’s discovery rule does not apply to 1933 Act claims; District of Massachusetts dismisses a 120-page complaint alleging securities fraud against Acacia Communications; Southern District of New York finds that False Claims Act litigation can be predicated on claims submitted to the GSEs; Delaware Chancery Court holds that squeeze out merger is reviewable under the entire fairness standard; and the SEC proposes amendments to its whistleblower program.

In a 7-2 opinion written by Justice Elena Kagan, the U.S. Supreme Court held on June 21, 2018 that the U.S. Securities and Exchange Commission’s administrative law judges (ALJs) are “officers of the United States” who must be appointed by the President or head of an agency pursuant to the Appointments Clause of the Constitution, and that an SEC ALJ who was not lawfully appointed had no authority to issue a decision. In Lucia, et al. v. SEC, the SEC charged former investment advisor Raymond Lucia with violating certain securities laws, and an SEC ALJ was assigned to adjudicate the matter. At the conclusion of the hearing, the ALJ imposed sanctions on Lucia, including civil penalties of $300,000 and a lifetime ban from the investment industry. On appeal, Lucia argued that the entire administrative proceeding was invalid because the ALJ had been appointed by SEC staff members, and not by the President or head of the SEC, in violation of the Appointments Clause. In response, the SEC argued that ALJs are mere federal “employees” because they “do not ‘exercise significant authority independent of [the SEC’s own] supervision,” and that the Appointments Clause was therefore inapplicable. The U.S. Court of Appeals for the D.C. Circuit agreed with the SEC, finding that Lucia’s administrative hearing was valid. The Supreme Court granted certiorari in January 2018 to resolve a circuit split between the D.C. Circuit and the Tenth Circuit, which had held in Bandimere v. SEC that ALJs are officers of the United States subject to the Appointments Clause. Guided by the Court’s prior decision in Freytag v. Commissioner, in which Tax Court special trial judges were found to be inferior officers, the Court stated that to qualify as an officer, an individual must “occupy a ‘continuing’ position established by law” and “must ‘exercis[e] significant authority pursuant to the laws of the United States.” The Court found that SEC ALJs are officers because: (i) they “receive[] a career appointment” to a statutorily created position; and (ii) have the authority to oversee adversarial hearings (similar to that of federal trial judges), at the conclusion of which they issue decisions. Accordingly, the Court found that the ALJ who presided over Lucia’s administrative hearing was not properly appointed and the hearing was therefore invalid, entitling Lucia to a new hearing. The Court did not address the impact of the SEC’s ratification, in November 2017, of “the agency’s prior appointment” of all sitting SEC ALJs. In response to Lucia, the SEC issued an order on June 21, 2018 staying for at least 30 days all administrative proceedings before its ALJs. While it is unclear how the SEC will address challenges to prior rulings handed down by their ALJs after the 30-day stay expires, other federal agencies will likely be watching, as Lucia opens the door to challenges of approximately 150 administrative judges across 25 other federal agencies who are similarly empowered to “decide adversarial proceedings.”

NEW YORK FEDERAL COURT HOLDS THAT INSYS CANNOT AVOID INVESTOR FRAUD SUIT ON LOSS CAUSATION GROUNDS

On June 12, 2018, the U.S. District Court for the Southern District of New York held that a shareholder fraud suit against Insys Therapeutics and several of its high ranking officers can continue. In In re Insys Therapeutics, Inc. Securities Litigation, U.S. District Judge Paul A. Crotty denied Insys’s motion to dismiss claims for violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder. Insys, a specialty pharmaceutical company that develops and commercializes pain management medication, successfully marketed Subsys, a sublingual fentanyl spray to treat breakthrough cancer pain, in 2013. In March 2017, Insys announced that its Audit Committee conducted an investigation and that the company’s previous financial statements should no longer be relied upon, after which Insys’s stock price dropped. Then, in April 2017, Insys restated its financial statements for the first, second, and third quarters of 2015 and 2016, resulting in an aggregate revenue decrease of $200,000 and a net income increase of approximately $1 million. Following this restatement, Insys’s stock price increased. The shareholder suit alleged that the March 2017 statement was the corrective disclosure. The defendants moved to dismiss the complaint on various grounds, including failure adequately to plead loss causation, because the March 2017 press release “did not specify the actual error in the alleged misstatements,” and because Insys’s stock price rose after the restatement was announced a month later. The court, however, disagreed, finding that the press release “reveal[ed] the ‘alleged misstatement’s falsity,’” which was sufficient to survive a motion to dismiss. The court noted that while “the announcement of an internal investigation is itself insufficient to plead loss causation,” it can be sufficient when the investigation is linked to “the actual fraudulent conduct alleged in the complaint.” The court found that the fact that Insys’s stock rose after the restatement had no bearing on whether the March press release was a corrective disclosure. The Insys decision underscores the difficulty that defendants face when seeking to challenge the adequacy of loss causation allegations at the motion to dismiss stage.

TEXAS FEDERAL COURT DISMISSES SECURITIES CLASS ACTION AGAINST ANADARKO

On June 19, 2018, U.S. District Court for the Southern District of Texas granted Anadarko Petroleum Corp.’s motion to dismiss a securities class action regarding safety risks of its gas wells in Edgar v. Anadarko Petroleum Corporation. The plaintiffs asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5, alleging that Anadarko made misleading statements in Health, Safety, and Environment Fact Sheets and in several SEC filings that the company’s activities complied with applicable environmental laws and regulations. Judge Lee H. Rosenthal held that statements made in the fact sheets were not statements of “present fact,” and that reasonable investors would not have understood these statements to mean that the company was in absolute compliance with all applicable rules and regulations. The court also ruled that Anadarko’s statements in its SEC Form 10-K that it believed it was in compliance with environmental regulations were nonactionable statements of opinion. Because the plaintiffs did not establish that Anadarko did not hold the stated the beliefs at the time the statements were made, the statements could not give rise to liability under the Supreme Court’s 2015 decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund. The court also rejected the plaintiffs’ arguments regarding statements in another fact sheet that Anadarko had “state of the art” facilities. Judge Rosenthal stated that this was the “sort of corporate cheerleading that cannot be the basis of securities-fraud claim.” Lastly, the court found that while Anadarko’s statement that it operated “in compliance with the applicable laws and regulations” was a misstatement, the plaintiffs did not adequately allege scienter with respect to that statement. Although the court granted Anadarko’s motion to dismiss, the judge gave the plaintiffs until August 3, 2018 to amend their complaint.

NORTHERN DISTRICT OF ILLINOIS DISMISSES IPO CLAIMS AGAINST UNDERWRITERS AS UNTIMELY, HOLDING THAT MERCK’S DISCOVERY RULE DOES NOT APPLY TO 1933 ACT CLAIMS

On June 26, 2018, the U.S. District Court for the Northern District of Illinois in Beezley v. Fenix Parts, Inc. dismissed with prejudice all claims against the syndicate of investment banks that underwrote the initial public offering of Fenix Parts, Inc. The underwriters were named for the first time in an amended complaint asserting claims under Section 11 of the Securities Act of 1933, based on alleged misstatements in the issuer’s offering documents regarding, among other things: (i) the valuation of acquired assets and goodwill; and (ii) the company’s expectations for expanding operations through additional acquisitions. The underwriter defendants moved to dismiss all claims against them as time-barred by the 1933 Act’s one-year statute of limitations, on grounds that the plaintiffs were on “inquiry notice” more than one year before suing the underwriter defendants. The plaintiffs argued that “inquiry notice” was no longer the operative standard for assessing whether the 1933 Act statute of limitations had run. Rather, the plaintiffs argued that the Supreme Court in its 2010 Merck & Co. v. Reynolds decision had adopted a stricter “reasonable discovery” standard under which the 1934 Act’s limitations period does not begin to run until a reasonably diligent plaintiff actually would have discovered the facts constituting the violation underlying the claim. Judge Charles R. Norgle, Sr. agreed with the underwriter defendants, holding that the plaintiffs were on “inquiry notice” of their 1933 Act claims more than one year before amending the complaint to add the underwriter defendants. The court noted that the 1933 Act and the 1934 Act are “readily distinguishable” because 1933 Act claims do not involve proof of intent to defraud. The court also observed that Merck focused on the effect that deceptive conduct has on when information regarding a securities violation may reasonably become discoverable, and that the concerns that underlie Merck’s adoption of a “reasonable discovery” standard for securities fraud claims simply do not apply to non-scienter claims under the 1933 Act. The district court thus held that the “inquiry notice” standard (which the Seventh Circuit Court of Appeals has applied in numerous 1933 Act cases) is still the operative standard after Merck. This thorough decision will be useful for defendants in future cases, where statute of limitations arguments appear to be available under the 1933 Act. The law on this issue is mixed, with the Third Circuit Court of Appeals and several district courts in the Second Circuit holding that Merck does apply to 1933 Act claims. This is one of the few cases outside of the Second and Third Circuits to have addressed the question. Goodwin litigators represented the underwriter defendants in the Fenix Parts case.

DISTRICT OF MASSACHUSETTS DISMISSES ACACIA SECURITIES CLASS ACTION WITH PREJUDICE

On June 18, 2018, the U.S. District Court for the District of Massachusetts in Tharp v. Acacia Communications, Inc. dismissed a 120-page class action complaint against Acacia Communications as inadequately pleaded. Acacia, a company that designs products to assist with high-speed networking and obtains the majority of its revenue from customers based in China, successfully completed initial and second public offerings in 2016. Share prices increased dramatically around the time of the public offerings, but plummeted in 2017. The plaintiffs, asserting violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) and Rule 10b-5 of the Securities Exchange Act of 1934, alleged that the stock price decline resulted from the company’s failure to warn investors of market uncertainties and an impending market downturn. The plaintiffs further alleged that Acacia made material misstatements and omissions in its offering documents by not warning of uncertainties in the Chinese market and the impending market downturn. Judge William G. Young analyzed the statements contained in Acacia’s offering documents and found there were no actionable misstatements or omissions. Judge Young further found that Acacia had warned that if it were to lose one of its large customers, its business would be materially harmed, thus rejecting plaintiffs’ arguments that the offering documents did not contain fair warnings. In dismissing the case with prejudice, Judge Young also denied the plaintiffs leave to amend their complaint, saying the lawsuit lacked necessary details explaining its allegations of corporate misdeeds.

SOUTHERN DISTRICT OF NEW YORK HOLDS THAT FCA CLAIMS PREDICATED ON CLAIMS SUBMITTED TO GSE’S CAN SURVIVE, BUT AFFIRMS RIGOROUS PLEADING STANDARD IN DISMISSING CLAIMS AGAINST MORTGAGE SERVICING FINANCIAL INSTITUTIONS

In United States ex rel. Grubea v. Rosicki, Rosicki & Associates, P.C., Judge Jed Rakoff of the U.S. District Court for the Southern District of New York denied a motion to dismiss a False Claims Act (FCA) lawsuit alleging that a foreclosure law firm, Rosicki, Rosicki & Associates PC, overcharged the Federal Housing Administration (FHA) and Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac, for foreclosure-related services. Specifically, the relator’s complaint alleged that Rosicki used affiliated vendors with the purpose of submitting inflated invoices for services like title searches and service of process. These inflated bills were submitted by the law firm to the mortgage servicers, who then forwarded the bills to the FHA and the GSEs for reimbursement. Among other arguments, defendant Rosicki asserted that the reimbursements submitted to the GSEs in particular were not “claims” as contemplated by the FCA, because the GSEs are private corporations. Judge Rakoff disagreed, finding that claims submitted to the GSEs qualify under the statute, because the GSEs were “other recipient[s]” of funds “to advance a Government program or interest” by virtue of the Government conservatorship, which resulted in $200 billion in federal funding provided to the GSEs to keep them afloat from 2008 to 2012. Judge Rakoff found that claims submitted to the GSEs even after 2012 could still qualify, since the GSEs are currently obligated to make quarterly disbursements to the Treasury based on their operating budgets, so “any request for payment on a false claim after 2013 decreased the amount that Treasury received from the GSEs dollar-for-dollar.” The court also endorsed a “reverse false claim” theory, based on the view that Fannie Mae’s obligation to submit quarterly disbursements to the Treasury were reduced by any payment made on a false claim. In the same opinion, the court dismissed the claims brought against a number of major banks servicing the mortgage loans, whom the relator alleged should have been more diligent in their review of the inflated invoices before passing them along for reimbursement, finding that the relator had failed after multiple opportunities to sufficiently plead scienter with respect to the servicer defendants. Judge Rakoff dismissed these claims with prejudice, finding that the relator had failed to plead more than “conjecture.” The Rosicki decision therefore underscores the “rigorous” standard applied by courts in assessing whether a complaint brought under the FCA pleads facts supporting a strong inference of fraudulent intent. This case is significant because it extends jurisprudence regarding the scope of potential liability under the FCA, following the Ninth Circuit’s decision in United States ex rel. Adams v. Aurora Loan Servs., Inc., which dismissed an FCA case predicated on claims made to the GSEs, but left open the possibility that such a claim could succeed if properly pleaded under Title 31, United States Code, Section 3729(b)(2)(A)(ii), the statutory subsection utilized here.

DELAWARE CHANCERY COURT ALLOWS SHAREHOLDER SUIT OVER HANSEN MEDICAL MERGER TO MOVE FORWARD

In In Re Hansen Medical, Inc. Stockholders Litigation, the Delaware Court of Chancery denied a motion to dismiss a shareholder suit over a squeeze-out merger. The plaintiffs alleged that the majority stockholders of Hansen Medical used their control of the company to negotiate a merger with Auris Surgical Robotics, Inc., a company co-founded by Hansen’s CEO, which benefited themselves and constituted a breach of fiduciary duty. The plaintiffs argued that the majority stockholders represented a control group, and therefore the merger should be considered under the entire fairness standard of review. In support of this argument, the plaintiffs described the long history of coordination between the defendants, beginning when they entered into a voting agreement over 20 years earlier declaring themselves as a “group” of stockholders in another company named Quidel. The plaintiffs further alleged that the defendants continued to work together, investing in several companies over the years. Although the defendants offered reasonable explanations for some of the parallel investment actions, Vice Chancellor Tamika R. Montgomery-Reeves explained that, at the motion to dismiss stage, “the question is not whether plaintiffs offer the only, or even the most reasonably conceivable version of events.” Instead, because the defendants had a long history of coordinated investment actions and received a different form of consideration than the minority stockholders–the opportunity to rollover their Hansen stock into preferred stock in Auris–the court held that the entire fairness standard was applicable and denied the defendants’ motion to dismiss. The court did, however, dismiss the plaintiffs’ claims against Auris for aiding and abetting a breach of fiduciary duty, holding that the plaintiffs had pleaded no facts to show that Auris knowingly participated in any breach.

THE SEC PROPOSES AMENDMENTS TO ITS WHISTLEBLOWER PROGRAM

On June 28, 2018, the U.S. Securities and Exchange Commission voted to propose amendments to its whistleblower rules. Through the SEC’s program, which was established in 2010, individuals who provide quality tips to the SEC receive monetary rewards if the information leads to an enforcement action where over $1,000,000 in sanctions is ordered. The SEC established the program in order to incentivize individuals to provide such information. To date, information provided by whistleblowers has led to SEC enforcement actions in which over $1.4 billion in sanctions have been ordered. If enacted, the proposed rules will, among other things, expand the available monetary awards beyond matters in which enforcement actions are brought, allowing whistleblowers to collect awards in cases where their tips lead to deferred prosecution agreements (DPAs) and non-prosecution agreements (NPAs). The proposed rules will also modify the definition of whistleblower to conform with that defined in Digital Realty Trust, Inc. v. Somers, in which the U.S. Supreme Court held that in order to qualify for protection against employment retaliation under Section 21F of the 1934 Act, a whistleblower must report a possible violation to the SEC. In sum, the proposed amendments would provide further incentives for whistleblowers to report issues of perceived misconduct to the SEC in the hope of a monetary reward.