Supreme Court Weighs "Fraud-on-Market" Case

By Ted Allen, Managing Editor

Hearing what one lawyer has described as "the biggest securities litigation case in a decade," the U.S. Supreme Court is weighing what evidence investors must present to pursue a lawsuit under the "fraud on the market" theory.

While it's hard to predict from the Jan. 12 oral arguments how the high court might rule, several of the justices appeared skeptical of the Ninth U.S. Circuit Court of Appeals' ruling that the investors may bring suit under Section 10(b) of the Securities Exchange Act of 1934 by simply showing that a company's stock price was inflated when it was purchased.

Other federal appeals courts, such as the Third and the Seventh Circuits, have required investors to show that their shares fell after a company specifically corrected an earlier misstatement. Investors say that standard ignores the reality that some companies, such as Enron Corp. and WorldCom Inc., fail to correct prior misstatements and fully disclose fraud until long after their shares have become worthless. Companies want a stricter pleading standard to weed out more lawsuits on motions to dismiss before they have to spend millions of dollars on pretrial discovery.

Before the court is an appeal by Dura Pharmaceuticals Inc., a unit of Irish drugmaker Elan Corp. The company is appealing the Ninth Circuit decision, which allowed a class-action lawsuit over the company's statements about the prospects for federal approval for an asthma-medication dispenser.

The oral arguments attracted prominent lawyers on both sides. Patrick Coughlin, of Lerach Coughlin Stoia Rudman & Robbins of San Diego, argued the case for the investors. William Sullivan of Paul, Hastings, Janofsky & Walker, who has defended many companies in securities litigation, represented Dura Pharmaceuticals. Also arguing the case was Deputy U.S. Solicitor Thomas Hungar, who was representing the Securities and Exchange Commission, which supports Dura's appeal.

Investors vs. Companies
The case also attracted more than a dozen amicus briefs. Supporting the investors are the City of New York Pension Funds, the California Public Employees' Retirement System (CalPERS), the California State Teachers' Retirement System, the Los Angeles County Employees Retirement Association, the New York State Common Retirement Fund, the Regents of the University of California, the National Association of Shareholder and Consumer Lawyers, the New Jersey Department of Treasury and Division of Investment, and the North American Securities Administrators Association.

Dura is backed by the U.S. Chamber of Commerce, the Securities Industry Association (SIA), the Bond Market Association (BMA), Merrill Lynch & Co., Broadcom Corp., the American Institute of Certified Public Accountants, the Washington Legal Foundation, and the Technology Network.

What's at Stake?
Before oral argument, both sides emphasized the importance of the case. Sullivan told Legal Times that the case was the "the biggest securities litigation case in a decade." The SIA and the BMA has warned that the Ninth Circuit's decision "opens the door to frivolous litigation by permitting plaintiffs to move forward with securities class-action lawsuits even if any alleged wrongdoing did not result in a decline in the security's price."

Christopher Patti, lawyer for the University of California, told reporters that the pleading standard put forth by Dura and its allies "would cripple the ability of securities laws to function because it would allow perpetrators who are able to successfully hide their fraud long enough to escape liability." Likewise, the New York and California public pension funds argued in their amicus brief that Dura's standard would "effectively eliminate a large number of meritorious actions at the pleading stage in order to address a very small subset of securities cases."

Background
The fraud on the market theory was recognized by the Supreme Court in a 1988 case, Basic Inc. v. Levinson. The high court said that investors' reliance on a material public misstatement can be presumed because the market price of the company's shares is supposed to reflect all the publicly available information about the company. At the same time, investors cannot recover for losses unrelated to corporate misrepresentations.

The original lawsuit against Dura arose from company's statements about its sales of Ceclor CD, an antibiotic, and the prospects for federal regulatory approval of Albuterol Spiros (AlSpiros), a device for dispensing asthma medicine. Investors claim that Dura officials reported that Ceclor sales were increasing in March and April 1997 and throughout the year, when in fact sales were declining. Dura also falsely reported that the AlSpiros device was performing well in tests and likely would receive approval from the Food and Drug Administration, investors allege. Meanwhile, the company's shares rose from $28 in April to a high of $52 in October 1997.

On Feb. 24, 1998, Dura announced that Ceclor sales were lower than previously stated, prompting the company's shares to fall from $39 to $21 the following day. The Feb. 24 statement did not mention AlSpiros. Dura's shares continued to fall, declining another 40 percent before November 1998, when the company announced that FDA had rejected its AlSpiros application. The company's shares fell another 20 percent before regaining that 20 percent loss in the next 12 trading days. In 2001, Dura was acquired by Elan.

Dura shareholders filed various lawsuits, claiming the company made false and misleading statements about Ceclor and AlSpiros. The investors proposed a class period of April 15, 1997, to Feb. 24, 1998. The lawsuits were later consolidated and Dura filed a motion to dismiss. A federal judge in California granted that motion, ruling that the investors had not alleged sufficient facts about the Ceclor statements to infer that Dura intentionally or recklessly committed securities fraud. The judge also rejected the AlSpiros claims, concluding that the investors had not sufficiently pleaded "loss causation" because the Feb. 24 disclosure did not mention AlSpiros, and thus could not have triggered investor losses over that device.

The Ninth Circuit upheld the judge's ruling on the Ceclor statements, but it reversed on loss causation on the AlSpiros allegations. The appeals court said Dura investors did not have to show that their shares lost value after a company finally corrected in November 1998 its earlier misstatements over AlSpiros, because their loss occurred when they originally bought the shares at an inflated price.

At the request of Dura, the Supreme Court agreed to review the case. Dura argued that the Ninth Circuit's ruling was in conflict with other appeals courts and the Private Securities Litigation Reform Act (PSLRA) of 1995, which was intended by Congress to curb frivolous securities lawsuits. Dura argued that investors should not be able to recover for AlSpiros-related losses, because the company did not make a corrective disclosure until November 1998, nine months after the end of the class period.

Oral Arguments
Throughout the Jan. 12 oral arguments, several of the justices appeared skeptical of the Ninth Circuit's view that investors can have a viable legal claim at the time of purchase--before any stock drop occurs. At the same time, they seemed reluctant to embrace Dura's argument that investors may only recover for losses after a specific corrective disclosure.

Sullivan, representing Dura, argued that investors do not have a claim until they lose money after a company makes a corrective disclosure. Hungar, on behalf of the U.S. government, offered a slightly different theory during questioning by Justice Ruth Bader Ginsburg. He stated that investors could meet their pleading burden by showing that price inflation was reduced by the dissemination of corrective information and did not have to point to a formal disclosure by the company. Justice Antonin Scalia appeared to embrace this position, noting all that matters is that the market learns the truth.

Hungar was asked by Ginsburg and Justice John Paul Stevens why an investor should have to go beyond the less-stringent notice-pleading requirements in Rule 8 of the Federal Rules of Civil Procedure, which require a "short and plain statement." Hungar said the appropriate standard is Rule 9(b), which requires fraud allegations to be plead with particularity. In arguing for that approach, he noted the millions of dollars that companies typically must spend on pretrial discovery if a securities lawsuit is allowed to proceed after a motion to dismiss.

The justices repeatedly questioned Coughlin over the Ninth Circuit's loss-causation theory. "I don't see how it makes any sense to have a cause of action right after you make the purchase," Justice David Souter said.

Coughlin responded by noting that the truth about the accounting fraud at Enron and WorldCom trickled out and was not fully known by investors until after the companies were in bankruptcy. At that point, the shares were virtually worthless and could not fall any further, he said. "If that's the case, then the [PSLRA] doesn't protect whom it was intended to protect," Coughlin said.

When pressed by the justices, Coughlin acknowledged that while investors could have a legal claim when they first purchase the inflated shares, they can't recover damages until the shares actually decline. This prompted Scalia to remark, "I'm really coming to believe that this is just a great misunderstanding" between the two sides.

Flexible Standard
In defense of the Ninth Circuit's decision, the New York and California pension funds urged the Supreme Court to adopt a "flexible" pleading standard that considers two questions: "Was the stock was inflated by fraud?" and "Has the inflation been removed?" If an investor can establish both, then loss causation is established, the pension funds argued in their amicus brief. Such an approach, they contend, is consistent with corporate finance principles, which recognize that a company's stock price reflects the market's estimation of the company's future cash flows.

While the PSLRA requires investors to plead with particularity allegations that certain corporate statements were fraudulent, the heightened standard of Rule 9(b) does not apply to loss causation, the pension funds argued. The funds urged the justices not to adopt pleading requirements that would effectively force investors to hire an expert to conduct an "event study" of possible influences on a company's share price before filing suit. This standard would likely deter many valid claims, because such studies can take months to complete and cost hundreds of thousands of dollars, the pension funds said.

Economic Theory
Brett Scharffs, a law professor at Brigham Young University who wrote an article previewing the case for the American Bar Association, said the case will test the limits of the "efficient market" theory that underlies fraud-on-the-market cases. That theory assumes that the price of a securities in an efficient capital market reflects all publicly available information, including a material misrepresentation. Consequently, Dura and its supporters argue that the theory should apply to loss causation: in other words, one should infer "the market price continues to reflect the inflationary impact of the misstatement until it is corrected," Scharffs noted.

Such an argument is one that "only an economist could love," because it is "based upon so many counterfactual assumptions about how markets and humans really work that it is of only limited usefulness. Whether or not the [justices] will be in the thrall of efficient market theory I do not know, but this would seem to me to be a good opportunity for them to choose not to be bound by some of its more silly implications," Scharffs told SCAS Alert.

Lyle Roberts, a partner with Wilson Sonsini Goodrich & Rosati in Reston, Virginia, and author of a securities law blog, The 10b-5 Daily, said he expects that the justices likely will embrace the U.S. government's position, given the complexity of the issues in the case. In other words, he anticipates that they will conclude that no formal corrective disclosure by a company is necessary, as long it can be shown that the market learned of the alleged fraud before the shares fell.

Roberts noted that this case is unusual, because loss causation is not difficult to prove in most securities suits. For instance, in a typical case over an accounting restatement, a company's shares fall immediately after company officials announce that they will restate financial results. In such a case, it's clear that the decline occurred after the company acted to correct the alleged fraud, he said.

"It's interesting that this case has gotten all this attention, but this ruling will probably affect only a minority of cases," Roberts told SCAS Alert.

The Supreme Court likely will issue its decision by the end of June.

Commentary: A Wake-up Call to File Claims By Bruce Carton, Executive Director

The stakes for institutional investors that fail to file claims in securities class action settlements just got much higher.

During the week of Jan. 10, more than 40 mutual fund managers were sued by investors alleging that the funds failed to collect as much as $2 billion in settlement payouts to which the funds were entitled, according to news reports. The class-action lawsuits allege that the funds' failure to claim this money in the past three years was a breach of fiduciary duty, negligence, and in violation of the Investment Company Act of 1940. The lawsuits seek compensatory damages for all of the money that the mutual funds allegedly left on the table, as well as punitive damages and the forfeiture of all commissions and fees paid by fund shareholders.

Several of the funds named as defendants promptly responded that they did, in fact, file claims in settlements in which they were eligible to recover, and that the allegations are without merit. But will they all have such a defense? Recent academic studies have indicated that as many as two thirds of institutional investors fail to file claims in securities class action settlements, resulting in an estimated $1 billion in settlement proceeds unclaimed per year. Unclaimed funds typically are distributed on a pro rata basis to those investors who do file claims in a particular settlement, providing them with an additional measure of recovery that they otherwise would not have received.

Key Issues
The lawsuits against these mutual funds will likely turn on several key legal and factual issues. As a threshold legal matter, the court will need to decide whether mutual funds have a legal obligation to file claims in settlements under any of the theories advanced by the plaintiffs: (1) a fiduciary duty to do so, arising under either common law or the Investment Company Act; or (2) a common law duty of care requiring them to do so (a "negligence" standard). The plaintiffs allege in one of the lawsuits that:

an investor pools her money with other investors in a mutual fund and entrusts complete control and dominion over her investments to the directors and advisors of the mutual fund. As a result of this relationship of special trust, directors and advisors of mutual funds owe a fiduciary duty directly to each individual in the fund….

The plaintiffs conclude that "Defendants' failure to protect the interests of the Fund investors by recovering monies owed them is a breach" of that fiduciary duty.

Although the existence of a mutual fund's duty to file claims does not yet appear to have been addressed by any court, it is well established that officers and directors of corporations owe a duty to shareholders to protect the company's assets. Several commentators have opined that it is not a big step to conclude that just as a mutual fund must assure the safety of the securities in its portfolio, it also must assure that material amounts of money owed to the fund that can be claimed in securities class action settlements are not left unclaimed. Whether the courts agree with this conclusion will be critical, as will be the court's (or jury's) determination on whether a failure to file claims is, in and of itself, negligent conduct.

Factual Questions
Key factual issues in these cases will include whether the funds were eligible to participate in settlements during the class period and, if so, whether they filed claims in such settlements. The lawsuits do not appear to include specific allegations concerning these facts, presumably because detailed information on fund holdings and claims filed by a fund is not publicly available. Rather, the lawsuits allege that (1) the fund in question typically owned billions of dollars in stocks; (2) during the class period there were hundreds of securities class action settlements, and the fund was eligible to participate in a "significant number" of these cases; (3) if the fund had filed claims in a particular settlement, the proceeds would have increased the total assets and immediately impacted the fund's net asset value (NAV); and (4) "upon information and belief, the Defendants failed to submit Proof of Claim forms in these cases and thereby forfeited Plaintiffs' rightful share of the recovery obtained in the securities class actions."

It is unclear upon what "information and belief" the plaintiffs base their conclusion that a particular fund failed to file claims in a particular case, but the allegations noted above suggest that this conclusion is based on the fund's net asset value not rising following the distribution of proceeds in a class action settlement. It is correct that any settlement proceeds from a class action relating to a fund's portfolio security belong to the fund, the receipt of which will have the effect of increasing the value of the portfolio and enhancing the portfolio's performance.

If this is the plaintiff's theory then there appear to be at least some holes in this logic. First, funds have not yet been distributed in many of the securities class-action settlements listed in the lawsuits. Second, there may well be situations where external negative forces such as a drop in the market or other securities in the portfolio offset any gain in the fund's NAV resulting from the receipt of any settlement proceeds. Third, proceeds from a settlement may in some cases simply be too small to impact the NAV.

Still, it is indisputable that funds often are entitled to receive hundreds of thousands--if not millions--of dollars in a single securities class action settlement, and the absence of any rise in a fund's NAV in certain cases may demonstrate that the fund did not file claims in such a case. The true facts concerning a fund's eligibility and claims filing are out there, of course, and can be easily determined by plaintiffs if they are able to obtain discovery (relevant documents and testimony) from the fund through the litigation process. The big question is whether a "NAV-based" allegation that a fund failed to file claims can withstand an immediate motion to dismiss the case filed by that fund seeking to have some or all of the lawsuit thrown out of court prior to any discovery.

TENTATIVE SETTLEMENTS

WorldCom Inc.
Ten former directors of WorldCom Inc. have agreed to pay $54 million to resolve a class-action lawsuit filed in April 2002 in U.S. District Court for the Southern District of New York. Investors who purchased WorldCom shares between Apr. 29, 1999, and June 25, 2002, are expected to be eligible to take part in the settlement.

In its amended complaint, lead plaintiff New York State Common Retirement Fund alleged that WorldCom's board of directors had been "utterly derelict in carrying out its most basic functions," provided "no internal checks and balances on WorldCom management," and was "completely beholden to management."

The former board members agreed to pay $54 million collectively, including $18 million out of their own pockets. The settlement is subject to the approval of the federal court handling the case. Investors are still pursuing claims against investment banks that underwrote WorldCom debt; a trial on those claims is set for Feb. 28.

WorldCom, now known as MCI Inc., is based out of Ashburn, Va., and provides business and residential communications services throughout the world.

Enron Corp.
Eighteen former directors of Enron Corp. have agreed to pay $168 million to investors. This agreement is the fourth that investors have negotiated in the Enron securities class action case in federal court in Houston.

The agreement, reached with lawyers for the University of California, the lead plaintiff, requires 10 of the 18 former Enron directors to contribute a combined $13 million from the profits that they reaped from selling company stock before Enron revealed it had exaggerated its sales and profits.

Enron, based out of Houston, operates natural gas pipelines in the United States, and has interests in international electric and natural gas utilities. The company filed for bankruptcy in December 2001.

PNC Financial Services Group Inc.
PNC Financial Services Group, Inc. has agreed to pay $34 million to settle a class-action lawsuit filed in February 2002 in U.S. District Court for the Western District of Pennsylvania. Investors who purchased PNC stock from July 19, 2001, to July 18, 2002, are expected to be eligible to take part in the settlement.

The investors alleged that that the company and its officers misrepresented PNC's financial results. PNC, based in Pittsburgh, is a diversified financial services organization that provides regional banking, wholesale banking, and asset management services.

McKesson Corp.
McKesson Corp. has agreed to pay $960 million to settle a class-action lawsuit filed by investors after the company's acquisition of HBO & Co. (HBOC). The investors sued after McKesson disclosed accounting improprieties at HBOC in April 1999 several months after completing the transaction.

The settlement likely will be open to investors who purchased shares of McKesson between Oct. 18, 1998, and April 29, 1999, and those who purchased HBOC shares from Jan. 20, 1997, and Jan. 12, 1999. The agreement is subject to the approval of a federal judge in the Northern District of California. The company has set aside another $240 million for investor lawsuits in state courts.

McKesson, based in San Francisco, distributes pharmaceuticals, medical-surgical supplies, and automation services to retail pharmacies and hospitals across the United States.

DISMISSALS

Radiation Therapy Services Inc.
A class-action lawsuit by Radiation Therapy Services Inc. investors has been dismissed. The suit was filed in September 2004 in federal court in the Middle District of Florida.

The investors sued over the company's handling of its initial public offering and related-party transactions.

Radiation Therapy Services, Inc., based in Fort Myers, Fla., develops and operates radiation therapy centers.

Gexa Corp.
A class-action lawsuit by Gexa Corp. investors has been dismissed. The lawsuit was filed in July 2004 in federal court in the Southern District of Texas.

The investors alleged that the company misled them about its business, finances and the intrinsic value of its securities.

Gexa, based in Houston, offers retail electric service to consumers and businesses in Texas.

American Physicians Capital Inc.
A lawsuit by investors in American Physicians Capital Inc. has been dismissed. The class-action suit was filed in February 2004 in federal court for the Western District of Michigan.

The lawsuit claimed that the company deceived the investing public regarding about its business, operations, management and the intrinsic value of its stock.

American Physicians Capital, based in East Lansing, Mich., is a medical professional liability insurance and workers' compensation insurance company.

• Corel Corp.
• Aid Auto Stores Inc.

Three former chief executives, Bernard Ebbers of WorldCom Inc., L. Dennis Kozlowski of Tyco International Ltd., and Richard Scrushy of HealthSouth Corp. went on trial in January.

Ebbers, who is in federal court in New York, is accused of orchestrating an $11 billion accounting fraud. He faces nine charges, including conspiracy, securities fraud, and filing false statements. His attorneys have said they will show that many of WorldCom's revenue-recognition practices and other accounting methods were proper. They also will try to shift blame to former Chief Financial Officer Scott Sullivan, who is testifying for the government. Prosecutors began calling witnesses on Jan. 25, and the trial is expected to last eight weeks.

Kozlowski is being tried again in state court in Manhattan. He and Mark Swartz, Tyco's former finance chief, together face 31 counts of stock fraud, falsifying business records, and grand larceny. Their first trial ended in a mistrial in April 2004 after a juror was threatened. Opening arguments began Jan. 26; the trial is slated to last four months.

Scrushy is on trial in federal court in Birmingham, Alabama. He is accused of overstating the company's income by $2.7 billion, lying to investigators about stock sales, and laundering money to finance a lavish lifestyle. Prosecutors presented opening arguments on Jan. 25. He is the first person to be charged under the Sarbanes-Oxley Act, which requires chief executives to attest to the accuracy of corporate financial statements. Scrushy has blamed the accounting problems on five former chief financial officers, who have pleaded guilty and are cooperating with prosecutors.

Samuel Waksal, former chief executive of ImClone Systems Inc., and his father agreed to pay $5 million to resolve civil insider trading claims, the Securities and Exchange Commission announced Jan. 19.

Waksal is now serving an 87-month prison term on related criminal charges. The SEC accused him of trying to sell $5 million in company stock in December 2001 and tipping off other investors after learning that Food and Drug Administration (FDA) officials would likely reject his company's Erbitux cancer drug.

His friend, Martha Stewart, was caught up in the scandal and was sentenced to five months in prison on charges of obstructing justice, conspiracy and lying to investigators over her sale of ImClone stock.

On Jan. 24, the company announced that it would pay $75 million to settle investor lawsuits over its public statements about Erbitux's prospects for FDA approval. The settlement is subject to court approval.

Goldman Sachs Group and Morgan Stanley & Co. have each agreed to pay $40 million to settle SEC civil claims that the banks improperly induced investors to buy shares in initial public offerings.

The settlements, which the SEC announced Jan. 25, end a two-year agency probe of allegations that the banks favored large customers over individual investors during the technology stock boom in 1999 and 2000. The agency accused the banks of violating Rule 101 of Regulation M under the Securities Exchange Act of 1934 by inducing investors to make aftermarket purchases in exchange for better share allocations in hot IPOs. The SEC faulted Goldman Sachs over the initial offerings for CoSine, Marvell, and WebEx, and took issue with Morgan Stanley's efforts to market shares in Avanex, Webmethods, and Martha Stewart Living Omnimedia.

On Jan. 7, the U.S. Supreme Court agreed to review Arthur Andersen's 2002 obstruction-of-justice conviction that stemmed from its auditing work for Enron Corp. The accounting firm is seeking reversal, arguing that the jury received improper instructions. The high court likely will hear arguments in that case in April.

The Supreme Court ruled Jan. 12 that the federal sentencing guidelines are unconstitutional but stated that the guidelines are now "advisory." The ruling has led business groups and lawyers to question how it might affect the U.S. Sentencing Commission's recent rule that corporations must have "effective" compliance programs to detect violations of the law.

In a Jan. 18 commentary for Compliance Week, lawyer Brian Chilton said companies should continue their compliance efforts, because federal judges will continue to look to the sentencing guidelines, even though they are no longer mandatory, to assess corporate behavior. Chilton, a senior counsel with Foley & Lardner in Washington, also noted that directors and officers also have a fiduciary obligation under Delaware law to ensure that a corporation has an effective compliance program.

Kirk Shelton, former vice chairman of Cendant Corp., was convicted Jan. 4 on securities fraud, conspiracy and other charges, while a jury failed to reach a verdict on charges against former chairman Walter Forbes.

The two executives were accused of inflating the earnings of CUC International, which became Cendant after a 1997 merger with HFS Inc. Cendant, which lost $14 billion in market value on April 15, 1998, when it disclosed the accounting irregularities, reached a $3.2 billion class-action settlement with investors in 2000. The company is the largest U.S. travel and real-estate services company.

U.S. District Judge Alvin Thompson in Hartford, Conn., declared a mistrial in the case against Forbes after 33 days of deliberations.

Companies that report internal control deficiencies have not been hit with a flurry of investor lawsuits so far, WebCPA reported, citing a study of companies by accounting firm Deloitte & Touche and Haynes & Boone LLP, a law firm.

The study examined about 600 internal control disclosures by 290 companies between November 2003 and August 2004. Of those companies, only 6 percent were sued over the problems that were disclosed.

The results surprised the study's authors, who said they had expected to see a sharp spike in class-action lawsuit filings, WebCPA reported.

A Review of 2004

Total Settlements: 158
According to the Securities Class Action Services database, the number of final settlements in 2004 was less than in 2003 (175), 2002 (170), 2001 (175), and 2000 (185). Nonetheless, the value of the settlements in 2004 as a whole has dwarfed the settlement amounts for the past four years.

Total Settlement Amount: $5.98 billion
During 2004, defrauded investors received more financial reimbursement than ever before. In recent years, the next highest total was in 2000, when there were $4.6 billion in total settlements. Since then, 2001, 2002, and 2003 recorded approximately $2.71, $2.3, $3.71 billion, respectively. 2004's lofty value of $5.98 billion trumps 2003's total by an astronomical 61 percent!

Average Settlement Amount: $37.8 million
Although the total number of settlements was down in 2004, the amount of money being returned by each settlement has significantly increased. In 2003, the average settlement was approximately $21 million. In 2002, it was $13.5 million, followed by $15 million in 2001. In 2000, the average settlement amount was $25 million, but this value was still off of 2004's mark by $10 million.