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We do not spend a great deal of time on the
substantive law that determines liability in a private action or
enforcement action under the securities laws. Nonetheless, it is
apparent that we must have a litigator’s understanding of the underlying
substantive law. We outline the framework briefly and as we go along it
is essential that you pick up the details from the cases we are
discussing or otherwise. Chapter 1 includes a detailed discussion of the
substantive law and we do not cover it systematically, but will cite it
from time to time as a reference source. Claims for securities fraud are
typically based on Rule 10b-5. Rule 10b-5 is discussed in some depth
beginning at § 1.04. A district court
judge considering a Rule 10b-5 typically begins his/her opinion by
describing the elements of a Rule 10b-5 claim. Judge Melinda Harmon,
presiding over the Enron private action; is no exception and we take her outline
of the elements of a Rule 10b-5 claim in a private action (
In re Enron Corp. Sec., Derivative & ERISA Litigation,--- F.Supp.2d
----, 2002 WL 31854963 S.D.Tex. Dec 20, 2002):
"To state a securities fraud claim under § 10(b) of the
Exchange Act and Rule 10b-5(b), a plaintiff must allege, in connection
with the purchase or sale of securities, (1) a misstatement or omission
(2) of a material fact, (3) made with scienter, (4) on which the plaintiff
relied and (5) which proximately caused his injury.
Abrams v. Baker Hughes, Inc., 292 F.3d 424, 430
(5 th Cir.2002), citing
Shushany v. Allwaste, Inc., 992 F.2d 517, 520-21
(5 th Cir.1990);
Nathenson v. Zonagen, Inc., 267 F.3d 400, 406-07
(5 th Cir.2001). Scienter for a private cause of action under § 10(b),
means "intent to deceive, manipulate or defraud" (Abrams,
292 F.3d at 430, citing
Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976))
or at least knowing misconduct (Herman
& MacLean v. Huddleston, 459 U.S. 375, 382-83 (1983)(mere
negligence is insufficient)). [ed.
See § 1.04[2].] Because the PSLRA does not define generally
the required scienter for private securities fraud claims under § 10(b)
and Rule 10b-5, but only mandates that the plaintiff plead facts with
particularity to give rise to a strong inference of the requisite state of
mind, the Fifth Circuit has held that severe recklessness, "limited to
those highly unreasonable omissions or misrepresentations that involve not
merely simple or even inexcusable negligence, but an extreme departure
from the standard of ordinary care, and that present a danger of
misleading buyers or sellers which is either known to the defendant or is
so obvious that the defendant must have been aware of it," is sufficient
to satisfy the scienter requirement.
Nathenson, 267 F.3d at 408.
A plaintiff must also demonstrate that the challenged
misrepresentations in dispute were material, that he relied on them, and
that as a proximate result, he was damaged. Misrepresentations or
omissions are material if there is a substantial likelihood that a
reasonable investor would have viewed the allegedly false, misleading or
omitted statement as having significantly altered the total mix of
information available to him in deciding whether to buy or sell his stock
or, phrased another way, "if there was a substantial likelihood that a
reasonable investor would consider the information important in making a
decision to invest."
Basic Inc. v. Levinson, 485 U.S. 224, 230-31 (1988);
ABC Arbitrage, 291 F.3d at 359.
Although materiality is a mixed question of fact and law and generally a
decision for the jury, nevertheless, in reviewing a motion to dismiss, the
court can determine that representations are immaterial as a matter of
law.
ABC Arbitrage, 291 F.3d at 359;
Nathenson, 267 F.3d at 422.
"Reliance ... generally requires that the plaintiff have
known of the particular misrepresentation complained of, have believed it
to be true and because of that knowledge and belief purchased or sold the
security in question."
Nathenson, 267 F.3d at 413.
[FN13]
To satisfy the reliance element in § 10(b) and Rule 10b-5
securities violation action, where a plaintiff investor who may not have
read or heard the purported misrepresentations, a plaintiff may employ the
"fraud-on-the-market" doctrine. The Supreme Court has stated that this
theory "is based on the hypothesis that in an open and developed
securities market, the price of a company's stock is determined by the
available material information regarding the company and its business.
.... Misleading statements will therefore defraud purchasers of stock
even if the purchasers do not directly rely on the misstatements. ...."
Basic, 485 U.S. at241-42, citing
Peil v. Speiser, 806 F.2d 1154, 1160-61 (3d Cir.1986).
Thus the presumption is that the plaintiff relied on the value of the
stock, which is the market's reflection of available material information
about a company including the company's fraudulent statements.
Fine v. American Solar King Corp., 919 F.2d 290, 298
(5 th Cir.1990), cert. dism'd sub nom.
Main Hurdman v. Fine, 502 U.S. 976 (1991).
A defendant may rebut "the presumption of reliance by 'any
showing that severs the link between the alleged misrepresentation and
either the price received (or paid) by the plaintiff, or his decision to
trade at a fair market price.' " Id., citing
Basic, 485 U.S. at 248. Thus the
defendant can rebut the presumption by demonstrating that the
nondisclosure had no effect on the stock's market price or that the
plaintiff would have purchased the stock at the same price even if he had
known the information that was not disclosed to the market or that the
plaintiff actually knew about the information that was not disclosed to
the market when he purchased the stock.
Id.;
Nathenson, 267 F.3d at 414. As a
corollary to the fraud-on-the-market doctrine and a defense to rebut that
doctrine's presumption that the defendant's misrepresentations affected
the price of the company's stock, the truth-on-the-market doctrine views a
misrepresentation as immaterial if the information is already known to the
market because that misrepresentation therefore cannot defraud the
market. In re Sec.
Litig. BMC Software, Inc., 183 F.Supp.2d 860, 905-06 n. 46
(S.D.Tex.2001).
Section 20(a) of the Exchange Act,
15 U.S.C. § 78t(a)(liability of controlling
persons and those who aid and abet violations), establishes a derivative
liability for persons who "control" those who are primarily liable under
the Exchange Act. It provides,
"[e]very person who, directly
or indirectly, controls any person liable under any provision of this
chapter or any rule or regulation thereunder shall also be liable jointly
and severally with and to the same extent as such controlled person to any
person to whom such controlled person is liable, unless the controlling
person acted in good faith and did not directly or indirectly induce the
act or acts constituting the violation or cause of action. liability is an alternate ground for liability from that of
a primary violation." Thus a plaintiff may allege a primary § 10(b)
violation by a person controlled by the defendant and culpable
participation by the same defendant in the perpetration of the fraud.
SEC v. First Jersey Sec., Inc., 101 F.3d 1450, 1472 (2d Cir.1996),
cert. denied,
522 U.S. 812 (1997). A person charged with
control liability may assert a defense that he acted in good faith with
respect to the securities violation, i.e., that he acted reasonably and
did not act recklessly. A defendant can meet the requirements of a good
faith defense by showing that he used reasonable care to prevent the
securities violation.
G.A. Thompson & Co. v. Partridge, 636 F.2d 945, 957-58, 960 (5th
Cir.1981);
Donohoe v. Consolidated Operating & Prod. Corp., 30 F.3d 907, 912
(7th Cir.1994). Negligence alone is
insufficient to support controlling person liability.
Id."
We resume our discussion to note it
is the Supreme Court’s adoption in Basic of fraud on the market
that makes securities fraud class actions viable as it basically
eliminates the need to establish that the members of the class were even
aware of the alleged misrepresentations.
See § 1.04[5][b]. Judge
Harmon failed to note that only a
purchaser or seller of securities can assert a Rule 10b-5 claim.
See § 1.04[3]. In
another direction, the Supreme Court's decision in Central Bank of
Denver, N .A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 114
S.Ct. 1439, 128 L.Ed.2d 119 (1994), abolished aiding and abetting
liability in a private action under section 10(b).
See § 1.08[1]. Judge
Harmon's decision in Enron deals at length with the issue of who is
a primary violator and we will discuss it in due course. Judge Harmon also
set forth the elements of a Section 11 claim, but to keep it brief we
include our own description. A Section 11 claim under
the Securities Act can be asserted by anyone who purchased the registered
security against the issuer, the officers who signed the registration
statement, all members of the board of directors, the lead underwriters
and members of the underwriting group, any expert named therein with
his/her/its consent. See § 1.02[2]-[3]. The plaintiff must establish that
a statement or statements in the registration statement were false or
misleading with respect to a material fact, or that the registration
statement omitted material information required to be included therein and
that plaintiff did not know the statements were false or misleading.
See
§ 1.02[4]. The issuer has no affirmative defense other than a causation
defense (see § 1.02[5]); other defendants have varying due diligence
defenses depending on whether the false or misleading statement is part of
the expertised portion of the prospectus/registration statement and
differing to some degree depending upon their role (e.g. expert and
non-expert). See § 1.02[5]-[9]. In limited circumstances, a Section 11
plaintiff must prove reliance. If the plaintiff "has acquired the security
after the issuer has made available to its security holders an earning
statement covering a period of at least twelve months beginning after the
effective date of the registration statement," the plaintiff must
establish that he has relied upon the misrepresentation or omission.
Section 12(a)(2) of the
Securities Act of 1933 provides that a person who "offers or sells" securities "by means of a prospectus" that misrepresents or omits a
material fact is "liable to the person purchasing such security from him."
15 U.S.C. § 771 (1981). See § 1.03[1]. Accordingly, the courts interpret
§ 12(a)(2) as having an express privity requirement, giving a cause of
action only to individuals who purchase securities directly from a person
who sells the securities by means of a prospectus. Joseph v. Wiles, 223
F.3d 1155, 1161 (10th Cir.2000). See § 1.03[2]. The definition of a seller
of securities extends " 'to the person who successfully solicits the
purchase [of securities], motivated at least in part by a desire to serve
his own financial interests or those of the securities owner.' " Maher v.
Durango Metals, Inc., 144 F.3d 1302 (10th Cir.1998) (quoting Pinter v.
Dahl, 486 U.S. 622, 647, 108 S.Ct. 2063, 100 L.Ed.2d 658 (1988)). [FN4]
See § 1.03[3]. In Gustafson, the Supreme Court held that the "word
'prospectus' is a term if art referring to a document that describes a
public offering of securities by an issuer or controlling shareholder.' "
Id. at 584, 115 S.Ct. at 1073-74. The Court concluded that the private
sales contract did not fall within this definition and, therefore, was not
a prospectus for the purposes of Section 12(a)(2). Defendants in a Section
12(a)(2) action can defend on the grounds (but have the burden of proof)
that “that he did not know, and in the exercise of reasonable care could
not have known, of such untruth or omission,” Can also defend on causation
grounds (i.e. misrepresentation did not cause plaintiff’s loss).
See
§ 1.02[10]. Section 15 of the 1933 Act, 15 U.S.C. § 77o, extends Section 11
and 12 liability to persons who control other persons liable under those
sections. See § 1.02[14].
To get a better feel for
the substantive law we take a look at two complaints filed by Milberg
Weiss. Click HERE to go to the Footstar complaint and
click HERE
to go to the SeaChange complaint. Use
the Find icon on the Toolbar or Ctrl+F to navigate.] Keep in mind that Milberg Weiss may be the leading class action firm, and it is hard to
argue with success, but their complaints have been criticized by a number
of courts because of their redundancies, prolixity, inflammatory language,
etc., etc. Peruse the Footstar
Complaint, noting that beginning at paragraph 21 under the caption
Substantive Allegations allegations to the effect that Footstar’s filed
reports and public releases were materially false and misleading because
of failure to disclose $35 million understatement of accounts payable;
lack of internal controls resulting in overstating balance sheet and
financial results. Other allegations under this caption spell out the
theory of the case. For good measure, however, go to the caption Scienter
Allegations beginning at paragraph 39. Then to caption Applicability of
Presumption of Reliance:Fraud on the Market Doctrine at paragraph 40. Then
to caption NO SAFE HARBOR at par. 42 with allegations rebutting the safe
harbor for forward-looking statements. Then to first claim (10b-5 claim)
at par. 49, realleging prior allegations and summarizing basis for Rule
10b-5 claim. Second Claim, beginning at paragraph 54 setting forth Section
20(a) claim against individual defendants alleging controlling person
liability. Again, this is not a model of plain English and may or may not
meet the pleading requirements of Rule 9(b) and the PSLRA, but at the
moment we are interested only in becoming familiar with the elements of a
Rule 10b-5 claim.
With a similar purpose in
mind we take a look at the complaint in SeaChange in which Section 11,
12(a)(2), and 15 claims under the Securities Act are asserted. Paragraph 6
alleges that plaintiff purchased stock “pursuant to the materially false
and misleading prospectus.” This is a significant allegation and is stated
vaguely to avoid the critical issue of whether it was purchased in the
offering covered by the registration statement or in the aftermarket.
There are some differences among the courts, although the better view is
that an aftermarket purchaser can assert a claim if s/he can trace the
shares back to the offering covered by the registration statement (see
§ 1.02[2]);
something not readily done in connection with a secondary offering, which
is the case here as it already was a public company at the time of the
offering in question. Note in paragraphs 7 through 18 the parties named as
defendants. Go to the Substantive Allegations beginning at paragraph 26.
Skim those under Background Facts, but note at paragraph 32 that nCube had
filed the patent infringement action on January 8, 2002 and at paragraph
35 that the prospectus/registration statement became effective on January
29. Note at paragraph 42, that on May 28, 2002, a jury found SeaChange had
infringed nCube’s patent, awarded $2 million in damages and that SeaChange
would have to pay nCube a 7% royalty, which at paragraph 44 became over
$31 million for reasons noted there. Beginning at paragraph 45 the
Complaint alleges the respects in which the prospectus was materially
false and misleading, which is the basis for the Section 11 claim. Count I
summarizes and sets forth the elements of the Section 11 Claim. Paragraph
68 again is vague as to what shares Plaintiff acquired (shares issued
pursuant to and in reliance on the registration statement). Count II
alleges a Section 12(a)(2) claim against the underwriters as sellers (par.
73) on
behalf of plaintiffs and other members of the class purchased or
otherwise acquired the shares pursuant to the defective prospectus (par.
76). Again,
do not take this as a model. A number of issues can be and probably will
be raised; particularly, with respect to the pleading of the Section
12(a)(2) claims in which it is even less clear whether purchasers in the
aftermarket can assert a claim and who is a seller for Section 12(a)(2)
purposes. The Section 12(a)(2) claims essentially are redundant if
plaintiff prevails on the Section 11 claims, although there may be a
difference with respect to damages. Count III is the controlling person liability claim
asserted against individual defendants based on Section 15 of the
Securities Act, which imposes joint and several liability on controlling
persons with persons liable under Sections 11 or 12 unless the controlling
person had no knowledge of or reasonable ground to believe in the
existence of the facts by reason of which the liability of the controlled
person is alleged to exist.
Based on the foregoing, be
prepared to discuss the elements of a Rule 10b-5, Section 20(a), Section
11, Section 12(a)(2), and Section 15 claim that are highlighted above.
With respect to some of the less apparent allegations, consider the
following:
(1) Plaintiff alleges at part. 68 of Count I of the SeaChange complaint
that plaintiff acquired shares issued pursuant to and in reliance on the
registration statement. Was the allegation as to reliance necessary?
Under what circumstances might it be necessary? See
Section
11(a).See § 1.02[ 2][a].
(2) What is the purpose of the allegation in Count
I (par. 70) at the time they purchased the shares were without knowledge
of the facts concerning the wrongful conduct? Is it a
necessary allegation? See § 1.02[7].
(3) Count I, Par. 69 of the SeaChange complaint alleges
that plaintiff and the class sustained damages and the value of the
shares declined substantially due to defendants violations. Does this
make any sense in view of the fact that
Section 11(e) specifies how
damages are to be measured. See § 1.02[12]. Would it be a defense as to both the
Section 11 and Section 12(a)(2) counts that the loss in value of the
SeaChange stock was due to the general decline in the economy and its
impact on technology sector as reflected by the general decline in stock
prices and technology stocks in particular? See
Section
11(e). Section
12(b). See § 1.02[10]. See
§ 1.03[7]. Has plaintiff muddied the waters by alleging
defendants caused plaintiffs' damages?
(4) What other unnecessary allegations are included in Count I
of the complaint in SeaChange?
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