Northwest Business Litigation

Supreme Court issues limited ruling against Sarbanes-Oxley Board

Last week the U.S. Supreme Court excised a relatively minor portion of the Sarbanes-Oxley Act, leaving intact much of that wide-ranging corporate reform law.  In Free Enterprise Fund v. Public Company Accounting Oversight Bd., the Court declared the legal structure of the Act's enforcement body, the Public Company Accounting Oversight Board ("PCAOB"), unconstitutional as violating separation of powers. 

Under the Sarbanes-Oxley Act, members of the PCAOB may be removed from office by members of the Securities and Exchange Commission ("SEC") only for good cause.  Members of the SEC, in turn, may be removed by the President only for good cause.  The Court found that Congress violated the Constitution by placing these "two layers" of protection from removal between the President and the members of the PCAOB.  Chief Justice John Robers, writing for the Court, stated:

"[S]uch multilevel protection from removal is contrary to Article II’s vesting of the executive power in the President. The President cannot 'take Care that the Laws be faithfully executed' if he cannot oversee the faithfulness of the officers who execute them. Here the President cannot remove an officer who enjoys more than one level of good-cause protection, even if the President determines that the officer is neglecting his duties or discharging them improperly. That judgment is instead committed to another officer, who may or may not agree with the President’s determination, and whom the President cannot remove simply because that officer disagrees with him. This contravenes the President’s 'constitutional obligation to ensure the faithful execution of the laws.' ”

Despite the constitutional flaw in the PCAOB's make-up, the court did not do away with the board.  Instead, it ordered that PCAOB members must now be subject to removal at will by the SEC. 

U.S. Supreme Court favors plaintiffs on securities fraud statute of limitations

On Tuesday the U.S. Supreme Court addressed when a securites fraud claim accrues and the statute of limitations begins to run.  The plaintiff investors in Merck & Co. v Reynolds alleged that Merck & Co. knowingly misrepresented the heart attack risks associated with Vioxx.  Justice Breyer, writing for the majority, held that, due to delayed discovery of the claim, the two-year statute of limitations did not bar the investors from bringing a securities fraud action under Section 10(b) of the Securities Exchange Act. 

 

Claims by private plaintiffs under Section 10(b) must be brought no later than the earlier of "two years after the discovery of the facts constituting the violation," or five years after the violation.  28 U.S.C. § 1658(b). The Court held that the two-year period begins to run when a plaintiff actually discovers “the facts constituting the violation,” or when a reasonably diligent plaintiff would have discovered such facts—whichever comes first.  The court held that the limitations period does not begin to run at “inquiry notice,” or the point at which a reasonably diligent plaintiff would investigate the facts, because the point at which a plaintiff would begin investigating is not necessarily the point at which a plaintiff would discover “the facts constituting the violation.”

 

The Court rejected Merck’s argument that facts showing scienter—“a mental state embracing the intent to deceive, manipulate, or defraud”—are not among “the facts constituting the violation” for purposes of delayed accrual under § 1658(b).  Noting that “the state of a man’s mind is as much a fact as the state of his digestion,” the Court held that the “‘fact’ of scienter ‘constitut[es]’ an important and necessary element of a § 10(b) ‘violation.’”  The court held that it would frustrate the purpose of the discovery rule if the limitations period began to run before the plaintiff discovered any facts related to scienter. The court also held that facts tending to show a materially false or misleading statement were ordinarily insufficient to establish scienter; instead it is often necessary for plaintiffs to discover facts specifically related to a defendant’s state of mind.

 

Justice Scalia, joined by Justice Thomas, concurred in part and concurred in the judgment.  Justice Scalia argued for an even more plaintiff-friendly result, stating that the statute of limitations should begin to run when a plaintiff actually discovers facts constituting the violation, rather than when a reasonably diligent plaintiff should have known such facts. 

No private right of action under Sarbanes-Oxley section 304, Ninth Circuit holds

In a case originating in the District of Oregon, the Ninth Circuit recently held there is no private right of action under Section 304 of the Sarbanes-Oxley Act, which provides for the forfeiture of bonuses and profits when corporate officers fail to comply with securities law reporting requirements.  In Diaz v. Davis, plaintiff asserted shareholder derivative claims against Digimarc Corporation and its officers and directors arising from accounting errors and a resulting restatement of earnings.  The Ninth Circuit is the first federal circuit court to address whether Section 304 creates a private right of action.

The Ninth Circuit also resolved an issue of subject matter jurisdiction in a derivative case.  While District Court Judge Ancer Haggerty correctly held that plaintiff had no claim under Section 304, the Ninth Circuit concluded that he erred in aligning the corporation with the plaintiffs, thereby eliminating diversity jurisdiction of the remaining state law claims.  Assessing the facts as of the date the suit was filed, the Ninth Circuit held there was antagonism between the derivative plaintiffs and the controlling members of Digimarc which required Digimarc to continue as a defendant.

Ninth Circuit outlines attorney liability for securities fraud

Today the Ninth Circuit Court of Appeals issued an opinion stating that an attorney who undertakes to make representations to prospective purchasers of securities can be liable for securities fraud under federal law if the representations turn out to be false. 

In Thompson v. Paul, the defendant attorney represented a company that was preparing to issue stock to plaintiff as part of a litigation settlement. Plaintiff claimed she agreed to accept the stock based on a representation by the attorney that the company's CEO was not under criminal investigation.  When the CEO was indicted three days later, the stock price dropped and plaintiff sued the attorney for securities fraud.  The attorney argued that he owed no duty to plaintiff, but only to his client, the issuer of the stock.  The Ninth Circuit disagreed, holding that the attorney-client relationship does not shield an attorney from liability to third parties under Section 10(b) of the Securities Exchange Act. 

Ninth Circuit fine tunes the pleading standard for securities fraud

Last week, the Ninth Circuit, in South Ferry LP v. Killinger, limited the use of the "core operations inference" to meet the heightened pleading standard of the Private Securities Litigation Reform Act in alleging securities fraud by a corporation's management.

The "core operations inference" is the principle that facts critical to a business's "core operations" or important transactions are known to key company officers when making statements about company operations that later turn out to be wrong or misleading.  Plaintiffs in a securities fraud case may seek to use that inference to show defendants' state of mind in making the false statements.  However, as explained by the Supreme Court in the 2007 case Tellabs, Inc. v. Makor Issues and Rights, Ltd., the PSLRA requires plaintiffs alleging securities fraud to plead facts that give rise to a "strong inference" of knowing or intentional misconduct that "must be cogent and compelling, thus strong in light of other explanations."  Given this guidance from the Supreme Court, the Ninth Circuit held that, in most circumstances, plaintiffs could not rely on the core operations inference alone to meet the PSLRA pleading standard.  Instead, the inference may be one of several factors that a district court considers as part of a holistic approach to evaluating a complaint.  In limited cases the inference might independently satisfy the PSLRA.  The court explained:

"In summary, allegations regarding management's role in a company may be relevant and help to satisfy the PSLRA scienter requirement in three circumstances.  First, the allegations may be used in any form along with other allegations that, when read together, raise an inference of scienter that is 'cogent and compelling, thus strong in light of other explanations.'  * * * This view takes such allegations into account when evaluating all circumstances together.  Second such allegations may independently satisfy the PSLRA where they are particular and suggest that defendants had actual access to the disputed information[.] * * * Finally, such allegations may conceivably satisfy the PSLRA standard in a more bare form, without accompanying particularized allegations, in rare circumstances where the nature of the relevant fact is of such prominence that it would be 'absurd' to suggest that management was without knowledge of the matter. "

U.S. Supreme Court declines to expand securities fraud liability

In the latest in a string of rulings favoring business interests, the U.S. Supreme Court held today that parties who did not directly mislead investors cannot be liable for securities fraud under SEC Rule 10b-5.  By a 5-3 vote, the court refused to recognize the concept of "scheme liability" as to third parties who participate in a fraudulent scheme but do not themselves issue a false statement.

See Justice Anthony Kennedy's opinion in Stoneridge Investment Partners v. Scientific-Atlanta here.  And see earlier discussion of the case in the Oregon Business Litigation Blog here.

U.S. Supreme Court considers landmark securities fraud case

On October 9, the U.S. Supreme Court hears oral argument in Stoneridge Investment Partners v. Scientific-Atlanta, which many view as the most important securities case in years.  At issue is the validity of "scheme liability" and whether third parties, such as financial advisors, auditors, attorneys, or vendors, who engage in allegedly fraudulent transactions with a public corporation, but who do not speak or provide financial statements or other disclosures to investors, can be held liable under SEC Rule 10b-5.

The bottom line is that a decision recognizing expanded liability under 10b-5 for third parties could have a potentially far-reaching impact, especially for auditors and lawyers who advise public corporations.  Find further discussion of the case and its implications here and here.

Defective notice blocks securities class action settlement

The Ninth Circuit today tossed out a $35 million securities class action settlement involving Veritas Software Corporation over a defective notice to class members.  In Petrone v. Malone, the court addressed a novel issue under the Private Securities Litigation Reform Act:  how must the notice of settlement describe the damages each member of the class will receive? 
Under the PSLRA, the notice must state the amount of settlement funds to be distributed on a per-share basis.  The notice at issue in Petrone calculated the per-share recovery with the unstated assumption that only 43% of the class members would file a claim for damages.  By failing to calculate the recovery based on all of the shares held by the class, the notice overstated the potential per-share recovery and violated the PSLRA. 

See our other coverage of securities fraud and the PSLRA here and here.

Supreme Court tightens pleading standards for securities fraud

On June 21, 2007, the United States Supreme Court issued an opinion in Tellabs, Inc v. Makor Issues & Rights, Ltd. which makes it more difficult for plaintiffs to state a claim for securities fraud under Section 10(b) of the Securities Exchange Act of 1934.  The Private Securities Litigation Reform Act of 1995 requires plaintiffs to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind" - i.e., an intent "to deceive, manipulate, or defraud."  In Tellabs, the Court stated that, to qualify as "strong," an inference of fraudulent intent must be more than merely plausible or reasonable - it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.  Accordingly, the Court must take into account plausible, nonculpable explanations for the defendant's conduct as well as inferences favoring the plaintiff.  In sum, "[a] complaint will survive . . . only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."

The Court rejected the argument that, by engaging in a comparative assessment of competing inferences, a court reviewing a securities complaint would usurp the role of the jury.  The Court explained that Congress, as creator of federal statutory claims, "has the power to prescribe what must be pleaded to state the claim, just as it has power to determine what must be proved to prevail on the merits."

From the plaintiffs' view, the decision is not as bad as it could have been.  Justice Scalia, in dissent, would have upheld an even stricter pleading standard.  Instead of letting plaintiffs proceed on the basis of an inference "at least as compelling as any opposing inference," Justice Scalia would have adopted a test of "whether the inference of scienter (if any) is more plausible than the inference of innocence."

Securities regulation trumps antitrust law, the Supreme Court holds

On Monday the U.S. Supreme Court held that joint activity in the underwriting of an initial public stock offering is immune from scrutiny under the antitrust laws.  In Credit Suisse Securities v. Billing, plaintiffs claimed that the underwriters of hundreds of IPOs acted together to drive up the fees they earned, in violation of federal antitrust law.  Justice Stephen Breyer, writing for the court, held that extensive regulation by the Securities and Exchange Commission of the underwriters' activities precluded the application of antitrust law. 

Justice Clarence Thomas was the sole dissenter.  He wrote that the claims must proceed because, according to the Securities Act of 1933, securities law remedies do not preempt other existing remedies, including those under the antitrust law.

See our earlier coverage of the case here.