Securities and Shareholder Litigation & Class Actions

Section 12(a)(2) Sellers, Materiality, Reasonable Care and Morrison

The Second Circuit, in Federal Housing Fin. Agency v. Nomura Holding America, Inc., No. 15-1872-cv(L) (2d Cir. Sept. 28, 2017), affirmed a bench trial verdict of over $800 million against two investment banks on behalf of the Federal Housing Finance Agency, on behalf of two government-sponsored enterprises (GSEs) who purchased mortgage-backed securities (MBS) in private label offerings (PLS) between 2005 and 2007. The Second Circuit upheld awards of rescissionary damages under Section 12(a)(2) and analogous provisions of the Virginia and D.C. Blue Sky laws, based largely on claims that the Prospectus Supplements for the MBS misrepresented the originators’ compliance with their own loan underwriting guidelines. The 151-page opinion, addressing a battery of arguments, covers many issues of specific interest to participants in MBS litigation, but a handful of the issues raised are of more general interest.

Issuers as Sellers

Following the Supreme Court’s 1988 decision in Pinter v. Dahl, many courts concluded that the issuers of securities were generally not “sellers” for the purposes of Section 12 claims where the securities were brought to market by underwriters or other intermediaries. Unhappy with these decisions, the SEC in 2005, issued Rule 159A, purporting to “clarify” that issuers are sellers. But a number of district courts have declined to defer to the SEC’s interpretation, especially given that Section 12 creates a private cause of action rather than one enforced by the SEC; no other Circuit has yet addressed the question. The Second Circuit, without addressing those decisions or their reasoning aside from its conclusion that Pinter found the language of Section 12 ambiguous, held that Rule 159A made issuers are statutory sellers for Section 12 purposes. Slip op. at 104-05. While the court’s decision rested in part on the fact that the rules designating MBS depositors as issuers “locate depositors within the selling process” and that “depositors play an essential role in [private label MBS] distribution schemes,” it did not explicitly limit its conclusion that Rule 159A was decisive of the question to the private label MBS context. 

Materiality

The court ruled on three general points regarding materiality. First, the Second Circuit found that the district court properly used a five percent numerical threshold. As the court noted, the use of a “partially quantitative” materiality analysis is proper so long as it is not treated as conclusive, and the Prospectus Supplements here had themselves used such a threshold, which the number of non-conforming loans “far exceeded”. Id. at 121-24.

Second, the court rejected the argument that Prospectus Supplements received after the trade date were not material, given that “[e]ach transaction was conditioned on Defendants’ promise that the ProSupp would not reveal a material difference between the true character of the supporting loans and those described in the free writing prospectus,” if the GSEs had the “opportunity to reassess” their purchase decisions after receiving the Prospectus Supplement. Id. at 127. As the court found, “[t]he ProSupps were the sole Section 10(a) prospectuses delivered in these transactions,” so the SEC’s permission to make sales in a “fluid process” based on a free writing prospectus under Rule 164 would otherwise leave investors with no Securities Act remedy at all. Id. at 126-29.

Third, the court departed from a number of its past decisions and those of other Circuits — without citing any of them — in rejecting the view that it should consider materiality in the context of “a reasonable investor with the GSEs’ knowledge and investment purposes, rather than a reasonable generic buyer of PLS certificates,” and instead applying a standard under which the plaintiff’s investment goals have no role to play in the reasonable investor test in this case. A court is not required to import the subjective motives of a particular plaintiff into its materiality analysis. The reasonable investor was designed to stand in for all securities offerees, whose purposes for investing and experiences with financial products may vary. Limiting the reasonable investor’s intentions and knowledge to the plaintiff’s subjective features would undermine that design.

Id. at 129, 131 (bold added; italics in original). Instead, the court concluded, the context-specific aspects of materiality are those that relate to “the objective features surrounding the sale and the seller.” Id. at 132 (italics in original).

Sellers’ Reasonable Care

The court upheld the district court’s grant of summary judgment dismissing the defendants’ reasonable care defense, while noting how few decisions had done so and cautioning that “[t]his raises a classic, mixed‐law‐and‐fact question of reasonableness, usually committed to a jury. For that reason, only in the rare case can a court, viewing the facts in light most favorable to defendants, resolve the reasonable care defense as a matter of law.” Id. at 70. Applying cases under both Section 11 and Section 12, the court cautioned that “[s]pecific review standards depend on the type of product offered,” and “[t]he nature of the defendant’s position within a given transaction also affects the standard of care.” Id. at 84. The court then elaborated on how a context-specific inquiry is affected by the appearance of “red flags”:

Unaffiliated underwriters are often the sole adversarial entities in a securities distribution. As a result, they assume a unique role…. Whether a defendant learns or should learn of alarming information that suggests a violation of the securities laws—so-called “red flags”—and how the defendant responds are perhaps the most important considerations in assessing reasonable care…. Reasonable care requires a context — appropriate effort to assure oneself that no such red flags exist. If a defendant encounters red flags, reasonable care mandates that it examine them to determine whether the offering documents contain a material falsehood and, if so, to correct it…. An RMBS seller must conduct further review when warranted in order to provide reasonable assurance that the offering documents are accurate in all material respects.

Id. at 85-86 (emphasis added; quotations and citations omitted). The court also cautioned that compliance with industry standards may not always be a defense and that, in any event, the court’s assessment of the defendants’ loan-level reviews, id. at 87-91, led it to conclude that they did not show that they complied fully with such standards:

[I]ndustry standards and customs are highly persuasive in setting the standard of care, but they are not controlling…. As Judge Hand famously explained…, in exceptional cases “a whole calling [or industry] may have unduly lagged in the adoption of new and available devices. It never may set its own tests, however persuasive be its usages. Courts must in the end say what is required.…” The reasonable care standard will not countenance an industry‐wide ‘race to the bottom’ to set the least demanding standard to assess its conduct…. Thus, particularly where the industry was comprised of only a few participants who controlled the practice, and where industry practices have not previously survived judicial scrutiny, … custom is less persuasive evidence of reasonable prudence. But…[c]ourts will not lightly presume an entire industry negligent.

… [Defendants’] argument is tellingly limited. Defendants do not contend that every choice they made was in keeping with best practices in the PLS industry, nor do they suggest that their actions, on the whole, were consistent with industry customs. They pick and choose instances of conduct that they claim met the standards of the industry. A seller’s scattershot compliance with industry custom does not deprive a plaintiff of a Section 12 remedy.

Id. at 86, 91 (emphasis added; alterations, quotations and citations omitted). The court also had no doubt that, had they exercised reasonable care, Defendants could have learned that a material number of the loans were not originated in accordance with the underwriting guidelines. This is not a case where Defendants incorrectly forecasted a future occurrence or inaccurately assessed the future impact of a past event. The relevant information in this case was static and knowable when Defendants securitized the loans and wrote the ProSupps. At that time, the manner in which the loans were originated had already occurred — they had been issued either in accordance with the underwriting criteria or not. And it was possible for Defendants, who owned the loans and regularly conducted business with third‐party vendors that perform re‐underwriting analyses, to learn whether they were.

Id. at 92-93 (emphasis added).

Plaintiffs’ Knowledge

The court concluded, after a detailed discussion of matters such as the GSEs’ counterparty reviews of the originators, general knowledge of the industry and credit downgrades, that the district court had properly ruled at summary judgment the GSEs were not on notice for statute of limitations purposes and that they had proven they did not have actual knowledge of the misrepresented facts. Id. at 49-70. Among other things, the court took note of the fact that the GSEs’ insider-trading compliance rules barred their traders from investigating loan-level information. Id. at 54. The court’s description of the Section 12(a)(2) legal standard is notable on two points.

First, the court emphasized that while “Section 12 does not require the plaintiff to undertake any investigation or prove that it could not have known the falsity of the misstatement at issue,” and is thus neither a reliance requirement nor a constructive knowledge standard, “[a]ctual knowledge may be proven or disproven by direct evidence, circumstantial evidence or a combination of the two,” including consideration of publicly available information. Id. at 65. Second, the court was also careful to distinguish the proof needed to show actual knowledge on the merits from the proof needed to show that actual knowledge would be an individualized issue, thus precluding class certification in a Section 12(a)(2) case. Id. at 67-68.

Territoriality Under Morrison

The Second Circuit found that the GSEs had presented sufficient evidence of the location of purchases in Virginia and D.C. to satisfy the territorial jurisdiction of their Blue Sky laws, a holding that is noteworthy because the court used the Second Circuit’s Absolute Activist test — which governs the territoriality of securities transactions for Section 10(b) purposes under Morrison. Specifically, the court found that the GSEs had not shown that the defendants had “incur[red] irrevocable liability” to sell the MBS in either jurisdiction, they were able to satisfy Absolute Activist by proof that the GSEs “incurred irrevocable liability to purchase” at their respective offices, based on proof that (1) their principal place of business was there; (2) their traders worked there; (3) the traders received emails from the banks at their work email addresses and thus presumably opened the emails there; and (4) the banks sent physical trade confirmations to the GSEs’ headquarters. Id. at 143-47.

Other Holdings

Addressing numerous other issues raised on appeal, the court held:

•  The statements in the relevant Prospectus Supplements were false; specifically, statements that loans were originated “generally” in accordance with underwriting guidelines were false where the originators materially deviated, and were actionable even where the GSEs did not specifically know the content of the guidelines. Id. at 105-120.
• The defendants had failed to carry their burden of proving that the GSEs’ losses were caused by the overall housing crisis rather than the poor quality underwriting of the specific MBS. Id. at 135-42. The court noted that the defendants’ experts had attributed “the entirety of the Certificates’ losses” to the crisis, and that the lower court had found that the defendants “failed to disaggregate the crisis from the ProSupps’ misstatements,” leaving the court with an “all-or-nothing” choice, under which it had properly concluded that negative loss causation could not be shown where the defendants’ conduct was “intimately intertwined” with the causes of the macroeconomic event. Id. at 141-42 (emphasis in original).
• The Housing and Economic Recovery Act of 2008 (HERA) displaces the federal and state statutes of limitations for actions brought by the FHFA, id. at 37-49, and no presumption against preemption (normally applicable to Blue Sky laws) applies in this analysis. Id. at 43 n. 30.
• Section 12(a)(2) claims do not give rise to a right to a jury trial under the Seventh Amendment, notwithstanding the addition of a common-law style loss causation defense. Id. at 93-101.

Finally, the Second Circuit explicitly declined to resolve three questions: whether the Virginia and D.C. Blue Sky laws require a showing of loss causation, id. at 14 n. 9; whether Merck applies to Section 13 of the Securities Act, id. at 59 n. 37; whether or how the Section 11 due diligence standard differs from Section 12’s reasonable care standard, id. at 82 n. 45; and whether the plaintiffs could have proven loss causation under Section 10(b) on the same facts, given the differing burden of proof. Id. at 139 n. 74.

https://perma.cc/FF85-6JAP

Insider Trading and Tipping

A divided panel of the Second Circuit, in United States v. Martoma, No. 14‐3599 (2d Cir. Aug. 23, 2017), explicitly overruled a prior panel decision in United States v. Newman in affirming a Section 10(b) insider trading conviction of a tippee and, in so doing, raised serious questions about the continuing viability in the Second Circuit of long-standing interpretations of the insider trading tipping rules set forth by the Supreme Court in SEC v. Dirks. The defendant in Martoma has since sought en banc review.

Dirks grounded tipping liability in the traditional bar on corporate fiduciaries personally profiting from corporate property, including inside information. To prevent insiders from doing indirectly what they could not do directly, it was also necessary to bar them from tipping others in exchange for some pecuniary or equivalent benefit from the tip. Dirks further noted that the same principle would be violated when “an insider makes a gift of confidential information to a trading relative or friend.” But if every tip is covered by the concept of a “gift,” there is nothing left of the “personal benefit” rule, so Newman had clarified that the “gift” rule does not apply “in the absence of proof of a meaningfully close personal relationship [between the tipper and tippee] that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” The Supreme Court, in an intervening decision in Salman v. United States, held that the Newman rule did not apply to a close personal relationship between brothers, but did not address Newman’s application to the sorts of casual friendships and business relationships that had given rise to Newman.

The facts of Martoma, as the Second Circuit framed them, represented the opposite pole: the tipping doctor — who had inside information about a drug clinical trial — was a regular, paid consultant for the tippee portfolio manager, easily satisfying Dirks:

Martoma was a frequent and lucrative client for Dr. Gilman, who was paid $1,000 per hour for approximately 43 consultation sessions. At the same time, Dr. Gilman was regularly feeding Martoma confidential information about the safety results of clinical trials…in the context of their ongoing relationship of quid pro quo, where Dr. Gilman regularly disclosed confidential information in exchange for fees, a rational trier of fact could have found the essential elements of the crime of insider trading beyond a reasonable doubt under a pecuniary quid pro quo theory.

Slip op. at 5-6, 18-19 (emphasis added: quotations and citations omitted).

Nonetheless, because the defendant challenged the failure to instruct the jury on the Newman rule, the court proceeded to analyze its viability after Salman, and held that “Newman’s ‘meaningfully close personal relationship’ requirement can no longer be sustained [because] Salman fundamentally altered the analysis underlying” it. Id. at 19-20, 24. Instead, the panel majority apparently accepted the argument that the government had presented in Salman and that the Salman Court had not adopted:

 [T]he straightforward logic of the gift‐giving analysis in Dirks, strongly reaffirmed in Salman, is that a corporate insider personally benefits whenever he “disclos[es] inside information as a gift . . . with the expectation that [the recipient] would trade” on the basis of such information or otherwise exploit it for his pecuniary gain. Salman, 137 S. Ct. at 428. That is because such a disclosure is the functional equivalent of trading on the information himself and giving a cash gift to the recipient. Nothing in Salman’s reaffirmation of this logic supports a distinction between gifts to people with whom a tipper shares a “meaningfully close personal relationship”....

Id. at 25 (emphasis added). Notably the ellipsis in the quote from Salman excises the words “to his brother.” 

Second Circuit precedent had previously imposed this expectation-of-trading rule as a separate element, and the panel offered, as examples of situations that would not equal a personal benefit, only situations where the tipper did not expect the tippee to trade. Id. at 29. Instead, under Martoma, it would appear that tipping can be found whenever an insider “disclos[es] inside information to an outsider as a gift with no legitimate corporate purpose.” Id. at 34. Nonetheless, the court insisted that

[t]here may also be other situations in which the facts do not justify the inference that information was disclosed “with the expectation that [the recipient] would trade on it,” Salman, 137 S. Ct. at 428, and that the disclosure “resemble[s] trading by the insider followed by a gift of the profits to the recipient,” id. at 427 (quoting Dirks, 463 U.S. at 664). As a result, our holding does not eliminate or vitiate the personal benefit rule; it merely acknowledges that it is possible to personally benefit from a disclosure of inside information as a gift to someone with whom one does not share a “meaningfully close personal relationship.”

Id. at 29-30 (bold added; italics in original). This disjunctive formulation appears repeatedly in the opinion, yet the court does not clarify what “resemblance” to a gift requires.

https://perma.cc/N964-N6H4

SLUSA Dismissals Without Prejudice and False Promises

The Ninth Circuit, in Hampton v. Pacific Inc. Mgmt. Co. LLC, 2017 WL 3623284 (9th Cir. Aug. 24, 2017), deepened a Circuit split by holding that “dismissals pursuant to SLUSA’s class-action bar must be for lack of subject-matter jurisdiction — and therefore without prejudice — rather than on the merits.” Slip op. at 4-5. The court thus concluded that a motion to dismiss under SLUSA in the Ninth Circuit should properly be brought under Rule 12(b)(1).

As the court noted, prior Ninth Circuit decisions had assumed but never explicitly decided whether an SLUSA dismissal should be treated as a dismissal on the merits. The Second and Third Circuits at least arguably treat such dismissals as jurisdictional and without prejudice, while the Seventh Circuit has held that they are on the merits and thus with prejudice. Id. at 6-7. The court stressed the statutory language:

The critical language here is SLUSA’s command, codified as an amendment to the 1933 Securities Act, that “[n]o covered class action . . . may be maintained in any State or Federal court” if it meets the statute’s various requirements. 15 U.S.C. § 77p(b) (emphasis added). At the time SLUSA was enacted in 1998, language specifying that an action could not be “maintained” in federal court had long been construed as jurisdictional.... Where a long line of Supreme Court decisions holding specific language to be jurisdictional has been left undisturbed by Congress, and used in a subsequent statute, it is difficult to escape the conclusion that when Congress used the same language, it clearly intended the same result.... To the extent that SLUSA bars [plaintiff’s] suit, it does so by depriving the district court of jurisdiction to hear his state-law claims on a class-wide basis....

Id. at 7-8 (italics in original; bold added; internal quotations and citations omitted). While the court found that any amendment would be futile, going forward, a dismissal without prejudice meant that plaintiff “is free to return to the district court (or depart for an appropriate state court) to replead his state-law claims on an individual basis, or to plead new federal securities claims either as an individual or as a class representative.” Id. at 8. (Note that repleading barred class claims in state court, however, could lead to a successive removal and dismissal under SLUSA).

http://cdn.ca9.uscourts.gov/datastore/opinions/2017/08/24/15-56841.pdf

In a related, unpublished order the same day, at 2017 WL 3638419, the Ninth Circuit also held that a class claim could not be stated for a fund’s breach of contract in failing to follow its stated investment objectives, without running afoul of SLUSA’s bar on state-law misrepresentation claims in securities cases masquerading as breach of contract claims: “Because the representations in the Fund’s prospectus were made continuously throughout the class period, it would be impossible for [plaintiff] to plead that [defendant’s] investment practices diverged from its public statements without creating a likelihood that those statements were false at the time they were made.” Id. at *3.

Section 29(b) and Releases

The Second Circuit, in Pasternack v. Shrader, Nos. 16-217 et al. (2d Cir. July 13, 2017), held that Section 29(a) of the Securities Exchange Act of 1934 invalidated a release of securities fraud claims given as part of a transaction, rather than in exchange for a later release of litigation. Pasternack arose from a former officer’s sale of common stock in his privately held former employer in connection with the sale of a division of the business. Slip op. at 4-6. As part of that sale, every selling shareholder executed a release in which he,

to the fullest extent permitted by applicable law, hereby releases and forever discharges [the employer and its affiliates, directors and officers] . . . from any and all claims, demands, proceedings, causes of action . . . whether known or unknown, suspected or unsuspected . . . by reason of, relating to or arising from the fact that the undersigned is or was a stockholder of [the employer] . . . or any other rights with respect to or with a value derived from or other interest in any equity of [the employer].

Id. at 13. The Second Circuit found that any such release is, under Section 29(a), “invalid, absent an exception to the general rule that blanket releases accompanying the sale of securities are void.” Id. at 14. And it concluded that a valid release will generally require the release of “a pre-existing securities claim,” typically in exchange for some additional consideration, rather than a waiver at the time of the transaction:

[A] waiver signed in the context of a settlement agreement may release securities-fraud claims.... And it is certainly possible that a release signed outside the context of settlement could serve the same function…. But such instances, properly understood, are not “exceptions.” What the antiwaiver provision of § 29(a) forbids is enforcement of agreements to waive ‘compliance’ with the provisions of the statute…. The sale of securities conditioned on the buyer’s complete release of the seller would in effect license non-compliance with the securities laws, in violation of § 29(a). A release signed in the context of negotiations to settle an alleged securities violation cannot be said to “waive compliance” with the securities laws; the aggrieved party receives an agreed remedy for an alleged securities violation, and that remedy satisfies “compliance” with the securities laws…. [A] release signed outside a settlement context might be enforceable because the releasor would essentially be using an alleged securities violation as a bargaining chip to receive some remedial benefit. In short, as a general principle, whenever a party offers consideration to another in order to remedy an alleged violation of the securities laws, acceptance of that offer in exchange for a release of securities-fraud claims is tantamount to establishing “compliance” with the securities laws. Such contracts do not run afoul of § 29(a).

Id. at 15-16 (emphasis added; quotations and citations omitted). While “[t]here may be exceptions to this general rule,” the court found no need to explore them in light of the fact that all sellers executed the same release, as a required condition of the transaction and received no compensation except for the per-share price. “In short, though [the seller] received $20 million by signing the Letter and selling his shares, no part of the transaction constituted consideration (in whole or part) for a securities claim.” Id. at 17. The court did, however, find that the release eliminated the plaintiff’s RICO and common law claims, noting in particular that because RICO bars any claim based on securities fraud as a predicate act, Section 29(a) could not bar the release of anything that could serve as a predicate act for a RICO claim. Id. at 17-18.

The court also held that the five-year statute of repose did not bar securities claims where the plaintiff timely requested leave to amend to add such claims, even though the court did not grant the motion within the period: “Under [defendant’s] theory, a plaintiff that requests leave to amend a complaint years in advance of the expiration of the statute of repose would still be barred from bringing the suit if the district court sat on the motion for years without fault of the plaintiff. However, for purposes of a statute of repose, when a plaintiff moves for leave to amend to add claims within the limitations period and attaches a proposed amended complaint to the motion, the claims are timely.” Id. at 20.

https://perma.cc/S25G-K485

Spokeo and Breach of Contract

The Eighth Circuit, in Kuhns v. Scottrade, Inc., No. 16-3426 et al. (8th Cir. Aug. 21, 2017), dismissed a breach of express or implied contract claim based on a data security breach, but only after finding that a claim for breach of contract creates Article III standing to sue after Spokeo even if the theory of breach is insufficiently plausible to survive a Rule 12(b)(6) motion to dismiss.

The plaintiff brokerage firm customers sued their broker under Missouri law after it suffered a data breach by hackers. The Eighth Circuit rejected the effort to extend Spokeo — which held that Article III standing may not exist in every case where a federal statute is violated — to breaches of contract:

Kuhns alleged that he bargained for and expected protection of his PII, that [defendant] breached the contract when it failed to provide promised reasonable safeguards, and that Kuhns suffered actual injury, the diminished value of his bargain. Whatever the merits of Kuhns’s contract claim, and his related claims for breach of implied contract and unjust enrichment, he has Article III standing to assert them. 

Slip op. at 6-7. But the claim was dismissed anyway. The brokerage agreement — while it incorporated a “privacy statement” — was not actually a contract for privacy services:

The Complaint alleged that Kuhns overpaid [defendant] because a portion of its services were for data management and security. But the Brokerage Agreement expressly provided for the purchase and sale of brokerage services in executing securities transactions “on a per order basis.” Given the express terms of this contract, the allegation that the failure of [defendant’s] security measures was a breach of contract that diminished the benefit of Kuhns’s bargain is not plausible.

Id. at 9 (emphasis added). The court also noted that a breach of contract claim could not be stated from a data breach without two crucial allegations: (1) that the defendant actually failed to provide the promised protection services (which could not be shown just from the fact of the hack); and (2) that the plaintiff suffered any loss from the stolen information. Id. at 8-9. Finally, the court rejected a request for a declaratory judgment: “[plaintiff] cites no precedent for the notion that the Declaratory Judgment Act provides federal courts with authority to order a party to ‘obey your contract.’” Id. at 10.

http://media.ca8.uscourts.gov/opndir/17/08/163426P.pdf