Update on Recent Interpretations of Federal Securities Laws
This client alert concerns two recent significant federal court opinions regarding the application of the federal securities laws. These cases are of particular interest to those responsible for disclosure issues or for managing the risk of the sale of securities in private or public offerings.
The Sixth Circuit Limits the “Loss Causation Doctrine” and Elaborates on the Discovery Rule
In Nolfi v. Ohio Kentucky Oil Corp., ___ F.3d ___, 2012 WL 1109634 (6th Cir. April 4, 2012), the Sixth Circuit defined aspects of the application of two decisions of the United States Supreme Court regarding the federal securities laws: Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), and Merck & Co., Inc. v. Reynolds, 130 S. Ct. 1784 (2010). The Nolfi case concerned the sale of oil and gas interests that plaintiffs alleged were misrepresented and were actually shams with no worth. The jury found for the plaintiffs on their claim pursuant to Section 10(b) of the Securities Exchange Act and granted rescission of the investments.
In Dura, the Supreme Court held that a plaintiff asserting a claim under Section 10(b) must prove “loss causation” – i.e., that the loss the plaintiff suffered in the investment was caused by the alleged misrepresentation. The Sixth Circuit found that Dura was not applicable because that case concerned shares traded on the open market that had actual value, while Nolfi concerned the sale of worthless interests in an oil and gas venture. 2012 WL 1109634, *4. That conclusion led to the Nolfi court’s decision that rescission is an available remedy under Section 10(b), when the “plaintiffs have established that the loss was complete and was caused entirely by defendants’ misrepresentation.” Id., *9.1
In Merck, the Supreme Court held that inquiry notice of scienter was necessary before the two-year statute of limitations period for a Section 10(b) claim accrued. The Sixth Circuit recognized the difficulty the plaintiffs faced in obtaining facts from the defendants and held that “[b]ecause knowledge of the intent to deceive was not something the plaintiffs could have known prior to the state court discovery, pursuant to Merck, the statute of limitations did not begin to run until then.” Id., *6. Following Merck, the Sixth Circuit essentially held that the statute of limitations does not begin to run until the plaintiff has actual facts concerning scienter or could have had such facts with the exercise of “reasonable” diligence. Id. It seemingly is a rare situation that plaintiffs will be privy to such facts prior to commencing a lawsuit.
Judge Quist Provides Guidance on Various Section 10(b) Pleading Issues
In a lengthy decision that addresses many issues, Judge Quist of the Western District of Michigan dismissed a purported class action that alleged numerous claims under Section 10(b) of the Securities Exchange Act. City of Pontiac General Employees’ Retirement System v. Stryker, 2012 U.S. Dist. LEXIS 45069 (W.D. Mich. March 30, 2012). As described by the court, plaintiffs’ allegations concerned the proposition that Stryker achieved 20% annual earnings by systematically cutting corners on quality and regulatory compliance spending, which exposed Stryker to unnecessary risks of product recalls and “millions of dollars” in regulatory compliance costs. Plaintiffs attempted to support their allegations with confidential statements from witnesses. Plaintiffs conceded that the operational results Styker reported were accurate, but Plaintiffs contended that Styker failed to disclose, among other items, that the company’s financial results were achieved by cutting corners on quality control, certain facilities were materially not in compliance with FDA regulations, and the company had received warning letters for two of its facilities from the FDA, including an investigative notification.
Among his various holdings, Judge Quist found that “accurately reported financial information is not rendered misleading by a failure to disclose conditions that might render future results less favorable.” Id., *29. With respect to Plaintiffs’ allegations that the company’s affirmation that “the manufacturing and quality control procedures it employs meet the requirements of” the FDA was false, the court rejected those allegations as being “soft” information that are not actionable under Sixth Circuit precedent. 2012 U.S. Dist. LEXIS 45069, *31-32. The court further rejected those allegations based upon confidential witness statements because plaintiffs had not shown that upper-management was aware of quality and regulatory issues. Id., *32-33. The District Court also held that management’s awareness of, and failure to disclose, the fact that some of the company’s manufacturing facilities had received written notices of unsatisfactory conditions from the FDA (Form 483) did not render its affirmation to be misleading. Judge Quist observed that the FDA notice was not a final agency determination of noncompliance and did not need to be disclosed. Id.,*34-38. With respect to scienter, Judge Quist analyzed each allegation r—one-by-one – regarding upper management’s intent and rejected each one in turn. Id., at 54-64.
One takeaway from Stryker for the corporate attorney is that the decision supports the determination that a public corporation does not have a duty to disclose a SEC subpoena issued to the corporation, even if the subpoena is issued pursuant to a formal order that is investigating the conduct of the client corporation.2 For the litigator, one takeaway is the difficulty lower courts have in applying the approach to analyzing allegations regarding scienter set forth in the recent Sixth Circuit decision of Frank v. Dana Corp., 646 F.3d 954 (6th Cir. 2011). Dana held that district courts must take a holistic approach and review scienter pleadings based on a collective rather than individual view of the facts. While Judge Quist appears to be mindful of this requirement, his opinion reflects the challenge of applying the Dana approach because his analysis reads as a traditional individual evaluation of the facts, where each separate allegation is individually weighed on its merits.
1 The Sixth Circuit, however, cautioned: “We emphasize that rescission is a fact-dependent remedy for Section 10(b) claims and is likely only appropriate in rare or unusual circumstances.” 2012 WL 1109634, *9.
2 Of course, the corporation may have a duty to disclose depending on its previous public statements or its knowledge of a probable violation of the securities laws.