On July 7, the Second Circuit affirmed in part and vacated in part an order by Judge Rakoff of the S.D.N.Y. certifying two classes in the In re Petrobras Securities litigation, — F.3d –, 2017 WL 2883874 (2d Cir., July 7, 2017). In doing so, the Second Circuit joined several other circuits in declining to adopt a “heightened” version of the implied class certification requirement of ascertainability, which arose in the Third Circuit. Having rejected defendants’ arguments on this point, however, the Second Circuit applied Morrison v. National Australia Bank, 561 U.S. 247 (2010), in assessing whether the plaintiffs had met the predominance standard for class certification, and held that they had failed to do so, because individual questions of transactional domesticity—which under Morrison must often be considered when the territorial scope of the securities laws is at issueprevailed over common ones.

Petrobras is a multinational oil and gas company based in Brazil and majority-owned by the Brazilian government. Plaintiffs in Petrobras were holders of Petrobras equity and debt securities, who alleged that value of these securities fell dramatically following the revelation of a long-term money-laundering and kickback scheme at the company. Defendants included Petrobras and a number of its executives. In re Petrobras, 2017 WL 28883874 at *1.

The district court certified two classes of plaintiffs, the first asserting claims under the Exchange Act, and the second asserting claims under the Securities Act. On appeal, defendants challenged class certification on the grounds that (1) these classes were not sufficiently “ascertainable”; and (2) plaintiffs had not met the Rule 23(b)(3) requirement “that questions of law or fact common to class members predominate over any questions affecting only individual members.” In an opinion written by Judge Garaufis of the E.D.N.Y. (sitting by designation), and joined by Judges Hall and Livingston, the Second Circuit rejected defendants’ acertainability argument, but sided with them on their predominance argument. Id. Specifically, the court of appeals found that the district court had “erred in conducting its predominance analysis without considering the need for individualized Morrison inquiries.” Id. at *6.

The ascertainability requirement for class certification does not appear in Rule 23 itself, but is instead an “implied” mandate that a class be “sufficiently definite so that it is administratively feasible for the court to determine whether a particular individual is a member.” Id. at *5 (quoting Brecher v. Republic of Argentina, 806 F.3d 22 (2d Cir. 2015)). In several opinions, including Byrd v. Aaron’s Inc., 784 F.3d 154 (3d Cir. 2015), the Third Circuit has interpreted the ascertainability requirement as requiring a showing of administrative feasibility at the class certification stage—that is, a showing by plaintiffs that there will be an administratively feasible means of determining whether class members fall within the class definition. Petrobras, 2017 WL 2883874 at *11.

In Petrobras, the Second Circuit joined the Sixth, Seventh, Eighth and Ninth Circuits in rejecting this “heightened” ascertainability standard, and clarified its own ruling in Brecher, holding that ascertainability should not be evaluated with reference to administrative feasibility, but rather whether the proposed class is “defined by objective criteria.” Id. at *10. In Petrobras, this “modest threshold requirement” was met, because the proposed classes were concretely defined to include “persons who acquired specific securities during a specific time period, as long as those acquisitions occurred in ‘domestic transactions.’” Id. at *12.

Having rejected defendants’ arguments regarding ascertainability, however, the Second Circuit nonetheless vacated the district court’s certification order on the ground that it did not adequately consider domestic territoriality as defined by Morrison in evaluating the Rule 23 predominance requirement.

In Morrison, the Supreme Court held that the US securities laws are presumed to apply only to (1) transactions in securities listed on domestic exchanges; and (2) “domestic transactions” in other securities. In a subsequent case, Absolute Activist v. Ficeto, 677 F.3d 60 (2d Cir. 2012), the Second Circuit elaborated on the second prong of Morrison, holding that transactions in securities not listed on domestic exchanges are “domestic” if “irrevocable liability is incurred or title passes within the United States”; and also ruled that transactional domesticity is a “merits” question of the kind that can considered in a Rule 12(b)(6) motion.

In Petrobras, there was no doubt that the equity transactions at issue fell within Morrison’s first prong, given that the Petrobras equity securities were traded on the NYSE. There was also no doubt that the debt transactions did not fall within the first prong, since the debt securities did not trade on any U.S. exchange, and were instead traded on various over-the-counter markets. The hard question in Petrobras was whether the over-the-counter debt securities transactions fell into the category of “domestic transactions” notwithstanding the fact that they were not conducted on domestic exchanges—a question rendered more difficult by the fact that these transactions differed in their particulars. Id. at 3.

The district court did consider Morrison-based challenges to plaintiffs’ claims before issuing its class certification order, dismissing two named plaintiffs from the case after finding that their over-the-counter debt securities transactions did not qualify as domestic under Morrison and Absolute Activist. Id. at *7-8. But the Second Circuit nonetheless found that the district court did not adequately address Morrison in the certification context. Id. at *14-16.

Generally speaking, a plaintiffs seeking to demonstrate that a particular over-the-counter transaction was domestic may offer “evidence ‘including, but not limited to, facts concerning the formation of the contracts, the placement or purchase orders, the passing of title, or the exchange of money.’” Id. at *14 (quoting Absolute Activist, 677 F.3d at 70). As the Second Circuit observed in Petrobras, “these transaction-specific facts are not obviously ‘susceptible to [ ] class-wide proof.’” Id. (quoting Tyson Foods v. Bouaphakeo, 136 S.Ct. 1036, 1045-46 (2016)).

The district court approved two class representatives with claims based on over-the-counter transactions in debt securities. For each of these two plaintiffs, domesticity was not seriously at issue, as they placed their purchase orders in the United States and procured their securities directly from U.S. underwriters. But the Second Circuit described these two class representatives as “the easy case,” and concluded that the district court’s certification order “offers no indication that [it] considered the ways in which evidence of domesticity might vary in nature or availability across the many permutations of transactions in Petrobras Securities.” Id. at *15.

According to the Second Circuit, these likely intra-class differences give rise to a predominance problem, because “the investigation of domesticity appears to be an ‘individual question’ requiring putative class members to ‘present evidence that varies from member to member.’” Id. at *14 (quoting Tyson Foods, 136 S.Ct. at 1045). In this case, the Second Circuit concluded, “it cannot be said that the class members’ Morrison inquiries will ‘prevail or fail in unison.’” Id. at *16. On this basis, the Second Circuit vacated the district court’s certification of the two classes insofar as they included all otherwise-eligible members who acquired their Petrobras securities in “domestic transactions”—allowing, however, that the district court might, on remand, properly certify one or more classes that would capture some or all of the members of the vacated classes. Id. at *16.

Finally, the Second Circuit also addressed a ruling by the district court, with respect to the Exchange Act class, that plaintiffs were entitled to a presumption of reliance under the “fraud on the market” theory established in Basic v. Levinson, 485 U.S. 224 (1998). While the defendants pointed to the fact that plaintiffs provided no empirical data showing that the price of the relevant Petrobras securities moved up and down predictably in response to news about the company, the Second Circuit noted that such data may suffice but is not necessary to show market efficiency, and held that the district court properly considered other forms of direct and indirect evidence in ruling that the Basic presumption applied for purposes of class certification. Id. at *20.

The Second Circuit, affirming the Southern District of New York’s dismissal of a ’33 Act securities class action, reaffirmed that the Circuit’s operative test for determining the materiality of omissions is the test set forth in DeMaria v. Andersen, 318 F.3d 170 (2d Cir. 2003), and explicitly rejected the First Circuit’s test in Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996).  In refusing to adopt Shaw’s standard—known as the “extreme departure” test—the court endorsed a test that it determined to be the “classic materiality standard in the omission context” and rejected the test that it found to “leave too many open questions” and to be “analytically counterproductive.”

Stadnick v. Vivint Solar, Inc. is a putative class action alleging violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 based on Vivint Solar’s alleged failure to disclose financial results for the quarter that ended the day before Vivint’s IPO, as well as Vivint’s alleged misstatements regarding the company’s expansion in Hawaii for failing to disclose the impact of the state’s evolving regulatory scheme.

The company’s unique business model and accounting methods are key to the case and the court’s analysis.  Vivint’s business model operates by leasing solar energy panels to its customers and maintaining ownership of the underlying panels.  This model allows Vivint to capitalize on the tax credits associated with solar energy.  Vivint finances its company through outside investors, who invest the capital necessary to purchase tranches of solar energy systems.  The outside investors then receive title to the system they financed and receive most of the monthly lease payments until the system is paid off.  At that time, Vivint then starts to receive most of the revenue.  Based on this set up, Vivint’s income is accordingly allocated between its public shareholders and its outside investors.  To properly calculate this income, Vivint employs an accounting method that allocates the income between the shareholders and outside investors.  Due to Vivint’s business model and this accounting method, Vivint shows significant income fluctuations from quarter to quarter.  Vivint experienced one such dramatic income swing in the quarter directly preceding its IPO.

Vivint issued its IPO on October 1, 2014.  In its registration statement, Vivint set forth the financial results from the previous quarters and warned investors that its business model and accounting practices could impact the allocation of income between shareholders and outside investors.  It also listed the “key operating metrics” for evaluating the company’s financial performance.

Vivint disclosed the financial results for the third quarter on November 10, 2014.  In that disclosure, Vivint revealed a significant decline in income to shareholders.  Specifically, the net income to shareholders was measured at negative $35.3 million, down from $5.5 million in the previous quarter.  However, the results showed that despite this loss, Vivint’s “key operating metrics,” which the company previously had set forth as its measure for evaluating the company’s financial success, were strong.  For example, the company’s installations were up 137 percent from the previous year and its market share increased from 9 percent to 16 percent in that quarter.

The plaintiff brought suit following the decline in stock as a result of the third-quarter earnings announcement.  The plaintiff raised two omissions as the basis for his suit: (1) Vivint’s failure to disclose the third-quarter financial information and (2) Vivint’s failure to disclose the adverse impact of the regulatory oversight in Hawaii.

The Second Circuit focused primarily on this first argument, and used this case as an opportunity to clarify the Second Circuit’s operative test for material omissions.  The plaintiff urged the court to adopt the First Circuit’s “extreme departure” test in Shaw v. Digital Equipment Corp.  In Shaw, the First Circuit held that an omission was actionable under Section 11 if there was “substantial likelihood” that the withheld information would represent an “extreme departure” from the previous financial performance.  Adopting this test would be its own extreme departure—pun intended—from the Second Circuit’s test in DeMaria v. Andersen, which looked instead to whether the information would “significantly alter[] the ‘total mix’ of information available.”  Vivint proved to be an ideal opportunity for the Second Circuit to re-exam its standards as it provides a situation in which the income swings were great enough to be reasonably seen as an “extreme departure,” but the company’s clear formula for evaluating its own performance makes clear that other factors more accurately reflect the company’s true financial health.

The court undertook an analysis of the “extreme departure” test, and affirmatively rejected that test.  The court noted that the DeMaria test used the “classic materiality standard in the omission context.”  Focusing on how the First Circuit test would allow a plaintiff to meet their burden based on two narrow metrics—which would not properly give the entire picture—the court had harsh words for the First Circuit’s test, calling it “analytically counterproductive” and “unsound[],” and noting that it “confuses the analysis.”  Once reaffirming that the Second Circuit would continue to rely on the DeMaria test, the court concluded that Vivint’s omission was not material because shareholder income and earnings-per-share are not the best indicators of Vivint’s financial performance.  The court also noted that the registration statement clearly set forth that Vivint’s unique business model meant that shareholder revenue and earnings would fluctuate.

Plaintiff’s second argument was rejected without much analysis—the court even noted this argument was “tack[ed] onto his complaint”—as the court concluded that the plaintiff failed to show that the regulatory changes adversely affected Vivint’s Hawaiian operations and that Vivint had sufficiently warned investors that such changes could impact their Hawaiian presence.

In a 5-4 decision split along traditional ideological lines, the U.S. Supreme Court held in CalPERS v. ANZ Securities, Inc., 582 U.S. ___ (2017), that the statute of repose in Section 13 of the Securities Act cannot be tolled under any circumstances. In particular, the Court held that the 3-year repose period—unlike the 2-year limitations period set forth in the same section of the Securities Act—is not tolled by the filing of a securities class action under the principles of American Pipe & Constr. Co. v. Utah, 414 U.S. 538 (1974).

Under American Pipe, the statute of limitations for a claim timely asserted in a putative class action is tolled for the period that the putative class claim is pending. Thus, if class certification is denied (or if a class member later decides to opt out of the class), individual putative class members can still pursue their separate claims, even if those claims would otherwise be untimely at the time they are filed. The question presented in CalPERS was whether that tolling principle likewise applied to Section 13’s 3-year statute of repose.

The CalPERS case arose out of the collapse of Lehman Brothers in 2008. Shortly after Lehman declared bankruptcy, a plaintiff filed a putative class action complaint alleging claims under Section 11 of the Securities Act against the underwriters of several of Lehman’s securities offerings from 2007 and early 2008. The complaint alleged that Lehman’s securities offered included material misstatements or omissions. CalPERS was not one of the named plaintiffs in that suit.

In 2011—more than three years after the last of those securities was first offered—CalPERS filed a separate complaint on its own behalf, alleging identical claims to those asserted in the putative class action. Shortly thereafter, the putative class action settled, and CalPERS opted out so it could continue to pursue its claims separately. However, the defendants then successfully moved to dismiss CalPERS’ separate lawsuit as untimely under Section 13, which provides, “In no event shall any [Section 11] action be brought…more than three years after the security was bona fide offered to the public….” The Second Circuit affirmed, and the Supreme Court granted certiorari.

Justice Kennedy delivered the opinion of the Court, joined by Chief Justice Roberts and Justices Thomas, Alito, and Gorsuch. The Court began by re-emphasizing the distinction between statutes of limitations and statutes of repose that the Court had described in CTS Corp. v. Waldburger, 134 S. Ct. 2175 (2014). Statutes of limitations are intended to encourage diligence on the part of plaintiffs, and are therefore typically triggered by the accrual of a cause of action. (Slip op. at 4-5.) Statutes of repose, by contrast, reflect “a legislative judgment that a defendant should be free from liability after the legislatively determined period of time[,]” and usually begin to run from the date of the defendant’s last culpable act. (Id. at 5 (quoting CTS Corp.).) The Court observed that Section 13 of the Securities Act has both types of time limits: a 2-year limitations period that runs from when the actionable untrue statement or omission was or should have been discovered, and a 3-year repose period that runs from the date the security was first offered. (Id. at 5-7.)

The Court explained that the distinction between the purposes of a statute of repose and a statute of limitations was decisive in the CalPERS case. Because the purpose of a statute of repose is to create an “absolute bar” to the defendant’s liability after a period of time, such statutes are generally not subject to tolling in the absence of some legislatively-enacted exception. (Slip op. at 7-8.) In particular, unlike statutes of limitations, statutes of repose are not subject to tolling based on equitable principles. (Id. at 8.) American Pipe tolling is based on just such equitable considerations: it was intended to serve judicial economy by obviating the need for protective motions to intervene by individual putative class members, while still serving the purpose of the statute of limitations by ensuring that the defendants were on notice of the substantive claims against them and the “generic identities” of the claimants. (Id. at 8-11 (quoting American Pipe).) Those considerations could not serve to toll a statute of repose, whose purpose “to grant complete peace to defendants….” (Id. at 11.) The Court found that “the text, purpose, structure, and history of the [Section 13] statute [of repose] all disclose the congressional purpose to offer defendants full and final security after three years.” (Id.)

The Court then quickly dispensed with the four counterarguments CalPERS had raised. First, the Court found that American Pipe was readily distinguishable based on the distinction between statutes of limitation and statutes of repose: while the first may be tolled based on equitable considerations, the second may not. (Slip op. at 11-12.) Second, the Court found that the fact that the class action put the defendant on notice of the putative class members’ claims missed the point—“the purpose of a statute of repose is to give the defendant full protection after a certain time.” (Id. at 12.) Moreover, while the defendant might be on notice of the claims generally, it would not be on notice of the “number and identity of individual suits, where they may be filed, and the litigation strategies they will use[,]” which could significantly affect a defendant’s “practical burdens” and “financial liability[.]” (Id. at 12-13.) Third, the Court found that a putative class member’s right to opt out, while important, could not override the “mandatory time limits set by statute.” (Id. at 13.) Fourth, the Court rejected the argument that its ruling would “create inefficiencies,” noting that the Court was not free to ignore the plain terms of the statute, and observing that, in any event, the Second Circuit had not seen any “recent influx of protective filings” since its rule was announced in 2013. (Id. at 13-14.)

Finally, the Court rejected CalPERS’ alternative argument that it had timely “brought” its “action” within the meaning of Section 13 because it was a member of the putative class on whose behalf the original lawsuit was brought, and that its separate action was merely part of that same “action.” The Court found that argument did violence to the term “action,” which generally refers to a particular “proceeding” or “suit.” (Id. at 14-15.) Moreover, the Court observed that the argument proved too much: if it were correct, there would be no need for American Pipe tolling at all, and even an action commenced “decades after the original securities offering” would be timely as long as a class action had been commenced within the applicable limitations and repose periods. (Id. at 15.)

Justice Ginsburg dissented, joined by Justice Breyer, Sotomayor, and Kagan. Justice Ginsburg accepted CalPERS’ alternative argument that its filing date should relate back to the filing of the original class action complaint, and that by filings its separate action, CalPERS “simply took control of the piece of the action that had always belonged to it.” (Slip op. at 2-3.) She asserted that the majority’s rule would render the right to opt out “illusory[,]” because most securities class actions reach their “critical stages” years after the initial complaint is filed. (Slip op. at 1-2, 4.) Moreover, Justice Ginsburg contended, the “harshest consequences” were likely to fall on the “least sophisticated” class members, who would be unaware of their need to file a protective claim within the repose period. (Id. at 4.) Finally, she stated that the majority’s ruling was likely to “gum up the works of class litigation” by encouraging defendants to engage in dilatory tactics and encouraging the filing of protective claims. (Id. at 4-5.)

The CalPERS decision is likely to have repercussions far beyond Section 11 securities cases. The Court’s logic would also apply to the 5-year statute of repose governing class action claims under Section 10 of the Exchange Act, which are much more common. Indeed, any federal statute of repose without an express legislative tolling provision will now be fully applicable in any class action asserting a claim governed by that statute. It will be interesting to see whether the inefficiencies predicted by Justice Ginsberg come to fruition.

In this putative class action, investors alleged that Biogen executives misled the public about the impact on sales of the company’s multiple sclerosis drug Tecfidera after one patient’s death. Plaintiffs alleged violations of Sections 10(b) and 20(a) of the Securities Exchange Act by Biogen and three Biogen executives. The First Circuit affirmed the District Court’s dismissal of the investors’ amended complaint for failure to meet the heightened pleading requirements of the Private Securities Litigation Reform Act, as well as the District Court’s denial of investors’ motion to vacate the dismissal and for leave to file a second amended complaint.

Tecfidera accounted for one-third of Biogen’s revenues prior to the announcement of the patient death during an earnings call in October 2014. Following the announcement and an FDA warning to the public about the patient death, Biogen eventually revised its estimate of overall 2015 revenue growth, “based largely on revised expectations for the growth of Tecfidera.” Biogen’s stock plummeted over 20 percent in one day following the announcement of the revised revenue growth estimate.

Plaintiffs’ amended complaint set forth numerous allegedly misleading statements made by defendants regarding the material impact of the patient death on Tecfidera sales, “alleg[ing] in substance that Biogen executives made statements about future Tecfidera sales that were misleading because they were unduly optimistic.”

To support their claims that the statements were made with scienter and were misleading, plaintiffs relied on the statements of several confidential witnesses. Of the 20 misrepresentations alleged in the complaint, the District Court found that only three of defendants’ statements appeared to be “plausibly misleading” based on the complaint’s allegations. The court found that the remainder of the statements were either protected by the Reform Act’s safe harbor for forward-looking statements, or constituted immaterial expressions of corporate optimism or puffery. With respect to the three “plausibly misleading” statements, the court commented that “[e]ven assuming that defendants made a materially false or misleading statement, plaintiffs have not sufficiently alleged that defendants made those statements with ‘conscious intent to defraud or a high degree of recklessness.’” The District Court also found that the record gave rise to inferences in the defendants’ favor. In granting the motion to dismiss, the court noted that, “[b]ased on the complaint as a whole, plaintiffs’ asserted inference of scienter may be plausible, but it is not strong, cogent, or compelling” as required by the Reform Act’s heightened pleading standards.

In affirming the dismissal, the First Circuit adopted the District Court’s analysis regarding the falsity of defendants’ statements, focusing on the complaint’s allegations of scienter with respect to the three “plausibly misleading” statements. The First Circuit found that the confidential witness statements, a substantial basis for the complaint’s allegations as to scienter, “very often made about events occurring after the defendants’ statements at issue, are so lacking in connecting detail that they cannot give rise to a strong inference of scienter.”  Elaborating on this conclusion, the First Circuit found that the allegations were “insufficiently particular, do not make misleading the defendants’ public disclosures, and do not speak with specificity as to why the defendants’ alleged misstatements were untrue or misleading.” In particular, the confidential witness statements did “not even begin to quantify the magnitude” of the decline in Tecfidera sales, “explain with any precision” the specific cause of the decline, or contain contemporaneous facts that “purport to contradict” Biogen’s financial reports during the class period. The allegations suffered from “a significant timing problem” in that the majority of the confidential witness statements and other alleged “evidentiary admissions” did not address how the defendants’ statements were “knowingly or recklessly misleading at the time they were made.” Indeed, the First Circuit found that the witness statements were “consistent with the defendants’ public disclosures,” and that the defendants repeatedly warned investors about the growth risks throughout the class period.

The court also rejected plaintiffs’ scienter allegations based on the “core operations” inference of scienter and the individual defendants’ motive. First, the court rejected the “core operations” allegations as “inapt” because plaintiffs did not plead “materially” contradictory “reasonably accessible data within the company” at the time the statements were made. As for motive, the court agreed that that the “most cogent inferences from the record favor the defendants,” including the defendants’ compensation structure, which was tied in part to revenue growth, as well as the fact that the individual defendants increased their Biogen stock holdings during the class period, thereby suffering losses as a result of the decline in share price. The court underscored the importance of “evaluating the complaint as a whole, including ‘plausible opposing inferences’,” as a part of the scienter analysis.

Overruling (or, at least, creatively re-characterizing) its own precedent, the Ninth Circuit held in Resh v. China Agritech, Inc., — F.3d —, 2017 WL 2261024 (9th Cir. May 24, 2017), that the pendency of an earlier uncertified class action tolls the statute of limitations not only for later-filed individual claims, but for subsequent class actions as well. The Ninth Circuit’s decision opens the door to the possibility of serial, successive attempts to certify a class in securities (and other) cases, potentially exposing defendants to an almost never-ending series of class action lawsuits.

Under American Pipe & Construction Co. v. Utah, 414 U.S. 538 (1974), and Crown, Cork & Seal Co. v. Parker, 462 U.S. 345 (1983), the pendency of a putative class action tolls the statute of limitations applicable to the individual claims of the putative class members. Thus, if the putative class action is timely brought, but class certification is later denied after the statute of limitations would have otherwise expired, putative class members would still be able to bring individual claims on their own behalf. The question in Resh was whether American Pipe tolling should apply to subsequent class actions as well.

The facts of Resh are relatively straightforward. In February 2011, a market research company raised questions about the accuracy of China Agritech’s financial reporting. Its stock price fell substantially. A few days later, a China Agritech shareholder filed a putative securities fraud class action complaint against the company and several of its managers and directors in the Central District of California. The court denied class certification, finding that, because plaintiffs had failed to establish the fraud-on-the-market presumption of reliance, issues common to the proposed class did not predominate over individual issues. Five months after that denial, and one year and eight months after the initial adverse press report, another shareholder filed a second putative securities class action in the District of Delaware. The case was transferred to the same judge in the Central District of California, who again denied class certification, this time on grounds of typicality and adequacy of the named plaintiffs.

Nine months later — and more than three years after the initial adverse press report — plaintiff Michael Resh filed yet another putative class action complaint alleging securities fraud against China Agritech and several individual defendants. A claim for securities fraud under the Exchange Act is subject to a two-year statute of limitations. Thus, if American Pipe tolling applied, the putative class action would be timely — only about 14 months had passed since the initial press report during which a putative class action was not pending. But if American Pipe tolling did not apply, the class action complaint was plainly time-barred.

The Ninth Circuit began its analysis by discarding one of its prior precedents. In Robbin v. Fluor Corp., 835 F.2d 213 (9th Cir. 1987), the Ninth Circuit had held that American Pipe tolling did not apply to a subsequent class action following a definitive determination of the inappropriateness of class certification. The Ninth Circuit dismissed Robbin as “a short opinion published 30 years ago” that had been “modified” in Catholic Social Services, Inc. v. INS, 232 F.3d 1139 (9th Cir. 2000) (en banc). 2017 WL 2261024, at *6.

In Catholic Social Services, the district court had certified a class, but had lost subject matter jurisdiction due to an intervening change in the law. See id. The Ninth Circuit held that American Pipe tolling applied to a subsequent class action in those circumstances. See id. But it also stated, “If class action certification had been denied in [an earlier case], and if plaintiffs in this action were seeking to relitigate the correctness of that denial, we would not permit plaintiffs to bring a class action.” Id. (quoting Catholic Social Services, 232 F.3d at 1147).

The Resh court found that interpreting that statement as forbidding the application of American Pipe tolling to subsequent class actions when class certification had previously been denied would be a “misreading” of Catholic Social Services. Id. at *6-*7. The court explained that it was not talking about American Pipe tolling at all. What it was actually talking about was issue preclusion — all it meant was that, if the same plaintiffs sought to bring a subsequent class action after certification had previously been denied, issue preclusion would bar them from doing so. Id. at *7.

That is, to say the least, an odd reading of Catholic Social Services. Other than the reference to “relitigat[ion],” nothing in Catholic Social Services’ analysis suggests that the court was thinking of issue preclusion. In particular, nothing in the quoted sentence indicates that, to be barred from “relitigat[ing]” class certification, the plaintiffs in the subsequent class action had to be the same plaintiffs who unsuccessfully litigated the first class action — a critical requirement for issue preclusion. In fact, the court actually cited Robbin in support of its statement, which was plainly made in the context of a discussion of the applicability of American Pipe tolling to subsequent class actions. See Catholic Social Services, 232 F.3d at 1145-49. Indeed, the Ninth Circuit expressly dealt with issue preclusion on a different issue in a separate portion of its opinion. Id. at 1151-53.

In any event, having reinterpreted Catholic Social Services as applying American Pipe tolling to subsequent class actions — regardless of the reason for the dismissal of the earlier class action — the Ninth Circuit went on to find support for its position in three recent Supreme Court precedents:

  • In Shady Grove Orthopedic Associates, P.A. v. Allstate Insurance Co., 559 U.S. 393 (2010), the Supreme Court held that Rule 23 empowers a federal court to certify a class in any type of case, not only those “made eligible for class treatment by some otherId. at 399 (emphasis in original). The Ninth Circuit concluded that to deny American Pipe tolling to subsequent class actions would essentially import “certification criteria” into Rule 23 from “some other law,” which Shady Grove forbids. 2017 WL 2261024, at *7.
  • In Smith v. Beyer Corp., 564 U.S. 299 (2011), the Supreme Court held that, after denying class certification, a federal court could not enjoin a state court from certifying a class under the “relitigation exception” to the Anti-Injunction Act because the state court action had different named plaintiffs who were not subject to claim or issue preclusion. The Court acknowledged the risk of “serial relitigation of class certification,” but found that risk was mitigated by principles of stare decisis and comity, as well as the possibility of removal under the Class Action Fairness Act (for state court actions) or MDL consolidation (for other federal actions). Id. at 316-18. The Ninth Circuit found that those considerations similarly ameliorated the unfairness of serial class certification litigation due to American Pipe 2017 WL 2261024, at *9.
  • Finally, in Tyson Foods, Inc. v. Bouaphakeo, 126 S.Ct. 1036 (2016), the Supreme Court noted that “use of the class device cannot ‘abridge…any substantive right.’” Id. at 1046 (quoting 28 U.S.C. 2072(b)). While acknowledging that Tyson Foods did not directly control, given that “statutes of limitation occupy a no-man’s land between substance and procedure,” the Ninth Circuit found that it “nonetheless reinforces our conclusion that the statute of limitations does not bar a class action brought by plaintiffs whose individual actions are not barred.” 2017 WL 2261024, at *8.

Despite the court’s insistence to the contrary, Resh represents a sharp break from prior law in the Ninth Circuit. Given that the court radically reinterpreted the en banc decision in Catholic Social Services, it will be interesting to see whether the Ninth Circuit elects to reconsider the Resh decision en banc.

In the meantime, Resh increases the pressure on defendants in putative class actions pending in the Ninth Circuit to settle, lest they be saddled with the costs of serially re-litigating class certification even after prevailing. The Resh court’s suggestion that plaintiffs’ counsel, whose fees are usually contingent on the outcome of the case, “at some point will be unwilling to assume the financial risk in bringing successive suits,” id. at *9, is sure to be cold comfort to class action defendants, for whom the cost of litigation is frequently the driving factor in deciding to settle a case.

Some relief may be forthcoming soon from the Supreme Court, however. The Court is currently considering whether American Pipe tolling applies to statutes of repose, in addition to statutes of limitations. See California Pub. Employees’ Retirement Sys. v. ANZ Securities, Inc., 137 S.Ct. 811 (2017) (granting writ of certiorari). If the Supreme Court affirms that American Pipe tolling does not apply to statutes of repose, that would at least put a hard backstop on serial re-litigation of class certification. And given that there is a clear circuit split on whether American Pipe tolling applies to subsequent class actions, see, e.g., Korwek v. Hunt, 827 F.2d 874, 879 (1987), the Supreme Court may eventually take up that issue as well.

In a matter of first impression in the Ninth Circuit, the court applied the Supreme Court’s Omnicare standard for pleading the falsity of a statement of opinion to a Section 10(b) claim in City of Dearborn Heights Act 345 Police & Fire Retirement System v. Align Technology, Inc., — F.3d —, 2017 WL 1753276 (9th Cir. May 5, 2017).

The litigation arose from Align’s $187.6 million acquisition of Cadent Holdings, Inc. in April 2011, and Align’s alleged failures to properly assess and write off the goodwill associated with the acquisition. Align’s statements regarding the fair value of goodwill, of course, were quintessential statements of opinion, because they were inherently subjective. In Omincare, the Supreme Court set the standard for pleading the falsity of an opinion claim under Section 11. Many practitioners, including Lane Powell’s securities litigation team, had opined—and the Second Circuit and other courts had held—that the rationale of Omnicare should equally apply to Section 10(b) claims, since the falsity element is the same. In Align, the Ninth Circuit agreed, and partially overturned a previous Ninth Circuit case that permitted plaintiffs to plead falsity by alleging that “there is no reasonable basis” for the defendant’s opinion.

Align’s accounting for the acquisition resulted in $135.5 million of goodwill, $76.9 million of which was attributable to one of Cadent’s business units (the “SCCS unit”). The plaintiffs alleged that the purchase price, and thus the goodwill, was inflated due to Cadent’s channel stuffing practices prior to the acquisition, and that the defendants must have known as much after performing their due diligence. Following the acquisition, the SCCS unit’s financial results suffered due to numerous factors. Nevertheless, at the end of 2011, Align found no impairment of its recorded goodwill. Align did not perform any interim goodwill testing in the first or second quarters of 2012. Id. at *2-3.

On October 17, 2012, Align finally announced it would be conducting an interim goodwill impairment test for the SCCS unit, which it said was triggered by the unit’s poor financial performance in the third quarter of 2012 and the termination of a distribution deal in Europe. That announcement led to a 20% hit to Align’s stock price. On November 9, 2012, Align announced a goodwill impairment charge of $24.7 million, and it announced subsequent goodwill charges in the following two quarters. Id. at *3. The plaintiffs alleged that the defendants made seven false and misleading statements concerning the goodwill valuation between January 30, 2012 and August 2, 2012. The plaintiffs’ allegation was that defendants deliberately overvalued the SCCS goodwill, thereby injecting falsity into statements concerning the goodwill estimates and the related financial statements. The district court dismissed the complaint with prejudice for failing to adequately plead falsity and scienter. Id. at *4.

At issue in the Ninth Circuit was whether the plaintiffs had adequately pled that Align’s statements were false. The first question was what analytic framework applied. The plaintiffs did not dispute that five of the seven statements at issue were pure statements of opinion. However, with respect to two statements, the plaintiffs alleged the opinions contained “embedded statements of fact.” Those statements were that “there were no facts and circumstances that indicated that the fair value of the reporting units may be less than their current carrying amount,” and that “no impairment needed to be recorded as the fair value of our reporting units were significantly in excess of the carrying value.” The Court held that the former statement was an opinion with an embedded statement of fact, but that the latter was an opinion. Id. at *5.

The Court also addressed the proper pleading standard for falsity of opinion statements. The panel concluded that Omnicare established three different standards depending on a plaintiff’s theory:

  1. Material misrepresentation. Plaintiffs must allege both subjective and objective falsity, i.e., that the speaker both did not hold the belief she professed, and that the belief was objectively untrue.
  2. Materially misleading statement of fact embedded in an opinion statement. Plaintiffs must allege that the embedded fact is untrue.
  3. Misleading opinion due to an omission of fact. Plaintiffs must allege that facts forming the basis for the issuer’s opinion, the omission of which makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context.

Importantly, the Ninth Circuit extended this Omnicare holding from the Section 11 context to the Section 10(b) and Rule 10b-5 claims at issue in Align. Id. at *7. In doing so, the Ninth Circuit joined the Second Circuit in extending Omnicare in this regard. See Tongue v. Sanofi, 816 F.3d 199, 209-10 (2d Cir. 2016). Finally, the court overruled part of its previous holding in Miller v. Gammie, 335 F.3d 889, 900 (9th Cir. 2003) (en banc), which allowed for pleading falsity by alleging that there was “no reasonable basis for the belief” under a material misrepresentation theory. City of Dearborn Heights, 2017 WL 1753276, at *7.

Applying this pleading standard to the Align facts, the Ninth Circuit concluded that the plaintiffs had not met their pleading burden. Because the plaintiffs did not allege the actual assumptions the defendants relied upon in conducting their goodwill analysis, the court could not infer that the defendants intentionally disregarded the relevant events and circumstances. Accordingly, six of the seven statements that relied on the material misrepresentation theory failed to allege subjective falsity and were properly dismissed. Likewise, the failure to allege the actual assumptions used by the defendants prevented plaintiffs from pleading objective falsity as to the one statement of fact embedded in an opinion statement. Id. at *8-10.

After concluding that the plaintiffs failed to allege falsity, the Ninth Circuit went on to hold that plaintiffs had not alleged scienter against the defendants, providing a second ground for dismissing the complaint. At most, the plaintiffs alleged that the defendants violated generally accepted accounting principles, but such a failure does not establish scienter. Likewise, the stock sale allegations, core operations inference, the temporal proximity between the challenged statements and the goodwill write-downs, the CFO’s resignation, and the magnitude of the goodwill write-downs did not create an inference of scienter. Id. at *10-13.

Judge Kleinfeld concurred in the judgment. He would have upheld the district court’s dismissal based on scienter alone, leaving the weightier issue of falsity described above to a future case where such a decision was necessary. Id. at *13-14 (Kleinfeld, J., concurring in the judgment).

In Brennan v. Zafgen, Inc., — F.3d –, 2017 WL 1291194 (1st Cir., April 7, 2017), the First Circuit affirmed a District of Massachusetts decision dismissing claims against Zafgen, Inc., a biopharmaceutical developer, and its CEO, Dr. Thomas Hughes. Judge Stahl, writing for a panel that included retired Supreme Court Justice Souter (sitting by designation), concluded that plaintiffs’ complaint did not allege facts giving rise to the “cogent and compelling” inference of scienter required by the Reform Act. Id. at *1 (quoting Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007)).

Between August 2012 and May 2013, before Zafgen went public, the company conducted a Phase II trial of an anti-obesity drug called Beloranib. As the trial progressed, four patients in the trial who were receiving the drug suffered adverse “thrombotic”—i.e., blood-clotting—events of varying severity. Third-party clinical investigators classified two of these adverse thrombotic events as “superficial,” and the other two events as “serious.” In April 2014, as Zafgen was preparing for a June 2014 IPO, it disclosed the two serious events, but not the two superficial events, in its Form S-1 Registration Statement. Id. at *1-2.

In mid-October 2015, Zafgen’s share price began to decline, falling from $34.76 on October 12 to $15.75 at close of trading the next day. On October 15, Zafgen disclosed that a patient in its ongoing Phase III trial of Beloranib had died; and on October 16, the company confirmed that this patient had been treated with the drug (rather than a placebo), and that the FDA had placed Beloranib on a partial clinical hold. Also on October 16, 2015, Zafgen’s chief medical officer, Dr. Dennis Kim, disclosed for the first time the two superficial adverse events from the Phase II trial that was conducted in 2012-2013. By the end of trading on October 16, the price of Zafgen stock had dropped to $10.36. Id. at *2.

The plaintiffs in Brennan sued Zafgen and Dr. Hughes on behalf of a putative class consisting of all persons and entities who bought Zafgen stock between its IPO on June 19, 2014 and October 16, 2015, when the company announced the FDA’s partial clinical hold. Id. at *3. They argued that the company had made misleading statements about its Beloranib trial in ten different documents that were signed by Dr. Hughes, and they asserted claims under Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5. Specifically, the plaintiffs claimed that the challenged statements were misleading because they failed to mention the two superficial adverse events from the Phase II trial, which were disclosed for the first time by Dr. Kim on October 16, 2015. Id. at *1-3. (Despite alleging material omissions in Zafgen’s Registration Statement, plaintiffs did not assert Securities Act claims.)

The district court dismissed plaintiffs’ complaint on the ground that it failed to adequately plead a “strong inference” of scienter, as is required by the Reform Act. In doing so, the district court placed particular emphasis on the materiality of the two superficial adverse events, which it described as “marginal,” thereby weakening any inference of scienter. Id. at *4.

On appeal, the plaintiffs argued that they had, in fact, satisfied the Reform Act’s scienter requirement, because they had pled that defendants (1) knew, or were reckless in not knowing, about news and scientific articles purportedly showing a link between Beloranib and adverse thrombotic events; and (2) had a motive to commit securities fraud, as shown by Zafgen’s compensation structure, and by “heavy” insider sales before the patient death was announced. Id. at *5.

Regarding the news and scientific articles cited by plaintiffs, the First Circuit noted that “‘[t]he key question … is not whether defendants had knowledge of certain undisclosed facts, but rather whether [they] knew or should have known that their failure to disclose those facts’ risked misleading investors.” Id. (quoting City of Dearborn Heights Act 345 Police & Fire Ret. Sys. v. Waters Corp., 632 F.3d 751, 758 (1st Cir. 2012)). In this case, the cited articles “may [have] suggest[ed]” that the defendants were aware of a link between Beloranib and thrombotic events. But the articles did not demonstrate that the defendants “deliberately or recklessly risked misleading investors” by not disclosing the two superficial events from the Phase II trial until October 16, 2015. Id.

Turning to plaintiffs’ motive allegations relating to insider trading and Zafgen’s compensation structure, the First Circuit agreed with the district court that “the strength of the insider trading allegations drifts towards the marginal end of that spectrum because [CEO] Hughes and all other Zafgen insiders kept the vast majority of their Zafgen holdings.” Id. at *6 (observing that after accounting for vested options, Dr. Hughes retained at least 93 percent of his Zafgen stock, and every other insider identified in the complaint retained at least 85 percent). In light of this fact, the district court was correct in determining that the plaintiffs’ insider trading allegations “d[id] not alter the conclusion that the complaint as a whole fails to raise a strong inference of scienter.” Id.

As for the plaintiffs’ arguments regarding Zafgen’s compensation structure, the First Circuit found that the complaint’s allegations offered no basis for inferring fraudulent intent, but showed only “the usual concern by executives to improve financial results.” Id. (quoting In re Cabletron Sys., Inc., 311 F.3d 11, 39 (1st Cir. 2002)). An allegation that a defendant had motive and opportunity to commit fraud, or that a corporation “rewards [its executives for] the achievement of corporate goals,” does not satisfy the Reform Act “without something more.” Id.

The First Circuit also discussed several other considerations that “bolster[ed]” its conclusion that the complaint’s allegations did not give rise to a sufficiently strong inference of scienter. These included the fact that (1) the materiality of the two undisclosed superficial adverse events was “marginal,” which “tends to undercut the argument that the defendants acted with the requisite intent … in not disclosing [them],” id. at *7 (quoting In re Ariad Pharm. Sec. Litig., 842 F.3d 744, 751 (1st Cir. 2016)); and (2) Zafgen’s disclosures before and during the class period mentioned the two serious thrombotic events from the Phase II study, and also stated that the company would not disclose all adverse events as they occurred, which “weaken[ed] the complaint’s scienter showing,” id. at *8.

Having thus concluded that the plaintiffs’ allegations, considered as a whole, did not give rise to a “cogent and compelling” inference of scienter, the First Circuit affirmed the dismissal of plaintiffs’ Section 10(b) claim as well as their Section 20(a) claim against Dr. Hughes, which was derivative of the former. Id.

In monitoring securities cases filed around the country, I like to keep an eye out for regional trends. Historically, plaintiffs’ counsel respected the company defendant’s forum, filing in the federal court closest to the company’s headquarters.  That is certainly not true today. Many plaintiffs’ firms initiate cases in New York or California—and sometimes, a seemingly random location—against companies headquartered elsewhere.

Sometimes, these firms file outside of the headquarters forum simply because their headquarters is there, which allows them to keep litigation expenses down and avoid splitting fees with another lawyer if local counsel in the headquarters form is be required.  Along with targeting smaller companies in what I call “lawsuit blueprint” cases, this type of cost savings has allowed some smaller plaintiffs’ firms to hurdle the high barriers to entry in the plaintiffs’ securities class action market, beginning with the Chinese reverse-merger cases in 2010.  These plaintiffs’ firms have used the business strategy and returns from those cases to continue filing securities class actions, mostly against smaller companies. This expansion of the securities class action plaintiffs’ bar is one of the most significant securities litigation developments of this decade.

But, often, these plaintiffs’ firms file in a particular jurisdiction for strategic reasons.  Over the last two years, I have noticed a small surge in certain securities complaints filed in the Third Circuit, even where defendants appear to have little connection to the forum.  In particular, there has been an uptick in the number of Third Circuit cases involving foreign defendants or overseas conduct and the purchase or sale of stocks traded in over-the-counter markets or on non-registered exchanges, including the Over-the-Counter Bulletin Board (“OTCBB”) and Pink Sheets.  I believe this trend relates to the Third Circuit’s interpretation of the Supreme Court’s ruling in Morrison v. Nat’l Australia Bank, 561 U.S. 247 (2010).

Before Morrison was decided, the lower courts had applied a number of different tests in determining when and how to apply Section 10(b) of the Exchange Act to fraudulent schemes involving conduct outside the United States. In Morrison, the Supreme Court held that Section 10(b) has no extraterritorial application, and can only apply to two categories of transactions: (1) “transactions in securities listed on domestic exchanges”; and (2) “domestic transactions in other securities.”

While Morrison simplified the framework for applying Section 10(b) in cases that involve overseas conduct, it inevitably left open a number of important questions, which have been addressed in the years since by the courts of appeals.  For a good recent discussion of post-Morrison issues, please see this March 6, 2017 guest post on Kevin LaCroix’s The D&O Diary by Wiley Rein’s David Topol and Margaret Thomas: “Post-Morrison Application of U.S. Securities Laws to Foreign Issuers.”

One such question is how the Morrison test applies in cases that involve non-domestic conduct and the purchase or sale of securities in OTC markets and on non-registered exchanges.  Two years ago, the Third Circuit addressed this question in a criminal case, United States v. Georgiou, 777 F.3d 125 (3d Cir. 2015), in which the defendant, Georgiou, had been charged with participating in a stock fraud scheme that involved the purchase and sale of shares in US companies quoted on the OTCBB and the Pink Sheets.  While Georgiou manipulated the price of these securities through offshore brokerage accounts, at least one of the fraudulent transactions in each target stock was executed with a market maker based in the United States.

Applying the first prong of Morrison, the Third Circuit held that none of the trades qualified as “transactions in securities listed on domestic exchanges,” because the OTBB and Pink Sheets are not among the eighteen national securities exchanges registered with the SEC.  This reasoning has since been cited and adopted by several district courts outside the Third Circuit.  See, e.g., In re Poseidon Concepts Sec. Litig., 2016 WL 3017395 (S.D.N.Y., May 24, 2016); Stoyas v. Toshiba Corp., 191 F.Supp.3d 1080 (C.D. Cal. 2016).

Turning to Morrison’s second prong, however, the Third Circuit concluded that the trades facilitated by US market makers were “domestic transactions,” because the purchaser or seller had incurred “irrevocable liability” for these trades in the United States.  In other words, by working with a domestic market maker, a purchaser or seller makes a “commitment” to the transaction in the United States, which brings the transaction within the scope of Section 10(b). On this basis, the Third Circuit affirmed Georgiou’s securities fraud conviction.

The Third Circuit’s ruling as to the second prong of Morrison does not put it directly at odds with any other circuit.  Yet by stating unambiguously that use of a domestic market maker renders a transaction “domestic,” Georgiou offers plaintiffs’ counsel more certainty than exists elsewhere.

The year before Georgiou was decided, the Second Circuit addressed a similar issue in Parkcentral Glob. Hub Ltd. v. Porsche Auto. Holdings SE, 763 F.3d 198 (2d Cir. 2014), but offered a more qualified ruling.  Like the Third Circuit, the Second Circuit indicated that a transaction should be considered “domestic” if irrevocable liability was incurred in the United States.  But while Georgiou suggests that Section 10(b) applies to all domestic transactions, Porche held that the domestic trades at issue in that case were beyond the territorial scope of the Exchange Act.  “While a domestic transaction or listing is necessary to state a claim under Section 10(b),” Judge Leval argued, “a finding that these transactions were domestic would not suffice to compel the conclusion that the plaintiffs’ invocation of Section 10(b) was appropriately domestic,” and it would be a mistake to “treat[ ] the location of a transaction as the definitive factor in the extraterritoriality inquiry.”

Porche involved an unusual fact pattern—foreign defendants, largely foreign conduct, and domestic trading in swaps tied to foreign securities—and it may be advisable to read the Second Circuit’s opinion narrowly.  See, e.g., Poseidon, 2016 WL 3017395 at *12-13 (holding that Porche was inapposite where plaintiff had purchased domestically a foreign stock traded on Pink Sheets in the United States).  Moreover, the Third Circuit decided Georgiou after Porche, and apparently felt no need to criticize, distinguish, or even mention the Second Circuit’s ruling.

Nonetheless, the bright-line rule that Georgiou arguably establishes—namely, that Section 10(b) applies in all cases involving a domestic transaction—currently makes the Third Circuit a more attractive destination for plaintiffs’ counsel in foreign-issuer cases, particularly in cases where other territorial factors might weigh against invoking jurisdiction.  For this reason, I expect to see more cases of this kind filed in district courts in the Third Circuit in the future.

A senior officer’s violations of a corporation’s code of conduct do not give rise to a claim for violation of the federal securities laws—even where the corporation (including the officer himself) has touted the company’s high standards for compliance with its own ethical code.  That was the Ninth Circuit’s holding in a recent opinion affirming a district court’s dismissal of a putative class action filed against Hewlett-Packard and its former CEO and Chairman, Mark Hurd.  Retail Wholesale & Department Store Union Local 338 Retirement Fund v. Hewlett-Packard Co. and Mark A. Hurd, 845 F.3d 1268 (9th Cir. 2017).  The case arose out of Hurd’s departure from the company following revelations of Hurd’s relationship with an HP contractor and subsequent efforts to cover up the relationship.  Plaintiffs brought claims under Section 10 of the Securities Exchange Act of 1934 and Rule 10b-5, alleging that HP had materially misrepresented or alternatively made material omissions about its high ethical standards and compliance with its Standards of Business Conduct (“SBC”), where its Chairman and CEO was found to have violated the SBC.

HP touted its strict code of conduct prior to Hurd’s resignation for violating the code.

Several years earlier, under Hurd’s leadership, HP had revised and strengthened its SBC following a 2006 ethics scandal in which it was revealed that HP had hired detectives to spy on directors, employees and journalists.  While the then-Chairman and General Counsel faced criminal charges, Hurd (then-CEO) was found free of any wrongdoing in that scandal, and was promoted to Chairman in addition to his role as CEO.  As the Ninth Circuit noted, following the scandal “Hurd took many opportunities to proclaim HP’s integrity and its intention to enforce violations of the SBC.”

Four years later, in 2010, former HP contractor Jodie Fisher contacted HP’s Board of Directors through her attorney, alleging that Hurd had sexually harassed Fisher.  The Board launched an investigation, and Hurd initially lied to the Board about the nature of his relationship with Fisher before admitting to a “very close personal relationship” with her.  The investigation revealed that Hurd had also falsified expense reports to hide his relationship.  Hurd resigned following the investigation, and HP acknowledged in a press release that Hurd knowingly violated the SBC and acted unethically.  HP’s stock dropped immediately upon the announcement of Hurd’s resignation, resulting in a $10 billion loss in market cap.

Statements about a code of conduct must be both objectively false and material to be actionable.

Investors filed a putative class action claiming that the violations of the SBC amounted to securities fraud, either in the form of material misrepresentations because HP’s statements about its ethics were inconsistent with Hurd’s conduct, or in the form of material omissions regarding Hurd’s unethical behavior, which Plaintiffs claimed HP had a duty to disclose.  The district court rejected both theories and dismissed the complaint with prejudice.  A three-judge panel of the Ninth Circuit unanimously affirmed the dismissal.

In this issue of first impression before the Ninth Circuit, the court articulated a two-part test for determining whether a violation of a corporate code of ethics may give rise to a securities fraud claim.  First, it examined the objective falsity of the company’s statements regarding its code of ethics.  Second, it turned to the materiality of those statements.  The court found that Plaintiffs’ claims failed under both elements.

As to objective falsity, the Ninth Circuit held that HP and Hurd had made no “objectively verifiable” statements about its compliance with the SBC, and instead characterized the code of conduct and statements about it as “inherently aspirational.”  Plaintiffs pointed in particular to Hurd’s comments prefacing the SBC as revised following the 2006 scandal, in which Hurd urged employees to “commit together, as individuals and as a company, to build trust in everything we do . . .”  But the Court reasoned that such statements are not “capable of being objectively false,” and thus found no affirmative misrepresentation.

The Ninth Circuit further found that the challenged representations were not material.  It noted that companies are required by the SEC to publish their codes of conduct, and “it simply cannot be that a reasonable investor’s decision could conceivably have been affected by HP’s compliance with SEC regulations requiring publication of ethics standards.”  Moreover, while plaintiffs pointed to the stock drop as evidence of materiality, the court cited its decision in Police Ret. Syst. Of St. Louis v. Intuitive Surgical, Inc., 759 F.3d 1051, 1060 (9th Cir. 2014), for the proposition that the stock drop goes to reliance, not materiality.  Where, as here, there was no actionable misstatement, the court would not reach the reliance analysis.

The court also rejected plaintiffs’ alternative theory that HP failed to disclose material facts concerning Hurd’s noncompliance with the SJC.  The court found that HP’s “transparently aspirational” statements in and about the SBC did not amount to a suggestion that nobody at HP would ever violate the SBC.  Absent statements creating the impression that everyone at HP was in full compliance with the ethical standards, there was nothing that gave rise to a duty to disclose noncompliance.

The future is dim for securities claims based on violations of a company’s ethical code—and that’s good news for companies and their directors and officers who wish to adopt and tout strong codes of conduct.

Plaintiffs may complain that the Ninth Circuit’s opinion takes away a tool for enforcing compliance with codes of conduct, as (at least in the Ninth Circuit) securities class actions based on alleged noncompliance with SEC-mandated codes of conduct are unlikely to survive a motion to dismiss.  Indeed, defense counsel are already brandishing Hewlett-Packard to support the assertion that statements about ethics-policy compliance are not actionable under the securities laws—Goldman Sachs sent a letter to the Second Circuit recently citing the HP decision in support of Goldman’s bid to decertify a class of investors suing over its Abacus CDO.

But I think the better view is that the court’s ruling finding that “aspirational” statements will generally not support a finding of falsity or materiality under the securities laws should provide a level comfort to companies seeking to adopt robust ethical codes, and to speak freely both within the company and publicly about their values and compliance goals—with a few notes of caution.

First, it probably goes without saying that, even under the Ninth Circuit’s newly-articulated standard, companies should avoid unequivocal statements in or about their codes of conduct suggesting for example that there will be no violations of the ethical code.  Such statements will likely prove false over time, and probably demonstrably so.  But apart from those types of unequivocal statements, the Ninth Circuit’s ruling should be an encouraging sign for companies who adopt and publish strong codes of conduct, and for directors and officers who make statements about their efforts to abide by such codes.  As the court made clear, these “aspirational statements” about a company’s compliance with its own code of conduct—even where strongly stated or oft-repeated—will typically be neither objectively false nor material under the securities laws.  As the court noted, “A contrary interpretation—that statements such as, for example, the SBC’s ‘we make ethical decisions,’ or Hurd’s prefatory statements, can be measured for compliance—is simply untenable, as it could turn all corporate wrongdoing into securities fraud.”

The second caution is that the Ninth Circuit’s ruling did not go so far as to say that non-compliance with a code of conduct could never be actionable under federal securities laws.  The court imagined that “the analysis would likely be different if HP had continued the conduct that gave rise to the 2006 scandal while claiming that it had learned a valuable lesson in ethics.”  Accordingly, companies should continue to be particularly vigilant to avoid repeating (or continuing) prior ethical lapses, which the Ninth Circuit suggested could give rise to causes of action, particularly where the company indicated through public statements that such conduct had ceased.

In Ganem v. InVivo Therapeutics Holdings Corp., 845 F.3d 447 (1st Cir. Jan. 9, 2017), the First Circuit affirmed a District of Massachusetts decision dismissing claims against InVivo Therapeutics Holdings Corp., a biotechnology company, and its former CEO, Frank Reynolds. The First Circuit held that InVivo could not be liable for its projections about the start and end dates of a clinical study, because the plaintiff failed to adequately allege that these statements were rendered materially misleading by the nondisclosure of conditions imposed on the study by the FDA. Having found that the complaint did not support a Section 10(b) or Rule 10b-5 claim against InVivo, the First Circuit held that the plaintiff could not pursue a control person claim against Reynolds.

In early March 2013, InVivo issued its Form 10-K for 2012, in which it stated that its “Lead Product Under Development” was a device called “biopolymer scaffolding,” which was designed to prevent further harm to patients who had already suffered a spinal injury. The annual report indicated that before InVivo could market the device in the U.S., it would have to obtain an Investigational Device Exception (IDE) from the FDA, which would allow it to conduct necessary human clinical trials. Id. at 450.

On March 29, 2013, the FDA sent InVivo a letter indicating that its application for an IDE had been “approved with conditions.” The letter said that InVivo could begin the study immediately with a single human subject, but that that InVivo would need to meet a set of 11 conditions in 45 days and any additional subjects could only be enrolled in the study in five stages over a minimum period of 15 months. The FDA letter also included eight recommended modifications to the study’s design. Id. at *451.

On April 5, the week after receiving the FDA letter, InVivo issued a press release stating that the FDA had approved its IDE application, and indicating that the company “intends to commence a … clinical study in the next few months.” The April 5 release also quoted Reynolds as saying, “we expect to have all data [from the completed study] to the FDA by the end of 2014.” On April 8, the first trading day after InVivo issued this release, its stock price rose from $2.85 to $3.19 on “relatively high” trading volume. Id. at *451-52.

On May 9, InVivo issued another press release, indicating that the company “expects to commence the [study] in mid-2013 and submit data to the FDA by the end of 2014.” There was no allegation that the May 9 release led to an increase in InVivo’s stock price. Id. at 452-53.

Finally, on August 27, InVivo issued another press release entitled, “InVivo Therapeutics Updates Clinical Plan.” This release stated that the company “now expects that, based on the judgment of new management, it will enroll the first patient in [the study] during the first quarter of 2014,” and that additional patients would be enrolled over a period of 21 months after the enrollment of the first. Between August 23, when InVivo’s stock had begun to trade at an unusually high volume, and August 28, the day after the issuance of the “update” release, InVivo’s stock price fell from $4.00 to $2.07. Id. at *453.

The plaintiff in the Ganem litigation sued InVivo and Reynolds on behalf of a putative class consisting of all persons and entities who bought InVivo stock between April 5 and August 26, 2013—that is, all purchasers between the date when InVivo announced it had obtained approval to conduct the study, and the date when it revised the study timeline. The complaint asserted that InVivo and Reynolds had violated Section 10(b) and Rule 10b-5 by making misleading statements about the timing of the study in the April 5 and May 9 press releases. The plaintiff’s basic theory was that the projections in these releases were materially misleading because InVivo had failed to reveal that the FDA’s approval was conditional; that InVivo would need to conduct the study in five stages; and that the FDA had recommended modifications to the study design. Id. at *453-55.

The district court dismissed the complaint, finding that the plaintiff had failed to allege material misrepresentations or scienter to support the first claim. On appeal, the First Circuit considered only whether the plaintiff had pled an actionable misrepresentation—a question that disposed of the entire complaint when answered in the negative. Id. at *454. Notably, although the challenged statements were forward-looking, the First Circuit did not apply the Reform Act’s safe harbor for forward-looking statements, finding that “the absence of a material misrepresentation or omission is determinative.” Id. at 454 n. 5.

Regarding InVivo’s statements in the challenged releases that it expected to begin the study “in the next few months” and in “mid-2013,” the First Circuit held that these projections were not materially misleading because there was nothing in the FDA approval letter that would have prevented InVivo from initiating the study on this schedule. Although the FDA had required, for example, that InVivo meet a set of conditions within 45 days, the plaintiff had alleged “no facts suggesting that InVivo would fail to meet that deadline.” Id. at 456.  Likewise, the First Circuit found that InVivo could conceivably have completed the study and submitted data to the FDA within the timeline it offered in these releases (i.e., “by the end of 2014”) while complying with all of the requirements in the FDA letter, including the stipulation that the study must have five stages to be completed over a minimum of 15 months. Id. at *456-57.

Given that the FDA’s approval letter was not inconsistent with InVivo’s projections, the First Circuit concluded that the plaintiff was left “only with the inference that because, in retrospect, the [study] lagged significantly behind the proposed timeline, the timeline must always have been impossible to achieve.” Id. at *457. The court noted, however, that “fraud in the hindsight does not satisfy the pleading requirements in a securities fraud case,” and although “’greater clairvoyance’ might have led InVivo to propose a more conservative timeline [for its study], ‘failure to make such perceptions does not constitute fraud.’” Id. (quoting Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978)).