A recent Third Circuit opinion demonstrates the high bar that plaintiffs face when attempting to plead the falsity of two categories of statements: (1) risk factors alleged to be misleading because the warned-of risk had already materialized, and (2) forward-looking earnings projections. In Williams v. Globus Medical, Inc., — F.3d —, 2017 WL 3611996 (3rd Cir. Aug. 23, 2017), the Third Circuit affirmed a district court ruling dismissing such claims.

Globus Medical is a medical device company that sells implants to medical professionals to be used on their patients. Globus formerly relied on both in-house sales reps and third-party distributors to sell its products. One of those distributors, Vortex Spine, LLC, was Globus’ exclusive distributor in parts of Louisiana and Mississippi. The exclusive deal between Globus and Vortex was set to expire on December 31, 2013, but the plaintiffs alleged that Globus had already decided to terminate its deal with Vortex by that date. Globus intended to take more of its sales operation in-house. Nevertheless, Globus extended the agreement with Vortex through April 2014, and it told Vortex it would use that four-month period to negotiate a new agreement. Instead, plaintiffs alleged, Globus used that time to hire an in-house salesperson to take over Vortex’s territory. Id. at *1-2

In the middle of that four-month period, during a February 26, 2014 earnings call, Globus CFO Richard Baron projected fiscal year sales of $480 million to $486 million, and earnings per share of $0.90 to $0.92. In its March 14, 2014 10-K, Globus included a risk factor cautioning:

If we are unable to maintain and expand our network of direct sales representatives and independent distributors, we may not be able to generate anticipated sales. . . . [I]f any of our independent distributors were to cease to do business with us, our sales could be adversely affected. Some of our independent distributors account for a significant portion of our sales volume, and if any such independent distributor were to cease to distribute our products, our sales could be adversely affected. In such a situation, we may need to seek alternative independent distributors or increase our reliance on our direct sales representatives, which may not prevent our sales from being adversely affected.

Id. On April 18, 2014, Globus met with Vortex and notified it that had hired an in-house sales rep for the Vortex territory. Just ten days later, on a quarterly earnings call, Baron projected the same revenue and earnings figures for the year, and on April 30, 2014, Globus filed its 10-Q that stated there had been no significant changes to its risk factors. Id. at 2.

Finally, on August 5, 2014, Globus issued a press release announcing its second quarter financial results. The press release revised its revenue guidance down by approximately $20 million for the year. In an earnings call that day, Globus COO David Demski explained the change in guidance was due to a decline in sales growth in part because, “early in the quarter we made the decision not to renew our existing contract with a significant U.S. distributor, negatively impacting our sales.” The next day Globus’ stock price dropped nearly 18 percent. When Globus announced its year-end financial results in early 2015, sales were $474.4 million — just 1 percent lower than the original guidance — and earnings per share beat the original guidance by over 5 percent. Id.

Plaintiffs filed a securities class action in the Eastern District of Pennsylvania in September 2015, alleging violations of Exchange Act Sections 10(b) and 20(a), and Rule 10b-5. The amended complaint named the company, Baron, Demski, and two others as defendants. The District Court granted the defendants’ motion to dismiss. The Third Circuit affirmed. Id. at *2-3.

The Third Circuit’s analysis began by separating the challenged statements into historical risk factor statements, and the forward-looking revenue and earnings projection statements. With respect to the historical risk factor statements, plaintiffs alleged that the Globus defendants had a duty to disclose its decision to terminate the relationship with Vortex when that decision was made around December 2013, and that they had a duty to disclose in April 2014 when Globus actually terminated the relationship. Id. at *4.

Of course, Section 10(b) and Rule 10b-5 do not require disclosure of all material information. Disclosure is required “only when necessary ‘to make . . . statements made, in light of the circumstances under which they were made, not misleading.’” Id. (quoting Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 44 (2011)). The plaintiffs in this case alleged that Globus’ failure to disclose its decision to terminate the agreement with Vortex made the existing risk disclosures inaccurate, incomplete and misleading. Globus’ risk factors warned of the potential consequences of losing a distributor when it had already decided to end its relationship with such a distributor. Typically, the Third Circuit explained, “courts are skeptical of companies treating as hypothetical in their disclosures risks that have already materialized.” Id.

“But this is not such a case.” Id. *5. The challenged risk factor was more specific — it warned of the adverse affect on sales of losing a distributor, not just the loss of the distributor. Plaintiffs did not allege that Globus’ sales were adversely affected by the decision to terminate Vortex, or the ultimate termination of Vortex, and nothing in the complaint was sufficient to infer that Globus was aware of an impact on sales prior to the disclosure in August 2014. Likewise, plaintiffs did not plead that a drop in sales was an inevitable consequence of the termination of the deal with Vortex. Indeed, sales at the end of the year were largely in line with the original forecast. Id.

The court next turned to the forward-looking statements at issue. Plaintiffs alleged that the Globus defendants violated Section 10(b) and Rule 10b-5 by issuing revenue projections that did not account for the company’s decision — already made at the time — to terminate the relationship with Vortex. The district court dismissed these claims on two grounds — that the plaintiffs failed to plead the projections were false when made, and that the statements were covered by the Private Securities Litigation Reform Act’s safe harbor for forward-looking statements. The Third Circuit again affirmed the district court ruling. Id. at *6.

Under Third Circuit precedent, when pleading the falsity of a forward-looking statement, plaintiffs must “plead factual allegations that show the projections were ‘made with either (1) an inadequate consideration of the available data or (2) the use of unsound forecasting methodology.’” Id. (quoting In re Burlington coat Factory Sec. Litig., 114 F.3d 1410, 1430 (3d Cir. 1997)). Here, the plaintiffs alleged that the Globus sales forecasts incorporated Vortex’s sales figures. Plaintiffs made that assertion based on “numerous inferences” including that defendant Baron said in the August 2014 earnings call that “the decision not to renew the distributor, and the impact to pricing will affect our top line expectations,” and other similar statements that could demonstrate that the loss of the Vortex sales were a driver in the change in revenue and earnings projections. Those allegations failed to plead the falsity of projections. In particular, the court was critical of the plantiffs’ use of hindsight conjecture rather than contemporaneous information to show that the Vortex sales were a component of the original projections. Id. at *6-7.

Finally, the Third Circuit addressed whether the statements were protected by the Reform Act’s safe harbor, which immunizes forward-looking statements if they are accompanied by meaningful cautionary language, are immaterial, or if the plaintiff fails to show the statement was made with actual knowledge it was false. In this case, the court determined that the plaintiffs did not meet their burden that the revenue and earnings forecasts were made with actual knowledge of their falsity. Plaintiffs could only point to three facts in support of the actual knowledge requirement:

(1) during the August 5, 2014, call explaining the revisions to the sales projections, COO Demski stated that the company “understood the risks to our short-term results” when it terminated its relationship with Vortex []; (2) during that same call, CEO Paul and CFO Baron acknowledged that they recalled Globus’s 2010 experience with “distributor turnover” and the two-year period it took to get the company “back to where [it was],”; and (3) the nature of the market for spinal implant products and the importance of goodwill between salespeople and customers.

Id. at *7. The Third Circuit agreed with the district court that these facts only made it plausible to infer that the defendants should have known that ending the Vortex relationship could have some effect on sales, but that is not the same as actual knowledge that the forecasts were false. Instead, the court found that the more plausible inference was that Globus accounted for the change from Vortex to an in-house sales rep when it made the initial projections. Id. at *7-8.

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.

The Third Circuit engaged in a searching analysis of plaintiffs’ falsity and scienter allegations and found them insufficient under the exacting standards of the Reform Act, upholding the district court’s dismissal of the complaint in OFI Asset Management v. Cooper Tire & Rubber, — F.3d —, 2016 WL 4434404 (3d Cir. 2016).

In its ruling, the Third Circuit also had some harsh words for plaintiffs’ “kitchen sink” pleading style, finding that it “has been a hindrance at every stage of these proceedings.”  Id. at *7.

The case is tied to Cooper’s failed merger with Apollo Tyres.  Cooper was valuable to Apollo largely due of its manufacturing facility in China (“CCT’), of which it owned 65%, with the remaining 35% owned by a Chinese company.  The merger fell through after workers at CCT went on strike, denied Cooper officials access to the facility, refused to provide Cooper with financial information, and stopped producing Cooper-branded tires.  At the same time, the merger announcement led to a labor dispute in Cooper’s U.S. manufacturing facilities, with a labor arbitrator eventually finding in favor of the union and barring Cooper from selling two of its U.S. plants to Apollo.

Plaintiffs alleged that Cooper made a number of false or misleading statements under Section 10(b) and 14(a) in connection with the failed merger, including in the merger agreement, the proxy statement, its financial statements, and two 8-Ks containing news about the merger.  The claim was dismissed by the district court in Delaware for failure to adequately allege falsity and scienter.

Prior to oral argument, the district court had ordered plaintiffs to submit a letter identifying the five most compelling examples of allegedly false statements, with three factual allegations demonstrating the falsity of each statement and three allegations supporting scienter as to each of the statements.  Upon appeal, plaintiffs’ first objection was as to the court’s process, arguing that the court abused its discretion by considering only five “artificially selected” allegedly false statements, and failing to rule on the whole of plaintiffs’ complaint.

The Third Circuit considered plaintiffs’ “umbrage. . . unfounded.” Far from harming OFI’s case, the court found that the district judge had tried to “give OFI an assist,” by offering it a chance to frame the issues in its complaint more clearly.  Asking OFI to bring some order and clarity to its 100-page, 245-paragraph complaint was well within the district judge’s discretion to manage complex disputes, and does not show that the judge failed to consider the allegations as a whole.  Id. at *6.

Held the Third Circuit: “As pled, the Complaint presents an extraordinary challenge for application of the highly particularized pleading standard demanded by the PSLRA. This is true not only due to the length of the Complaint, but also its lack of clarity. . . . Now that OFI has come to us with the same kind of broad averments that drove the District Court to demand specificity, we find ourselves more than sympathetic to the Court’s position.”  Id. at *6.

After holding that the district court had not abused its discretion in managing the case, the Third Circuit went on to explore in detail each of the allegedly false statements, finding that none of them were sufficient to maintain a claim.  In doing so, the court considered the context of each allegedly false or misleading statement, and examined whether the allegations of falsity as to each were sufficiently specific, rejecting those allegations that lacked the particularity required of the Reform Act or which failed to show how a statement was misleading rather than simply incomplete.

As to a number of forward-looking statements, the Third Circuit held that its allegations of falsity failed to account for the Reform Act’s Safe Harbor.  Because the statements had been accompanied by meaningful cautionary statements, the court held that the Safe Harbor immunized them from liability—and thus they were not actionable even if plaintiffs could show that they were false and made with scienter.  Id. at *15.

In regard to one isolated statement, the court also found that even if OFI had sufficiently pleaded technical falsity, it nevertheless failed to raise a strong inference of scienter, because the “plausible opposing inferences” were more likely, “including that the statement was simply imprecise or received little attention due to the context in which it was made[.]”  Id. at 12.

Wrote the court: “OFI’s post hoc scouring of countless pages of documents for a stray and inartfully phrased comment that can be argued to be technically false seems like just the sort of litigation maneuver the PSLRA was meant to eliminate. One purpose of the statute was to prevent disappointed investors from treating every imprecise statement during a transaction as an invitation to file a lawsuit.”  Id. at *13.