securities litigation book of war

http://www.orrick.com/practices/securities_litigation/

THE ORRICK GUIDE TOSECURITIES LITIGATION

October 2010

Orrick, Herrington & Sutcliffe LLP


COPYRIGHT

Copyright 2011 Orrick, Herrington & Sutcliffe LLPwww.Orrick.com

ISBN 978-0-615-50866-5


SUMMARY OF CONTENTS

ABOUT ORRICK

PREFACE

HOW TO USE THIS GUIDE

SECURITIES LITIGATION & REGULATORY ENFORCEMENT GROUP

I. JURISDICTION AND EXTRATERRITORIAL REACH OF THE SECURITIES LAWS

II. OVERVIEW OF SECURITIES CLASS ACTIONS

III. ELEMENTS OF FEDERAL SECURITIES CLAIMS

IV. THEORIES OF SECONDARY LIABILITY

V. STATE LAW SECURITIES CLAIMS

VI. SEC INVESTIGATIONS AND ACTIONS

VII. WHITE COLLAR LITIGATION

VIII. INTERPLAY OF SECURITIES CLASS ACTIONS, DERIVATIVE ACTIONS, SEC INVESTIGATIONS AND CRIMINAL PROSECUTIONS

ABOUT ORRICK

Founded in San Francisco in 1863, Orrick today ranks among the world's leading global law firms. We offer acomprehensive set of the highest quality practices and a platform that spans the United States, Europe and Asia.Orrick maintains a well-balanced practice, including a mix of transactional, litigation and regulatory expertise.Our winning record at trial sets us apart from other litigation firms, while we act in the most complex and novelcorporate and finance transactions. Our clients include the world's preeminent public companies, emerginggrowth companies, government entities and virtually every major global bank, as well as other financialmarkets participants. The firm is known for our strength in the technology, energy and financial servicessectors.


PREFACE

Orrick has a long history of providing our annual "Guide to Securities Litigation." In fact, we are in our 24thyear of this publication, and look forward to an exciting 25th edition in 2011.

In 2010, we have seen the global economic crisis continue to have a profound effect on mortgage markets, ournation's banking system, the global economy, and securities litigation. The impact of the crisis on securities classactions and regulatory proceedings cannot be overstated. The important trends for 2010 are easy to spot.

1. Dodd-Frank has forever changed the landscape of securities litigation.

2. Significant changes have occurred at the Securities and Exchange Commission.

3. We have seen massive litigation arising out of the mortgage meltdown.

4. There is a significant impact on securities law as a result of the Supreme Court's decision in Morrison.

5. We continue to see a decline in the number of class action filings in federal courts in 2009 and 2010.

First, the passage of Dodd-Frank is historic. Not only does it fundamentally change the way that financialinstitutions will be regulated in the future but it unleashes an enormous amount of activity by a variety of federalagencies that will go on for years. It also regulates hundreds of funds that have never faced regulation before. All ofthat change creates risk and opportunity for securities litigators.

Second, and related to the first, is the rebirth of the SEC. The SEC is conducting at least a dozen statutorilymandated studies that could result in future changes in law. They range from a review of private aiding and abettingto a review of the rules that apply to municipal issuers. Further, the new director of enforcement has made greatchanges in the enforcement division. He has created nationwide subject matter groups. He has shortened the SEC’sprocesses. He has brought the DOJ to the SEC. Currently, the budget battles have slowed these efforts. Once thoseare resolved, we should see increased activity from the SEC.

Third, the tsunami of mortgage crisis litigation is still gathering strength. Some firms are already riding thewave. The litigation has taken the form of class and individual actions against banks, mortgage originators,underwriters, insurance companies and trustees. The most significant cases involve investors in mortgage securitiesalleging that they were misled when they purchased the mortgage certificates. This litigation seeks billions ofdollars and will occupy hundreds of securities litigators in dozens of firms.

Fourth, the Supreme Court’s decision in Morrison marks a significant change in the theory and scope of thesecurities law as it applies to foreign private issuers. Not only did the Supreme Court end decades of “jurisdictional”analysis and introduce a transactional approach, it significantly contracted the practice. As expected, many fewerforeign private issuer cases are being filed. Many fewer are surviving a motion to dismiss and class certification.

Finally, the decline in the overall practice remains one of the dominant trends of the last two years. Fewercases are being filed. There is less work to do. What work there is to do is coming in different ways and fromdifferent sources. This means that securities litigation groups must change their approach to getting the work anddoing the work.

The amount of change in this practice area is breathtaking. While the future is always uncertain, the shape ofsecurities litigation for the next five years is particularly unclear. This practice guide, now older than some of ourassociates, is intended for practitioners. We hope it is useful.

October, 2010San Francisco, CA

Michael Torpey

http://www.orrick.com/lawyers/Bio.asp?ID=1752

Partner and Chair of the Securities Litigation Group [email protected](415) 773 - 5932

mailto:[email protected]

HOW TO USE THIS GUIDE

The Orrick Guide to Securities Litigation is created by securities litigators for securities litigators. Yes, itcontains a very thorough discussion of securities law and would be a valuable asset for any securities law studentwho wants to drill down on a particular issue. But the outline is not a textbook. It is not meant to be read to cover tocover and does not purport to tell the history of the law or put it in a broader social perspective.

Instead, the Guide is the securities litigator’s bible, how-to guide and book of war – the one place that everysecurities litigator should start whenever a question arises. Whether the issue is consolidating multi-district actions,grappling with the “continuous ownership rule” or responding to a Wells Notice, the Guide will get you started downthe path that leads to an ultimate answer. As we tell our junior associates here at Orrick: always start with the Guide– if it does not have at least the beginning of an answer, you probably have the question framed wrong.

To use the Guide properly, begin with the table of contents. The Guide is dense and lengthy, so it can be veryhelpful to narrow down the chase. Does a question implicate pleading requirements or evidentiary concerns? Is losscausation at issue or is a damages analysis necessary? By targeting in on the particular area of practice, an answerwill be more quickly forthcoming.

Within each section of the Guide, it makes sense to read. Lawyers often have no idea of the question theyshould be asking, and by reading a section of the Guide a more thorough understanding of the issue can arise and,with it, new questions can be formed. While reading, note the density of the Guide’s string cites. The Guide is notintended to provide only one or two exemplary cases, but to list one or two cases in each district – the “classic” casethat everyone cites and the more recent case that explains the evolution of the law. Instead of plugging awayaimlessly online and praying for a hit, one look at the Guide instantly provides you the substantive cite necessary toput your search on the road to completion.

When helpful, the Guide also provides context, describing, for example, the pleading standards for scienter ineach circuit prior to the Reform Act, how the Reform Act conflicted with those standards and how the circuit courtsresponded. The Guide also offers practice suggestions, transferring the wisdom of Orrick’s distinguished securitieslitigation partners through their published articles and war stories. So much of the securities litigation practice canbe learned only by experience, and wherever possible that experience has been transcribed here.

Of course, the Guide cannot be entirely comprehensive, and some discussions are better shorthanded in avolume such as this (see, e.g., the discussion of shareholder derivative litigation and the special litigation committeeprocess). But again: the Guide is a starting point, a jump-off to the more granular details that can be wroughtthrough directed research. Begin your search here every time. Learn the layout of the book and familiarize yourselfwith how to find things in quickly. If you do, the Guide may not always instantly give you every answer you need,but it will always point you in the direction of the ultimate answer you desire.

And when all else fails, call one of the trained securities litigators whose names appear at the front of this bookfor help. We wrote this bible, this how-to guide and book of war, and we are standing by to help you in all yoursecurities litigation needs.

ORRICK, HERRINGTON & SUTCLIFFE LLPSECURITIES LITIGATION & REGULATORY ENFORCEMENT GROUP

Partners

William F. Alderman

James E. Burns, Jr.

Robert Cohen

Russell D. Duncan

Daniel J. Dunne

Richard Gallagher

Joseph Frank

Penelope A. Graboys Blair

George E. Greer

Kenneth Herzinger

James N. Kramer

Richard Martin

James A. Meyers

Lori Lynn Phillips

Susan D. Resley

Amy M. Ross

Michael Torpey - Chair

Michael C. Tu

Robert P. Varian

Counsel

Patryk Chudy

Steve Knaster

Senior Associates

Charles J. Ha

M. Todd Scott

Teodora Manolova

Danielle P. Van Wert

Managing Associates




















Benjamin Geiger

Joseph E. Giometti

Christin Hill

Amy Laughlin

Rebecca Lubens

Justyna Walukiewicz Lee

Paul Rugani

James Thompson

Associates

Justin Bagdady

Lily Becker

Stephanie Cowles

Josh Deitz

Michael Duckworth

Steven Hong

David Keenan

Susanne Klaric

Katie Lieberg

Christine Louie

Katie Lubin

Rebecca Mroz

Antoin Newman Nahas

Jennifer Nejad

Alexander Talarides

Matthew Tolve

Cover Page

Title Page

Copyright Page

About Orrick

Preface

How To Use This Guide

ORRICK, HERRINGTON & SUTCLIFFE LLP SECURITIES LITIGATION & REGULATORY ENFORCEMENT GROUP


A. Jurisdiction And Venue Provisions

1. The "Jurisdictional Means" Requirement

2. Venue Considerations

3. Forum Non Conveniens In Securities Cases

B. Extraterritorial Application Of Securities Laws

1. Statutory Ambiguity Relating To Extraterritoriality

2. Jurisdictional Issues Relating To Extraterritoriality

a. Subject Matter Jurisdiction

b. Personal Jurisdiction

1) Jurisdiction Over Entities

2) Jurisdiction Over Individuals


A. Consolidating Multiple Complaints And Actions

B. Selection Of Lead Plaintiff And Lead Class Counsel

1. Court Appointment Of Lead Plaintiff

a. Presumption Of Most Adequate Plaintiff

b. Rebutting The Presumption

c. Single Largest Loss

d. Multiple Lead Plaintiffs Or Aggregation Of Numerous Plaintiffs

e. Institutional Investors

f. Investment Advisors

g. Discovery Related To Purported Most Adequate Plaintiff

h. Restrictions On Professional Plaintiffs

i. Filing Requirements

2. Selection Of Lead Class Counsel

3. Legal Fees For Non-Lead Counsel

a. Pre-appointment Work

b. After Appointment Of Lead Counsel

c. Representation Of Individual Class Members

d. Representation of Uncertified Subclasses

4. Other Responsibilities And Rights Of Lead Plaintiff

5. Defendants' Role In Appointment Of Lead Plaintiff

a. Multiple Lead Plaintiffs

b. Statutory Criteria

1) The Representative Should Not Be Subject To Unique Defenses

2) The Lead Plaintiff Should Not Be A Professional Plaintiff

C. Motion To Dismiss

1. Pleading Requirements For All Civil Actions

a. Pleading Requirements Before Twombly And Iqbal

b. Twombly And Iqbal: To Survive A Motion To Dismiss, The Complaint Must Be "Plausible On Its Face"

c. Application to Securities Cases

1) Iqbal Raises The Pleading Standards For SEC Civil Enforcement Actions

2) Iqbal May Give Courts Greater Latitude To Dismiss Securities Claims Outside The PSLRA's Ambit

3) Iqbal Raises Pleading Standards For Federal Derivative Actions

2. Pleading Requirements For Claims Sounding In Fraud

3. Claims To Which The PSLRA Applies

4. The Reform Act's Effect On Pleadings Standards

a. The Reform Act's Innovations

1) Heightened Standard As To Statements And Omissions

2) Heightened Standard As To Scienter

3) Stay Of All Proceedings

4) Mandatory Sanctions For Frivolous Securities Fraud Claims

5. The PSLRA's Pleading Requirements With Respect To Statements And Omissions

a. Increased Factual Specificity And Analysis Required

b. Specification Of Each Allegedly Misleading Statement

c. The Reason Or Reasons Why The Statement Is Misleading

d. "All Facts" Forming Basis For "Information And Belief"

1) Use Of Experts Or Consultants In Support Of Allegations

2) Use Of Unnamed Confidential Witnesses

6. The Safe Harbor For Forward-Looking Statements

a. Forward-Looking Statements

b. Applicability Of The Safe Harbor

c. No Duty To Update

d. Effect On Bespeaks Caution Doctrine

7. The PSLRA's Pleading Requirements With Respect To Scienter

a. Heightened Pleading Standard

b. Following The PSLRA, The Circuits Split As To The Stringency Of The "Strong Inference" Standard

c. The Supreme Court Resolves The Split In Tellabs

d. Statements Of Present Or Historical Fact

e. Heightened Scienter Standard For Forward-Looking Statements

f. Use Of Sarbanes-Oxley Certifications To Plead Scienter

g. Use Of GAAP Violations To Plead Scienter

1) Misapplication Of Accounting Principles

2) Red Flags

3) Magnitude Of The Restatement

4) Misstated Earnings Figures

5) Simplicity Of Accounting Rules Violated

6) Indicia Of Fraudulent Intent In General

8. Non-Speaking Defendants And Group Pleading

a. Overview Of Tactics And the Doctrine

b. Did The Reform Act Abolish Group Pleading?

9. Other Procedural Considerations At The Motion To Dismiss Stage

a. Documents The Court May Consider On A Motion to Dismiss

b. Mandatory Sanctions Under PSLRA For Frivolous Securities Fraud Claims

c. Leave To Amend

D. Motions For Class Certification

1. Timing Of Certification Motion And Decision

a. Dispositive Motions

b. Impact Of The Reform Act's Stay Of Discovery

2. The Lead Plaintiff And Class Must Have Article III And Statutory Standing

3. Required Elements: Federal Rule Of Civil Procedure 23

4. Class Certification – Prerequisites Of Rule 23(a)

a. Numerosity

b. Commonality And Predominance

c. Adequacy Of Representation

d. Typicality

1) Damages

2) Reliance

3) Time Of Purchase

4) Unique Defenses

(a) In-And-Out Traders

(b) Professional Plaintiffs

(c) Impact Of "Fraud On The Market" Theory

(d) The La Mar Doctrine

5) Limiting The Class In A Multiple Offering Case

e. Superiority Of Class Action Treatment

5. Alternatives To Denial When Prerequisites Are Not Met

a. Subclasses

b. Length Of Class Period

1) Court's Discretion

2) Variance In Factual Issues

3) Curative Disclosures

(a) Partial Curative Disclosures

(b) Effectiveness Of Curative Statements

(c) Whether Statement Was Curative May Merit Inquiry

6. Statute Of Limitations Considerations On Dismissal

7. Rule 23(f) Interlocutory Appeal

E. Class And Merits Discovery Issues

1. Class Discovery

2. The Reform Act's Discovery Stay

a. Automatic Stay Of Discovery

b. Cases Interpreting The Discovery Stay

c. Exceptions To The Discovery Stay

d. Applicability Of The Discovery Stay On Renewed Motions To Dismiss

e. The Discovery Stay And Related State Actions

1) Motions To Stay Discovery Brought In Federal Court

2) Motions To Stay Discovery Brought In State Court

3) Motions To Stay Proceedings Brought In State Court

3. Depositions

a. Ten Deposition Statutory Limit

b. Rule 30(b)(6) Depositions

1) Speaking For The Corporation

2) Designation Of Knowledgeable Persons

F. Privilege Considerations

1. Public Policies Supporting The Attorney-Client Privilege And Work Product Doctrine

2. Attorney-Client Privilege Issues

a. Immunity From Disclosure

b. Relevance Of Communications And Challenges To Privilege

3. Reliance On Counsel Defense

a. Asserting Defense Waives Privilege

b. Limitation Of Implied Waiver

c. Assertion Of Defense Waives Accountant-Client Privilege

4. Dissemination Of Information To Third Parties

a. No Privilege, Or Implied Waiver

b. No Implied Waiver

c. Prejudice

d. Joint Defense Privilege

e. Dissemination To Regulatory Agencies

1) Waiver Of Privilege?

2) Selective Waiver Theory

f. Federal Rule Of Evidence 502

g. Sarbanes-Oxley "Professional Responsibility" Dissemination

1) Duty To Report Evidence Of A Material Violation

2) Disclosure Of Confidential Information

5. Crime-Fraud Exception

6. The Accountant-Client Privilege

a. No Federal Accountant-Client Privilege

b. State Statutory Privilege

c. Federal Court – Federal Rules Of Evidence Apply

d. Federal Court – No Privilege If Both Federal And State Claims

e. Federal Court – Diversity Action

7. Fifth Amendment Privilege

a. Corporations

b. Producing Documents

c. Adverse Inference

d. Preclusion Of Evidence

8. Assertion Of "Work Product" Protection Over Identities Of Confidential Witnesses

G. Motions For Summary Judgment

1. Legal Standard

a. Burden On Moving Party

b. Opposing Party

2. Scienter

a. Insider Trading

b. Inconsistencies Between Internal Documents And Public Statements

c. Liability Of Outside Directors

d. Liability Of Auditors

3. False Or Misleading Statement Of Material Fact

a. False Or Misleading Statement

b. Adopting Statements In Analyst Reports

c. Materiality

4. Reliance

5. Loss Causation

H. Trial Of Securities Class Actions

1. Jury Education

2. Simple Strategy

3. Plaintiff Witnesses

4. Pre-Trial Elimination Of Claims

5. Damages

I. Settlement Considerations

1. The Court's Role In The Settlement Process

a. Court Approval Or Disapproval

b. Notice

1) General

2) Reform Act's Settlement Notice Requirements

3) Case Law On Notice

c. Fairness Hearing

1) Burden Of Proof

2) Objections

3) Fairness Factors

2. Settlement Prior To Certification Of A Class

a. Hesitancy

b. Court Approval

c. Temporary Class

3. Settlement Prior To Appointment Of Lead Counsel

4. Settlement With Individual Class Members

5. Rule 23 And The "Opt-out"

6. Practical Considerations With Settlements

a. Timing

b. Parties

c. Publicity

d. Admissions

e. Releases

f. Scope Of The Class

g. Consideration

1) Stock

2) Warrants

3) Contingent Value Rights

4) Waiver Of Rights As Consideration

5) Corporate Restructuring

6) Corporate Governance Changes

h. Future Litigation Costs

i. Effect On Other Litigation

j. Appeal And Collateral Attack

7. Partial Settlements

a. Global Settlements Not Always Possible

b. Indemnity

c. Contribution

1) General

2) The Reform Act

3) Settlement Bar Statutes

(a) General

(b) The Reform Act Settlement Bar

(c) Examples of State Good Faith Settlement Statutes

4) Judicial Approval Is Required

5) Application Of Settlement Bars By Federal Courts

6) Calculating Set-off Amounts For Non-Settling Defendants

(a) The Pro Tanto Method

(b) The Pro Rata Method

(c) The Proportional Method

7) The Reform Act Approach To Set-offs

8) Parties Not In Suit

d. Cross-Actions

e. Severance Of Claims

8. Collateral Attack Of Settlement

a. Potential Derivative Suits

b. Issue Preclusion Of Federal Claims

9. Insurance Issues

a. Allocations Are Made From Time Of Settlement

b. An Insurer's Ability To Allocate

10. Attorneys' Fees After Settlement

a. Lead Counsel

b. Reasonable Fee

c. Non-Lead Counsel


A. Section 10(b) Of The 1934 Act And Rule 10b-5

1. Definition Of Security

2. Private Right Of Action

3. Overview Of The Elements Of Rule 10b-5

4. Purchaser/Seller Requirement

5. The Materiality Requirement

a. Definition

b. Mixed Question Of Law And Fact

c. Materiality Of Small Accounting Misstatements

d. Materiality Of Statements Concerning Medical Devices

e. Materiality Of Proposed Mergers

f. The Level Of Detail

g. Information Of Which The Market Is Already Aware

6. Actionable Misstatements

a. Accurate Statements Of Historical Fact

b. General Statements Of Optimism And Puffery

c. Qualitative Statements Of Opinion

d. Statements Rendered False Due To GAAP Violations

e. Statements Regarding Legal Compliance

f. Forward-Looking Statements And The Reform Act's Safe Harbor

1) Covered Forward-Looking Statements

2) Definition Of The Safe Harbor

3) The Safe Harbor Applies To Oral Statements

4) No Duty To Update Forward-Looking Statements

5) Defining "Meaningful Cautionary Language"

6) Some Forward-looking Statements Ineligible For The Safe Harbor

g. Statements That "Bespeak Caution"

1) Evolution Of The "Bespeaks Caution" Doctrine And Its Application

2) Cautionary Language Need Not Necessarily Be In Same Document

3) Limitations On The "Bespeaks Caution" Doctrine

h. Projections

i. Mosaic Misrepresentation Thesis

j. Statements In Analyst Reports

1) The "Adoption" Or "Entanglement" Theory

2) The "Conduit" Theory

7. Omissions

a. The Requirement Of Identifying A Duty To Disclose

b. Affirmative Misstatements May Trigger A Duty To Disclose

c. No Duty To Disclose Mismanagement

d. Duty To Update And Duty To Correct

e. No Duty To Disclose Forecasts

f. Duty To Disclose Triggered By Insider Trading

g. Attorneys' And Accountants' Duty To Disclose Misconduct

1) Section 10A Of The Exchange Act

2) Section 307 Of The Sarbanes-Oxley Act

3) Auditors' Duty To Correct Prior Audit Opinions

h. Duty To Disclose Under Item 303

i. Duty To Disclose Under Item 103

j. No Duty To Disclose Business, Products And Plans Of Competitors

k. Duty To Disclose Technical Or Development Problems

8. Market Manipulation

9. The "In Connection With" Element

10. Causation

a. Transaction Causation

b. Loss Causation

c. Dura Pharmaceuticals

d. Dura's Effect In The Eighth And Ninth Circuits

e. Dura's Effect In Other Circuits

f. "Corrective Disclosure" Approach To Pleading Loss Causation Since Dura

g. The "Materialization Of Risk" Approach To Pleading Loss Causation

h. Pleading Standard For Loss Causation After Dura

i. Limitations On The Scope Of Dura

11. Reliance

a. Fraud On The Market Presumption Of Reliance

1) Existence Of An Efficient Market

2) Misrepresentation Must Be A Public Presentation

3) Application Of Fraud On The Market Theory To Short Sellers

4) Application Of Fraud On The Market Theory To State Securities Law And State Common Law Fraud Claims

b. Rebutting The Presumption Of Reliance

1) Underdeveloped Or Inefficient Markets

2) Truth On The Market Defense

c. Variations On The Fraud On The Market Presumption

1) "Fraud Created The Market"

(a) Evolution Of The "Fraud Created The Market" Theory

(b) Courts Utilizing The "Fraud Created The Market" Theory

(c) Cases Rejecting Or Uncertain About The Fraud Created The Market Theory

2) Reliance On Integrity Of Regulatory Process

d. Reliance On Omissions And The Affiliated Ute Presumption

e. Additional Issues Relating To Reliance

1) Effect Of Central Bank

2) Plaintiff's Diligence To Discover The True Facts

3) Forced Sale Doctrine

12. Scienter

a. Scienter Defined

b. Pleading Scienter Prior To The Reform Act

c. The Reform Act Pleading Standard For Scienter

d. The Post-Reform Act Debate

1) The Supreme Court's Decision In Tellabs

2) The Pre-Tellabs Circuit Split

e. First Circuit

f. Second Circuit

g. Third Circuit

h. Fourth Circuit

i. Fifth Circuit

j. Sixth Circuit

k. Seventh Circuit

l. Eighth Circuit

m. Ninth Circuit

n. Tenth Circuit

o. Eleventh Circuit

p. DC Circuit

q. Corporate Scienter

13. Damages Under Section 10(b)

a. Pre-Reform Act Damage Theories

b. Post-Reform Act Damage Calculations

1) Basic Effect

2) Effect On "Largest Financial Interest" Standard

c. Burden Of Proof

14. Statute Of Limitations

a. The Lampf Standard

b. Period Extended By Sarbanes-Oxley Act

c. Concerns Raised By The Extended Limitations Period

d. "Inquiry Notice" v. "Discovery"

e. Equitable Tolling

B. Section 11 Of The 1933 Act

1. Elements Of A Section 11 Claim

a. Liability Limited To Registration Statement Or Prospectus

b. Material Misstatement Or Omission

1) Materiality

2) Misrepresentation Or Omission

3) Statements That "Bespeak Caution"

c. Plaintiff's Standing To Assert Claim

1) Split Authority Over "Tracing"

2) No Privity Requirement

d. Limited Class Of Defendants

e. Reliance

f. Causation

g. Statute Of Limitations

2. Defenses To Liability Under Section 11

a. Plaintiff's Knowledge

b. Due Diligence Defense

c. Reliance On Counsel Defense

d. The Good Faith Or Due Care Defense

e. "Negative Causation" Defense

3. Damages Under Section 11

a. Measure Of Damages

b. Underwriter's Liability Limited

c. Outside Director's Liability Limited

d. Attorney's Fees And Costs

e. Interest On Damages

4. Contribution And Indemnity

5. Applicability Of The Heightened Pleading Requirements Of Rule 9(b) And The Reform Act

6. Due Diligence – Defense Or Duty

a. The Statutes

b. The SEC's View

c. The FINRA View

d. Judicial Views

7. The Due Diligence Defense

a. No Issuer Defense

b. Due Diligence Defenses For Non-Issuer Defendants

1) "Non-Expertised" Portions

2) "Expertised" Portions

3) "Official" Portions

c. Scope of Due Diligence Defenses

1) Section 11(c)

2) "Standard Of The Street"

3) Financial Industry Regulatory Authority (FINRA) Delineations Of "Reasonableness"

4) SEC Rule 176

d. Due Diligence Defense For Underwriters

1) Reliance On Management Representations

2) Reliance On Accountant Representations

3) Factors In Determining "Reasonableness"

4) Considerations For Due Diligence

(a) The Issuing Entity

(b) Business and Industry

(c) Management, Counsel, and Auditors

(d) Financial Statements

(e) Properties

(f) Material Contracts

(g) Employees

(h) Litigation and Administrative Proceedings

(i) Use of Proceeds

(j) Prior Filings

(k) Investigate "Red Flags"

5) Non-Managing Underwriters

6) Counsel For The Underwriters

e. Officers And Directors Of The Issuer

f. Counsel For The Issuer

g. Accountants And Other Experts

8. Documenting Due Diligence

9. The Timing Of Due Diligence

10. Drafting Offering Documents

a. Risk Factors

b. Forward-Looking Information

c. Safe Harbor

11. Professional Malpractice

a. Elements Of Cause Of Action For Professional Malpractice

b. To Whom Is The Duty Owed?

1) Privity

2) Accountant Liability

C. Section 12 Of the 1933 Act


a. Definition Of Security

b. Definition Of "Sale" Of Securities

1) Stock And Stock Options

2) Affirmative Investment Decision

c. Defendant Must Be A "Seller" Of Securities

d. Supreme Court Definition of "Seller"

1) Privity

2) Supreme Court Rejects "Substantial Factor" Test

3) In Pari Delicto

e. Officers And Directors Of A Corporate Seller

2. Section 12(a)(1)

a. Elements Of A Section 12(a)(1) Claim

b. Exempt Security

c. Exempt Transaction

d. No Due Diligence Defense

e. Measure Of Damages Under Section 12(a)(1)

3. Section 12(a)(2)


1) No Reliance

2) No Scienter

3) No Causation

4) Limited To Initial Offering Or Sale – No Tracing

5) Scope Of Investors' Duty

b. "Seller" Status Issues Under 12(a)(2)

1) Defendants In Public Offering Litigation

2) Firm Commitment Indemnity

3) Actual Participation

4) Section 12 Claims Against Professionals

5) Professionals As Sellers

6) No Secondary Liability

c. Measure Of Damages Under Section 12(a)(2)

1) Rescission

2) Damages

3) Reform Act Limitation

4) Attorney's Fees

5) Punitive Damages

d. Not Applicable To Private Offerings

e. Defenses Available Under Section 12(a)(2)

1) Plaintiff's Knowledge

2) Reasonable Care/Due Diligence

3) Materiality

4) Statute Of Limitations

5) Equitable Tolling

6) Rule 9(b)

7) Not Applicable To Aftermarket Transactions

4. Comparison Of Due Diligence Defense Under Sections 11 And 12(a)(2)

a. Different Standards

1) The Section 11 Standard As More Stringent

2) The Sections 11 And 12(a)(2) Standards As Equivalent

3) The Section 12(a)(2) Standard As More Stringent

D. Section 14 Of The 1934 Act

1. Section 14(a) And SEC Rule 14a-9

a. Section 14(a)

b. Rule 14(a)‑9

c. Elements Of A Section 14(a) And Rule 14(a)(9) Violation

d. Breach Of Fiduciary Duty

e. Applicability Of The Reform Act

f. Statute Of Limitations

2. Section 14(d) And SEC Rule 14d-10

a. Best Price Provision

b. SEC Rule 14d-10

c. Elements Of A Rule 14d-10 (a)(2) Violation

1) During Pendency Of The Tender Offer

(a) Formal Test

(b) Possible Exception For Successive Tender Offers

(c) Functional Test

(d) The Third Circuit's Approach

2) Pursuant To The Tender Offer

d. Other Important Provisions In Rule 14d-10

1) The "All-Holders" Rule

2) Offering More Than One Type Of Consideration In A Tender Offer

e. Applicability Of The Reform Act To Section 14(d) Claims

3. Section 14(e)

a. Purpose

b. Private Cause Of Action

c. Elements Of A Section 14(e) Claim For Misstatements Or Omissions

1) Materiality

2) Scienter

3) In Connection With A Tender Offer

4) Reliance/Causation

(a) Permanent Injunctions

(b) Omissions

(c) Misstatements

d. Section 14(e)'s Prohibition Of "Fraudulent, Deceptive, Or Manipulative" Practices


E. Section 16 Of The 1934 Act

1. Purpose

2. Strict Liability

3. Standing


F. Section 17 Of The 1933 Act

1. Existence Of A Private Right Of Action

2. SEC Enforcement Actions

G. Section 18 Of The 1934 Act

1. Elements Of Claim

a. Purchaser/Seller

b. Specific Reliance

c. Material Misstatement

2. Documents To Which Section 18(a) Applies

3. Liability Under Section 18

4. Defenses Under Section 18

5. Attorneys' Fees


H. Insider Trading Claims Under Section 10(b) And Section 20A

1. Statutory Provisions

a. Section 10(b) Of The 1934 Act

b. Section 20A Of The 1934 Securities Exchange Act

2. Private Right of Action For Insider Trading

a. Actions Brought Under Rule 10(b)

1) Classical Theory

2) Misappropriation Theory

b. Actions Under Section 20A

1) Independent Violation Required

2) Contemporaneous Traders

3) Same Class Of Securities

c. Civil And Criminal Liability Under A Misappropriation Theory

d. Definition Of Insider

e. Materiality

I. Securities-Related RICO Suits

J. The Investment Company Act Of 1940

1. Section 36(b) Of The Investment Company Act

2. Initial Litigation – The Excessive Fee Cases

3. Recent Attempts To Expand The Scope Of Section 36(b)

a. Mergers

b. Rights Offerings

c. Leveraged Funds

d. Annuity Contracts

e. Multiple Fund Boards

f. Membership Dues To ICI

4. Preemption Of State Law Claims In Section 36(b) Action

5. Implied Right Of Action Under The 1940 Act

a. Legislative History

b. Courts Finding Implied Rights Of Action

c. Courts Finding No Implied Rights Of Action

6. Section 36(a)—The Perceived Catchall

a. Elements Of Section 36(a)

b. Judicial Evolution Of Section 36(a)

c. Private Right Of Action

d. Eliminating The Implied Right Of Action Under Section 36(a)

e. Breach Of Fiduciary Duty Cases Involving Board Actions

7. Avoiding The Reform Act

a. Section 13(a)(3) (Investment Objectives)

b. Section 7 (Unregistered Non-US Investment Companies)

c. Section 35(d) (Misleading Names)

d. Section 12(b) (Distribution Plans)

8. Defenses To Implied Rights Suits

a. Statute Of Limitations

b. Aiding And Abetting

c. Direct Versus Derivative

d. Failure To Make A Demand

e. Bespeaks Caution

K. Sarbanes-Oxley And Dodd-Frank


A. Control Person Liability Under Section 15 Of The 1933 Act and Section 20(a) of the 1934 Act


a. Section 15 Of The 1933 Act

b. Section 20(a) Of The 1934 Act

2. Elements Of A Control Person Cause Of Action

a. Primary Violation

b. Nature And Degree Of Control Over Corporate Operations

1) SEC Definition Of Control

2) Other Definitions Of Control

c. Exercising Control: A Circuit Split

1) Culpable Participation Test

(a) Culpable Participation Required

(b) Culpable Participation Not Required

(c) Allegations Of Status Alone Deemed Sufficient

(d) Status Alone Deemed Insufficient

(e) Potential Control Test

3. Factual Nature Of Inquiry

4. "Transitive" Control Liability

5. Defenses Under Control Person Statutes

a. Securities Act, Section 15

b. Securities Exchange Act, Section 20(a)

c. Burden Of Proof

1) Good Faith Defense

2) Duty

3) Sliding Scale

4) Fact-Intensive Inquiry


B. Respondeat Superior Liability

1. Respondeat Superior Available

a. Application of Respondeat Superior To Corporations

b. Respondeat Superior After Stoneridge

c. Third Circuit View

C. Aiding And Abetting Liability

1. No Aiding And Abetting Liability In Private Suits

2. Impact Of Central Bank

a. Expansion Of Primary Liability Allegations

1) Bright-Line

2) Substantial Participation

b. Application To SEC Enforcement Actions

c. Effect On Conspiracy Claims

d. Effect On Group Pleading Doctrine

e. Reliance

D. Scheme Liability

1. Application Of Stoneridge

2. Pre-Stoneridge Scheme Liability Decisions

a. Eighth Circuit

b. Ninth Circuit

c. District Courts


A. The Uniform Standards Act: Limiting State Court Claims

1. Impetus For The Uniform Standards Act

2. Background On The Uniform Standards Act

a. Exclusive Federal Jurisdiction And Preemption Of State Securities Law For Most Shareholder Class Actions

b. In Connection With

c. Strong Preemption

d. Retroactive Application of SLUSA

e. Shareholder Actions Brought In State Court Are Removable To Federal Court

f. Reviewability of Remand Order

g. Federal Courts Can Issue Stays Of State Court Actions

3. Requirements For Removal

a. Misrepresentation Or Omission Must Be "In Connection With" Purchase Or Sale Of Covered Security

b. Covered Securities

c. Covered Class Actions

1) Actions Seeking Damages

2) Presence Of Uncovered Claims

3) 1933 Act Claims In State Court

d. Scienter Pleading Requirement

4. Exclusions Under The Uniform Standards Act

a. Derivative Actions Excluded

b. Actions Brought By A State

c. Trustee Actions

d. "Delaware Carve-Out"

1) Venue Limitation

2) Remand Of Improperly Removed Actions Required

5. Practical Effect Of The Uniform Standards Act

B. Securities Fraud Claims

1. Individual Actions In State Court

2. Internal Affairs Doctrine

3. California Corporations Code Section 25400

a. California's Blue Sky Laws

1) Section 25400

2) Elements

3) Reliance

4) Privity

5) Section 25500Id. at 113.

4. California Business And Professions Code Sections 17200 and 17500

5. California Civil Code Sections 1709 And 1710

6. Common Law Fraud And "Holding" Claims

C. Shareholder Derivative Actions

1. Definition

2. Standing

a. Shareholder Requirements

b. Effect of Merger

c. Choice Of Law

d. Fair And Adequate Representation

e. Security

3. Demand Requirement

4. Pleading Demand Futility

a. Burden

b. Must Be Pled Without The Benefits Of Discovery

5. Standard For Board Action

a. Challenges To Board Action

b. Challenges To Board Inaction

6. Responding To The Demand

a. Acceptance Of Demand

b. Rejection Of Demand

c. Demand Deferred

7. Special Litigation Committees

D. California Corporations Code Section 1101: The All-Holders Rule


2. Inapplicability Of Tender Offers



A. The Power Of The SEC

1. Broad Investigatory Powers

2. Enforcement Actions: Key Statutory Provisions

a. Securities Act Of 1933

b. Securities Exchange Act Of 1934

1) Section 10(b): Anti-fraud

2) Section 13: "Books And Records" And Internal Controls

3) Section 15: Broker-Dealer Regulation And Enforcement

c. Investment Company Act Of 1940

d. Investment Advisers Act Of 1940

e. Sarbanes-Oxley Act Of 2002

B. The Initiation And Escalation Of An SEC Investigation

1. Sources Of An SEC Investigation

2. Informal Inquiries

a. Guidelines Governing Informal Inquiries

b. Document And Testimonial Discovery In Informal Inquiries

c. Conclusion Of An Informal Inquiry

3. Formal Investigations

a. Formal Order Of Investigation

b. Contents Of A Formal Order

c. Guidelines Governing Formal Inquiries

d. Conclusion Of A Formal Inquiry

4. Wells Notice And Submission

a. No Right To Receive A Wells Notice

b. Whether To Make A Wells Submission

c. Content Of A Wells Submission

5. Internal Investigations

6. Action By The Commission

7. Litigating Against The Commission

C. Disclosing An SEC Investigation

1. Nondisclosure By The SEC

2. Disclosure By The Company Under Investigation

D. Commission Enforcement Actions

1. Types Of Cases

a. Accounting And Financial Fraud

b. False And Misleading Statements

c. Insider Trading

d. Market Manipulation

e. Mutual Fund Cases – Market Timing/Late Trading

f. Options Backdating

g. Foreign Payments

h. Regulation FD

i. Ponzi Schemes, Investment Schemes And A Renewed Focus On Enforcement

j. "Implied Representation" Theory

2. Remedies

a. Injunctive Actions

1) Preliminary Injunction

2) Final Injunction

b. Civil Penalties

c. Disgorgement

d. Prospective Relief

1) Undertakings

2) Appointment Of Independent Consultant Or Corporate Monitor

E. Administrative Proceedings

F. Rule 102(e) Proceedings

1. Process

a. Conduct Of Hearings

b. Appeal To The Commission

c. Appeal To United States Court Of Appeals

2. Sanctions

a. Cease And Desist Orders

1) Enforcing A Cease And Desist Order

2) Disgorgement And Accounting

b. Monetary Penalties

c. Suspension/Permanent Bar


A. Parallel Civil And Criminal Proceedings

1. Potential Benefits To Defendants

a. Civil Discovery

b. Collateral Estoppel And Persuasive Effect Of Civil Victory

2. Benefits To The Government, Regulators, And Civil Plaintiffs

a. SEC Information Gathering And Disclosure

3. Judicial Scrutiny

4. Self-Regulatory Organizations

5. Communicating With The Government

a. Fifth Amendment

b. Proffer Agreements

c. Immunity

1) Transactional Versus Derivative Use Immunity

2) Informal Immunity

d. Privilege And The Holder/Thompson/McCallum/McNulty/Filip Memos

1) Holder Memo

2) Thompson Memo

3) McCallum Memo

4) McNulty Memo

5) Filip Memo

6) KPMG Cases

6. Grand Juries And Subpoenas

a. The Grand Jury

b. Subpoenas

7. Criminal Discovery And Trial

a. Defendants' Discovery Rights

b. Defendant's Discovery Obligations

8. Double Jeopardy

9. Multiple Defendant Issues

a. Ethical Considerations

b. Joint Defense Agreements

10. Stays And Protective Orders

a. Stays

b. Protective Orders

B. Penal Provisions Of The Federal Securities Laws

1. Section 24 Of The 1933 Act And Section 32(a) Of The 1934 Act

a. Sentencing

2. Mens Rea: Knowingly And Willfully

3. Sarbanes-Oxley Act Of 2002

a. Certification Of Periodic Reports – Section 906

b. Certification Of Quarterly And Annual Reports – Section 302

c. Whistleblower Provisions

C. The Non-Securities Criminal Code

1. Mail And Wire Fraud

a. Elements Of Mail And Wire Fraud

b. Scheme To Defraud And Fraudulent Representations

c. Use Of The Mails Or Wires In Furtherance Of The Scheme

d. Specific Intent To Defraud

e. Honest Services

2. Conspiracy

a. Elements Of Conspiracy

b. Agreement

c. Specific Intent

d. Overt Act

e. Pinkerton Liability

3. Racketeer Influenced And Corrupt Organizations Act

a. Elements

b. Enterprise

c. Conducting Or Participating In The Activities Of The RICO Enterprise

d. Pattern Of Racketeering Activity

4. False Statements Statute

a. Section 1001

b. "Conceals Or Covers Up By Any Trick, Scheme, Or Device"

c. "False, Fictitious Or Fraudulent Statements Or Representations"

d. "Makes Or Uses Any False Writing Or Document"

e. Materiality

5. Perjury

a. General Perjury

b. Subornation Of Perjury

c. Perjury Before A Grand Jury

d. False Testimony

e. Materiality

f. Oath Administered And Oath Authorized

g. Proceeding

h. Willfully And Contrary To Such Oath

i. One Witness Plus Or Corroboration Rule

6. Obstruction Of Justice

a. Elements Of Obstruction Of Justice

b. Specific Intent

c. Corruptly

d. Endeavors

VIII. INTERPLAY OF SECURITIES CLASS ACTIONS, DERIVATIVE ACTIONS, SEC INVESTIGATIONS AND CRIMINAL PROSECUTIONS

A. Case Initiation

B. Preliminary Discovery

C. Privilege Concerns

D. Representation Issues

E. Discovery

F. Written Discovery

G. Depositions

H. Settlement

I. Insurance Concerns


The forces of globalization have not bypassed the practice of securities litigation. In recent years, plaintiffshave initiated large numbers of cases – many in New York – against foreign companies that have restated theirfinancials or experienced other business setbacks. This development has raised interesting and evolving questionspertaining to the extent of the courts’ jurisdiction to apply the federal securities laws to foreign companies andforeign transactions. Understanding these issues requires a basic familiarity with the jurisdiction and venueprovisions of the U.S. securities laws.

A. Jurisdiction And Venue Provisions

1. The “Jurisdictional Means” Requirement-

Pursuant to 28 U.S.C. § 1331, the general federal question jurisdictional statute, federal courts possess subject-matter jurisdiction over securities class actions and other suits under the federal securities laws. Sec. InvestorProt. Corp. v. Vigman, 764 F.2d 1309, 1314 (9th Cir. 1985). Despite this general subject matter jurisdiction,many federal securities provisions are implicated only where the purported violator used the requisite“jurisdictional means” in connection with the securities transaction or transactions at issue. See, e.g., SecuritiesAct of 1933 §§ 5, 12, 17; Securities Exchange Act of 1934 §§ 9(a), 10(b), 15(c)(1), 15(c)(2). Suchjurisdictional means are generally present where the alleged violation occurred by use of the mails, by means oftransportation or communication in interstate commerce, or under some provisions – notably Section 10(b) ofthe Securities Exchange Act – by use of the facilities of a national securities exchange. See Hooper v.Mountain States Sec. Corp., 282 F.2d 195, 205 (5th Cir. 1960) (holding that use of interstate telephone lines tocall one person in another state was sufficient use of jurisdictional means).

As a practical matter, the jurisdictional means requirement is rarely disputed in major securities litigation casesinsofar as such cases almost always involve large entities that are active in more than one state and are listed onnational securities exchanges. Furthermore, courts have largely denuded the jurisdictional means requirementand it is well-recognized that “the jurisdictional hook need not be large to fish for securities law violations.” Lawrence v. S.E.C., 398 F.2d 276, 278 (1st Cir. 1968) (citing several circuit authorities). However, as ajurisdictional prerequisite to invoking the federal securities laws, the jurisdictional means requirement cannot beignored, and defense counsel should remain aware of its occasional significance. No matter how clearly itappears that jurisdiction exists in an action, plaintiffs still have the burden of both pleading and proving that theappropriate jurisdictional means were used. See Wells v. Monarch Capital Corp., No. 91-10575-MA, 1991 WL354938, at *10 (D. Mass. Aug. 23, 1991) (requiring plaintiff to amend complaint to allege jurisdictional meansdespite fact that allegations in complaint made it “difficult to imagine that the allegedly fraudulent statementsdetailed in the complaint did not necessitate the use of the mail, telephone or some other interstate facility”).

2. Venue Considerations-

The special venue provisions applicable in federal securities class actions are quite broad. See Securities Act §22(a); Securities Exchange Act § 27. Under both the 1933 Act and the 1934 Act, plaintiffs may file an action inthe federal district where (a) the defendant is found or is an inhabitant, (b) the defendant transacts business, or


(c) any act or transaction constituting the securities law violation occurred. Id.; Bourassa v. Desrochers, 938F.2d 1056, 1057 (9th Cir. 1991) (holding telephone call to resident of district was “act or transaction”supporting venue in district); Kansas City Power & Light Co. v. Kansas Gas & Elec. Co., 747 F. Supp. 567,572-73 (W.D. Mo. 1990) (holding that “found” in district means having presence and continuous activity thereand “transacts business” in district requires that activities be continuous and substantial part of ordinarybusiness). But see Luther v. Countrywide Home Loans Servicing LP, 533 F.3d 1031, 1032-24 (9th Cir. 2008)(affirming remand to state court after removal because “the Class Action Fairness Act of 2005, which permits ingeneral the removal to federal court of high-dollar class actions involving diverse parties, does not supersede §22(a)’s specific bar against removal of cases arising under the ‘33 Act”). Contra Katz v. Gerardi, 552 F.3d558, 562 (7th Cir. 2009) (disagreeing with Luther and holding that § 22(a)’s general grant of state courtjurisdiction is modified by the Class Action Fairness Act).

In securities fraud actions under § 10(b) involving several defendants acting across more than one district, anymaterial act committed by any defendant in furtherance of the purported scheme will satisfy the SecuritiesExchange Act’s venue requirement as to all defendants. In re Triton Ltd. Sec. Litig., 70 F. Supp. 2d 678, 687(E.D. Tex. 1999); FS Photo, Inc. v. PictureVision, Inc., 48 F. Supp. 2d 442, 446 (D. Del. 1999). The breadth ofthis “co-conspirator venue” rule is counter-balanced by the liberal venue transfer rules under the federal venuestatute, 28 U.S.C. § 1404. Section 1404(a) allows a district court to transfer a securities suit, despite thepropriety of plaintiffs’ initial choice of venue, “to any other district or division where [the suit] might have beenbrought.” 28 U.S.C. § 1404(a). While courts will accord some deference to plaintiffs’ initial choice of forum, acourt may transfer a class action to another district for any one of a number of reasons, including theconvenience of the parties and witnesses, the cost of obtaining the presence of witnesses, the relative ease ofaccess to sources of proof, relative court congestion, relative proximity to where material events occurred, aswell as the court’s determination of whether a transfer will enhance the administration of justice. See Wash.Pub. Utils. Group v. Dist. Court, 843 F.2d 319, 326-27 (9th Cir. 1987) (holding change of venue wholly withintrial court’s discretion); Troyer v. Karcagi, 488 F. Supp. 1200, 1207 (S.D.N.Y. 1980) (according little weight toplaintiffs’ choice of forum “where the operative facts of the case have no material connection with [the chosen]district”). Contractual forum selection clauses may be voided. See, e.g., NutraCea v. Langley Park Invs. PLC,No. 2:06-cv-2019-MCE-DAD, 2007 WL 135699, at *2 (E.D. Cal. Jan. 16, 2007) (declaring a forum selectionclause mandating litigation be brought in New York void under Cal. Corp. Code § 25701).

3. Forum Non Conveniens In Securities Cases

The special venue provisions of the 1933 and 1934 Acts, as well as Section 1404(a), do not supersede theapplicability of the common law doctrine of forum non conveniens in securities cases. See Alfadda v. Fenn, 159F.3d 41, 46-49 (2d Cir. 1998) (affirming dismissal on forum non conveniens grounds of lawsuit in which SaudiArabian investors in corporation brought suit under U.S. federal securities and other antifraud laws); Warlop v.Lernout, 473 F. Supp. 2d 260 (D. Mass. 2007) (dismissing lawsuit on forum non conveniens grounds becauseplaintiff sought to form class of investors who bought stock on European exchange and, under facts of case,alternative forum was available and private and public factors supported dismissal); In re Corel Corp. Sec.Litig., 147 F. Supp. 2d 363, 365-67 (E.D. Pa. 2001) (finding that Canadian courts would provide adequateforum for securities class action, but declining to transfer action to Canada due to balance of factors underforum non conveniens analysis).

Defendants often invoke the doctrine of forum non conveniens where plaintiffs have sought out the protectionsof U.S. securities laws despite the fundamentally foreign character of the dispute at issue. In this sense, thedoctrine of forum non conveniens is a venue-based challenge to the application of U.S. court processes in anextraterritorial securities dispute. As discussed next, plaintiffs’ attempt to apply U.S. securities lawsextraterritorially may, in certain cases, move beyond a matter of mere venue convenience or inconvenience, andmay stretch the jurisdiction of the securities laws further than was intended.

B. Extraterritorial Application Of Securities Laws

Private plaintiffs continue to seek to haul foreign issuers into U.S. courts, raising a number of difficultlegal issues relating to the extraterritorial reach of U.S. securities laws in light of due process andminimum contacts requirements. While these topics could fill a treatise, some basic issues andsignposts are touched on here, culminating in a discussion of the Supreme Court’s decision inMorrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010).

1. Statutory Ambiguity Relating To Extraterritoriality

The federal securities laws do not expressly define the extent to which provisions apply extraterritorially. Section 22 of the 1933 Securities Act, for example, states simply that:

The district courts of the United States … shall have jurisdiction of offenses and violationsunder this title … of all suits in equity and actions at law brought to enforce any liability orduty created by this title. Any such suit or action may be brought in the district wherein thedefendant is found or is an inhabitant or transacts business, or in the district where the offeror sale took place, if the defendant participated therein, and process in such cases may beserved in any other district of which the defendant is an inhabitant or wherever thedefendant may be found.

Section 27 of the Securities Exchange Act of 1934, Section 44 of the Investment Company Act of 1940, andSection 214 of the Investment Advisors Act of 1940 similarly provide for federal jurisdiction over a defendantin any district where the defendant inhabits or is found, transacts business, or offers or sells securities. Sincethe statutory language is quite general in scope, these provisions provide little guidance when confronted withan issue relating to a specific party’s potential liability under U.S. securities laws.

Prior to Morrison, numerous courts had candidly recognized that the extraterritorial application of the securitieslaws involves policy considerations and the courts’ best judgment rather than clear statutory guidance. See,e.g., Robinson v. TCI/US W. Commc’ns, Inc., 117 F.3d 900, 904-905 (5th Cir. 1997) (“[W]ith one smallexception the Exchange Act does nothing to address the circumstances under which American courts havesubject matter jurisdiction to hear suits involving foreign transactions.”); Itoba Ltd. v. Lep Group PLC, 54 F.3d118, 121 (2d Cir. 1995) (“It is well recognized that the Securities Exchange Act is silent as to its extraterritorialapplication.”); Zoelsch v. Arthur Andersen & Co., 824 F.2d 27, 30 (D.C. Cir. 1987) (stating that provisions of1934 Act furnish “no specific indications of when American federal courts have jurisdiction over securities lawclaims arising from extraterritorial transactions”). But see S.E.C. v. Kasser, 548 F.2d 109, 114 (3d Cir. 1977)(“[T]he anti-fraud laws suggest that such [extraterritorial] application is proper. The securities acts expresslyapply to ‘foreign commerce,’ thereby evincing a Congressional intent for a broad jurisdictional scope for the1933 and 1934 Acts.”) (citing preambles to Acts).

In Carnero v. Boston Scientific Corp., 548 U.S. 906, the U.S. Supreme Court denied certiorari of a First Circuitdecision holding that the whistleblower provisions of the Sarbanes-Oxley Act did not have extraterritorialeffect.

2. Jurisdictional Issues Relating To Extraterritoriality

Due to the ambiguity in federal securities legislation, courts are required to make an independent determinationof subject matter and personal jurisdiction. See S.E.C. v. Carrillo, 115 F.3d 1540, 1542 (11th Cir. 1997)(quoting In re Chase & Sanborn Corp., 835 F.2d 1341, 1344 (11th Cir. 1988)) (“It is well established that ‘[t]hedue process clause . . . constrains a federal court’s power to acquire personal jurisdiction’ over a nonresidentalien.”).

a. Subject Matter Jurisdiction

In determining whether to exercise subject matter jurisdiction over an action, U.S. courts have long focused onthe policy considerations that led to the extraterritorial application of the laws – protecting or punishing U.S.parties and markets. Interbrew v. Edperbrascan Corp., 23 F. Supp. 2d 425, 429 (S.D.N.Y. 1998). In so doing,courts have developed two tests to determine whether the exercise of jurisdiction is proper – the conduct testand the effects test.

Under the “conduct test,” the inquiry in pre-Morrison cases focused on whether a defendant’s alleged conductin the U.S. was material to fraud committed elsewhere. To the extent that circuit courts adopted the conducttest, they were divided as to how to apply the test. See In re Cable & Wireless, PLC, 321 F. Supp. 2d 749, 758-59 (E.D. Va. 2004) (observing the circuit split regarding the extent of domestic conduct that triggers subjectmatter jurisdiction and noting that the Fourth Circuit had not yet adopted either the conduct or effects test). Themost restrictive version of the conduct test was applied by the Second, Fifth, and District of Columbia Circuits. The conduct test was met in these circuits only when the defendant’s allegedly fraudulent conduct in the U.S.:(1) amounts to more than just actions that are “merely preparatory” and (2) is the direct cause of the claimedlosses. S.E.C. v. Berger, 322 F.3d 187, 193 (2d Cir. 2003) (holding subject matter jurisdiction existed overNew York resident who formed an offshore investing company). See also Europe & Overseas CommodityTraders, S.A. v. Banque Paribas London, 147 F.3d 118 (2d Cir. 1998) (affirming dismissal for lack of subjectmatter jurisdiction under the conduct test); Robinson v. TCI/U.S. W. Commc’ns, Inc., 117 F.3d 900, 904-905(5th Cir. 1997); In re Vivendi Universal, S.A., 381 F. Supp. 2d 158, 168 (S.D.N.Y. 2003) (applying “conducttest” and concluding court had subject matter jurisdiction); Zoelsch v. Arthur Andersen & Co., 824 F.2d 27, 33(D.C. Cir. 1987). In applying the second prong of the conduct test, the court in In re AstraZeneca Sec. Litig.,559 F. Supp. 2d 453 (S.D.N.Y. 2008), aff’d, 33 F. App’x 404 92d Cir 2009), declined to adopt a “global fraud-on-the-market” presumption. While the court noted that previous courts had rejected such a presumptionbecause of the belief that it would over-extend the extraterritorial reach of the United States securities laws, thecourt refused to apply the theory absent guidance from the Second Circuit on the issue. Id. at 466. Applying aless restrictive version of the “conduct test,” the Third Circuit exercised subject matter jurisdiction where thereis material and substantial conduct that occurs in the United States in pursuit of the fraudulent scheme,regardless of whether it has a substantial effect on the larger fraud. See S.E.C. v. Kasser, 548 F.2d 109, 114 (3dCir. 1977); In re Royal Dutch/Shell Transp. Sec. Litig., 380 F. Supp. 2d 509, 543 (D.N.J. 2005) (under the“conduct test,” court held there were significant and material acts relating to the alleged fraud that occurredwithin the U.S.).

The Seventh, Eighth, and Ninth Circuits prior to Morrison employed a middle ground approach to the conducttest. These circuits held, to various degrees, that a court has subject matter jurisdiction when a defendant’sU.S.-based conduct was (1) significant and (2) substantial or material to the larger scheme. Kauthar SDN BHDv. Sternberg, 149 F.3d 659, 666-67 (7th Cir. 1998); Butte Mining PLC v. Smith, 76 F.3d 287 (9th Cir. 1996);Cont’l Grain (Austl.) Pty. Ltd. v. Pac. Oilseeds, Inc., 592 F.2d 409, 420-21 (8th Cir. 1979). Notwithstandingthe Fourth Circuit’s silence on this issue, the Eastern District of Virginia adopted the middle ground approachin a 2004 decision. In re Cable & Wireless Sec. Litig., 321 F. Supp. 2d 749, 762-64 (E.D. Va. 2004) (exercisingsubject matter jurisdiction over foreign purchasers’ claims where defendants’ U.S.-based conduct involvedtransactions worth hundreds of millions of dollars and served as the basis for defendant’s allegedly materialoverstatement of its revenues and earnings).

Under the “effects test,” courts directed their “attention to the impact of overseas activity on U.S. investors andsecurities traded on U.S. securities exchanges.” Interbrew v. Edperbrascan Corp., 23 F. Supp. 2d 425, 429(S.D.N.Y 1998).

Although only one of the two tests must be satisfied for a court to properly exercise subject matter jurisdiction,certain courts have analyzed the conduct and effects tests in conjunction with each other. Itoba Ltd. v. LepGroup PLC, 54 F.3d 118, 122 (2d Cir. 1995). “Indeed an admixture or combination of the two often gives abetter picture of whether there is sufficient United States involvement to justify the exercise of jurisdiction byan American court.” Nikko Asset Mgmt. Co. v. UBS AG, 303 F. Supp. 2d 456 (S.D.N.Y. 2004) (noting that theeffects test and the conduct test provide independent grounds for establishing subject matter jurisdiction, yetdismissing the case because neither test was satisfied). In the face of this variety of approaches, a district court

may choose to examine a number of different tests before reaching a conclusion. See Blechner v. Daimler BenzAG, 410 F. Supp. 2d 366 (D. Del. 2006) (applying a range of different tests before concluding that jurisdictionwas not supportable under any of them).

In Morrison v. Nat’l Australia Bank, Ltd., the Second Circuit applied the conduct and effects tests to a securitiesclass action in which foreign plaintiffs sued a foreign issuer in the United States for a violation of Americansecurities laws based on securities transactions in foreign countries (a so-called “foreign-cubed” class action). 547 F.3d 167, 175 (2d Cir. 2008). The court affirmed dismissal of the class action, but declined to adopt abright-line ban on foreign purchaser claims and expressed concern that such a rule would “conflict with the goalof preventing the export of fraud from America.” Id. See also Lapiner v. Camtek, Ltd., No. C-08-1327 MMC,2009 WL 1542708 (N.D. Cal. June 2, 2009) (dismissing “foreign cubed” securities class action) (slip op.) In Inre CP Ships Ltd. Sec. Litig., the Eleventh Circuit distinguished Morrison and affirmed the exercise of subjectmatter jurisdiction in a case between foreign parties because, although the relevant financial statements wereissued abroad, the alleged conduct that took place in the U.S. “represente[d] substantial acts in furtherance ofthe fraud which directly caused the claimed losses.” 578 F.3d 1306, 1316 (11th Cir. 2009).

The Supreme Court affirmed the Second Circuit’s decision in Morrison, but on different grounds. Morrison v.Nat’l. Australia Bank, Ltd., 130 S. Ct. 2869 (2010). Holding that the district court had subject matterjurisdiction, the court nevertheless concluded that dismissal had been proper because the complaint failed tostate a claim in light of the fact that the “presumption against extraterritoriality applies in 10b-5 cases. Thecourt rejected the Second Circuit’s “conduct” test and instead adopted a bright-line “transactional” that asks“whether the purchase or sale is made in the United States, or involves a security listed on a domesticexchange.”

Nothing that courts’ failure to apply the presumption against extraterritoriality in 10b-5 cases had “produced acollection of tests for divining what Congress would have wanted, complex in formulation and unpredictable inapplication,” the Court rejected the fact-intensive approach required by the “conduct” test as “judicial-speculation-made-law” that risked interfering with other nations’ regulation of transactions on their ownsecurities exchanges.

While the Supreme Court’s adoption of a bright-line “transactional” test in Morrison makes clear that “foreign-cubed” cases (private actions by foreign purchasers of foreign companies’ securities on foreign exchanges) maynot be brought in U.S. courts, as either individual or class actions, it has not ended plaintiffs’ efforts to posequestions that continue to arise in post-Morrison cases. See, e.g., Stackhouse v. Toyota Motor Co., 2010 U.S.Dist. LEXIS 79837 (C.D. Cal. Jul. 16, 2010) (rejecting attempt to escape Morrison in “foreign-squared” case ofU.S. purchasers of foreign securities on foreign exchange).

A further example of uncertainty in the wake of Morrison is the divergent treatment of ADRs. In In re AlstomSA Sec Litig., 2010 U.S. Dist. LEXIS 98242 (S.D.N.Y. Sept. 14, 2010), the court rejected plaintiff’s claim thatstock purchasers on foreign exchanges should be able to sue in the U.S. because ADRs are traded here, butallowed claims to proceed on behalf of purchasers of the ADRs in the U.S. In contrast, the court in In reSociété Générale Sec. Litig., 2010 U.S. Dist. LEXIS 107719 (S.D.N.Y. Sept. 29, 2010), held that Morrisonprecluded claims by purchasers of ADRs in the U.S. because “trade in ADRs is considered to be apredominantly foreign securities transaction.” Id. at 19.

b. Jurisdiction

To satisfy the due process requirements of the Fifth Amendment, every defendant must have sufficient“minimum contacts” with the U.S. for the court of the forum state to exercise personal jurisdiction. Exercise ofpersonal jurisdiction comports with due process if “(1) the nonresident defendant has purposefully establishedminimum contacts with the forum . . . and (2) the exercise of jurisdiction will not offend traditional notions offair play and substantial justice.” Carrillo, 115 F.3d at 1542 (analyzing personal jurisdiction in the context ofthe extraterritorial reach of the federal securities laws) (quoting Francosteel Corp. v. M/V Charm, 19 F.3d 624,

627 (11th Cir. 1994)). See also Pinker v. Roche Holdings Ltd., 292 F.3d 361, 369 (3d Cir. 2002); S.E.C. v.Knowles, 87 F.3d 413, 416 (10th Cir. 1996). While the “minimum contacts” test is framed in the plural, amultiplicity of contacts are not required to establish personal jurisdiction. Knowles, 87 F.3d at 419 (“Even asingle purposeful contact may be sufficient to meet the minimum contacts standard when [the] underlyingproceeding is directly related to that contact.”).

1) Jurisdiction Over Entities

To determine if a court has personal jurisdiction over a foreign entity within the securities context, courtsconsider a number of factors. Typically, courts consider whether the defendant entity transacts business withinthe U.S., acts wrongfully in the U.S. within the context of the allegations, or purposefully avails itself of U.S.commerce while directly and foreseeably causing injury within the U.S. based on wrongs committed outsideU.S. borders. See S.E.C. v. Unifund SAL, 910 F.2d 1028, 1033 (2d Cir. 1990) (noting that due process permits“exercise of jurisdiction over a defendant whose ‘conduct and connection with the forum State are such that heshould reasonably anticipate being haled into court there.’ … One circumstance making such anticipationreasonable is where defendant has acted in such a way as to have ‘caused consequences’ in a forum state”);Bersch v. Drexel Firestone, Inc., 519 F.2d 974, 998-99 (2d Cir. 1990) (noting that the Second Circuit considerswhether the defendant is: (1) doing business in the forum; (2) doing an act in the forum; or (3) causing an effectin the forum from an act originating outside the forum); Europe & Overseas Commodity Traders, S.A. v.Banque Paribas London, 940 F. Supp. 528 (S.D.N.Y. 1996), aff’d, 147 F.3d 118 (2d Cir. 1998).

Courts also consider whether the entity is registered to do business in the United States, maintains an office,bank account, property, or personnel within the United States, or advertises within the United States. See, e.g.,Pinker, 292 F.3d at 369 (“Just as solicitation of business in the forum state is generally sufficient to establishpersonal jurisdiction over the defendant for claims arising out of injuries to purchasers within the forum state . .. so too is personal jurisdiction appropriate where a foreign corporation has directly solicited investment fromthe American market.”) (internal citations omitted); Bersch, 519 F.2d at 998-99 (finding that a firm’sdiscontinued office, sporadic visits to investment houses in New York, trading securities on CanadianExchanges for Americans and arranging, through American brokers, for Canadians to trade on Americanexchanges did not amount to “doing business” within the United States because “if it were, every securitiesdealer of any significant size anywhere in the world would be ‘doing business’ here”); Carrillo, 115 F.3d at1540 (“It is well settled that advertising that is reasonably calculated to reach the forum may constitutepurposeful availment of the privileges of doing business in the forum.”). A foreign entity will not be subject topersonal jurisdiction simply because it possesses an American subsidiary. Fed. Deposit Ins. Corp. v. Milken,781 F. Supp. 226, 231 (S.D.N.Y. 1991) (concluding that parent-subsidiary relationship itself did not createpersonal jurisdiction over foreign parent corporation in the absence of any indication that the subsidiary was thealter ego or mere agent of the defendant).

2) Jurisdiction Over Individuals

A U.S. court’s jurisdiction over a foreign corporation does not necessarily confer jurisdiction over the foreigncorporation’s officers and directors. Rather, jurisdiction over each employee must be assessed individually. See Calder v. Jones, 465 U.S. 783, 790 (1984); Keeton v. Hustler Magazine, Inc., 465 U.S. 770, 781 n.13(1984). Individual defendants are better positioned to contest personal jurisdiction if they: (1) did not prepare,sign, or issue the challenged public disclosure; (2) did not sign the issuer’s filings with the SEC; and (3) did notact as a corporate spokesperson. See In re CINAR Corp. Sec. Litig., 186 F. Supp. 2d 279, 305 (E.D.N.Y. 2002)(finding personal jurisdiction solely on vice-president general counsel’s signing of fraudulent registrationstatement, since, as general counsel, she must have known that the statement would be used and relied on byU.S. investors).

If a court possesses personal jurisdiction over a foreign entity, it may find jurisdiction over an individualparticipating in the actions which formed the basis of jurisdiction over the entity. See, e.g., Carrillo, 115 F.3dat 1547-48 (“By virtue of [the Costa Rican defendants’] control over [the Costa Rican corporation] and theiradmitted involvement in the alleged contacts with the United States, we find it appropriate to apply essentiallythe same minimum contacts analysis to them as to [the Costa Rican corporation] itself.”); Knowles, 87 F.3d at418 (“As the Supreme Court held in Calder v. Jones, employees of a corporation that is subject to personaljurisdiction of the courts of the forum may themselves be subject to jurisdiction if those employees wereprimary participants in the activities forming the basis of jurisdiction over the corporation.”). An officer ordirector residing outside the United States may be subject to a federal court’s personal jurisdiction whenparticipating in the alleged fraud through conduct directed at the United States while acting in an officialcapacity. See Calder, 465 U.S. at 790 (writing an article directed at California residents with knowledge of itspotentially devastating impact makes defendants primary participants in wrongdoing and thus subject topersonal jurisdiction); UI, 115 F.3d at 1547-48. However, a defendant’s control person status over acorporation violating the securities laws cannot be the sole basis for personal jurisdiction. See In re Baan Co.Sec. Litig., 81 F. Supp. 2d 75, 79-82 (D.D.C. 2000) (holding that, because minimum contacts were lacking andalter ego was not shown, the corporation’s domestic contacts could not be automatically imputed to a relatedcompany that owned a significant share of the corporation nor to the corporation’s director-president. Cf.McNamara v. Bre-X Minerals Ltd., 46 F. Supp. 2d 628 (E.D. Tex. 1999) (finding personal jurisdiction whereinvestors made a prima facie showing of corporation’s CEO’s ability to control corporation’s general operationsand directly exercise control over corporate activities).

U.S. courts have also found personal jurisdiction in cases involving insider trading. See S.E.C. v. Unifund SAL,910 F.2d 1028, 1033 (2d Cir. 1990) (upholding personal jurisdiction over foreign investors alleged to haveconducted insider trading in the purchase of U.S. Securities traded on a U.S. exchange because “[i]nsidertrading . . . has serious effects that can reasonably be expected to be visited upon United States shareholderswhere, as here, the securities are those of a United States company traded exclusively on a United Statesexchange”); S.E.C. v. Euro Sec. Fund, No. 98 CIV. 7347 (DLC), 1999 WL 76801, at *1-3 (S.D.N.Y. Feb. 17,1999) (finding personal jurisdiction over an Italian national domiciled in Switzerland and a president of aninvestment entity located in Switzerland for purchasing $6 million worth of a Netherlands corporation’ssecurities registered under the Exchange Act and traded exclusively on the New York Stock Exchange in a onemonth period while in possession of material nonpublic information). But see S.E.C. v. Alexander, 160 F. Supp.2d 642, 655-57 (S.D.N.Y. 2001) (finding lack of personal jurisdiction against an Italian resident who soldshares of an Italian corporation through an Italian bank while unaware that the shares would be sold through thesale of ADRs listed on the New York Stock Exchange).


From rigorous motion practice to lengthy discovery, “committees” of aggressive plaintiffs to sky-highsettlements, securities class actions are a complex and daunting creature all their own. They demand that securitieslitigators take the broadest of world views, attuning themselves to procedural and business concerns that are notusually thought to be part of litigation. They require the securities litigator to also be a consultant, a disclosure expertand, at times, a wizard of negotiation, all the while staying focused on a nuanced area of the law that is constantly influx.

To help provide some perspective on the complexities surrounding securities class action, the followingsection addresses big picture considerations and other practical issues before then turning to the substantive elementsof securities claims in Section III.

A. Consolidating Multiple Complaints And Actions

In securities class actions, plaintiffs will typically file multiple identical or virtually identical complaints,sometimes in different jurisdictions. Until these actions are consolidated, the lead plaintiff and lead counselappointments cannot be made. Sections 27(a)(3)(B)(ii) of the Securities Act and 21D(a)(3)(B)(ii) of theSecurities Exchange Act, as amended by the Private Securities Litigation Reform Act of 1995 (“the ReformAct” or “the PSLRA” ), provide that “if more than one action on behalf of a class asserting substantially thesame claim or claims arising under this chapter has been filed, and any party has sought to consolidate thoseactions for pretrial purposes or for trial, the court shall not” appoint the lead plaintiff “until after the decision onthe motion to consolidate is rendered.” See also Takeda v. Turbodyne Techs., Inc., 67 F. Supp. 2d 1129, 1133(N.D. Cal. 1999).

Consolidation in a single federal district court is proper “[i]f actions before the court involve a commonquestion of law or fact.” Fed. R. Civ. P. 42(a). “In securities actions where the complaints are based on thesame ‘public statements and reports’ consolidation is appropriate if there are common questions of law and factand the defendants will not be prejudiced.” Mitchell v. Complete Mgmt., Inc., No. 99 CIV. 1454 (DAB), 1999WL 728678, at *1 (S.D.N.Y. Sept. 17, 1999) (citations omitted). Pending suits need not be identical in order tobe consolidated. A.F.I.K. Holding SPRL v. Fass, 216 F.R.D. 567, 570 (D.N.J. 2003). “[I]n deciding whether toconsolidate, . . . the court must balance the risk of prejudice and possible confusion against the risk ofinconsistent adjudications of common factual and legal issues, the burden on the parties and witnesses, thelength of time required to conclude multiple lawsuits as against a single one, and the relative expense to allconcerned of the single-trial and multiple-trial alternatives.” Id. Courts have held that a motion forconsolidation will not be denied simply on the basis that the actions to be consolidated allege claims againstdifferent parties. See, e.g., Werner v. Satterlee, Stephens, Burke & Burke, 797 F. Supp. 1196, 1211 (S.D.N.Y.1992). Courts have also held that differences in alleged class periods will not bar consolidation. See Takeda,67 F. Supp. 2d at 1133; Constance Sczesny Trust v. KPMG, 223 F.R.D. 319, 322 (S.D.N.Y. 2004) (“Althoughsome variations exist in the parameters of the alleged class periods, such ‘minor differences’ are insufficient topreclude consolidation.”).

Consolidation typically occurs by motion of one or more parties or by stipulation of all the parties. Thisprocess is not controversial, as all parties typically benefit from streamlining the litigation. The cases areusually consolidated under the first-filed case and assigned to that judge. After each individual class action is


filed, defendant’s counsel usually requests the consent of plaintiff’s counsel to delay filing the response to thecomplaint until after the various actions are consolidated. If the delay is not agreed upon, an answer to thecomplaint is required within 21 days of service of the complaint. Fed. R. Civ. P. 12(a)(1)(A)(i) (effective Dec.1, 2009).

While no longer an indicator of which plaintiff will control the litigation, the first-filed case often determinesthe judge who will hear the consolidated matter and also appoint the lead plaintiff and lead counsel. Theconsolidation order typically provides that later-filed actions will automatically be consolidated and re-assignedto the same judge. Plaintiffs will typically be allowed 60-90 days to file a consolidated amended complaint. Counsel will often use this time to conduct additional fact investigation in an attempt to strengthen theallegations of fraud in order to defeat a challenge to the pleadings. Defendants are well-served during this timeperiod to conduct their own factual investigation to determine how best to defend against the claims anticipatedin the consolidated amended complaint. Once the consolidated amended complaint is filed, a response by thedefendant is required within 21 days unless a longer time period is agreed to by the parties. The district courtshave “broad discretion” in determining the propriety of consolidation, “although they generally espouse theview that ‘considerations of judicial economy favor consolidation.’” Bassin v. deCODE Genetics, Inc., 230F.R.D. 313, 314 (S.D.N.Y. 2005) (citations omitted).

B. Selection Of Lead Plaintiff And Lead Class Counsel

Under the Reform Act, where multiple plaintiffs have filed suits against the same defendants the court isrequired to appoint the “most adequate plaintiff” as lead plaintiff for the consolidated actions. 15 U.S.C. §77z-1(a)(3)(B)(i); 15 U.S.C. § 78u-4(a)(3)(B)(i). The Reform Act changed the standards and procedures forselecting the lead plaintiff in securities class actions in order to eliminate abuses involving the use of“professional plaintiffs” and the race to the courthouse to file the complaint.

1. Court Appointment Of Lead Plaintiff

Prior to the enactment of the Reform Act, courts generally selected the first plaintiff to file suit as lead plaintiff. See H.R. Conf. Rep. No. 104-369, at 33 (1995). The Reform Act sought to eliminate that practice by directingthe court to “appoint as lead plaintiff the member or members of the purported plaintiff class that the courtdetermines to be most capable of adequately representing the interests of class members.” Id. at 3, 9. Inaddition, the Reform Act requires that the plaintiff in the first-filed action publish a notice advising of thependency of the action so that any member of the proposed class can come forward and move to be appointedlead plaintiff. See 15 U.S.C. § 77z-1(a)(3)(A)(i)(II); 15 U.S.C. 78u-4(a)(3)(A)(i)(II). See also Janovici v. DVI,Inc., No. CIV. A. 2:03CV04795-LD, 2003 WL 22849604, at *4-5 (E.D. Pa. Nov. 25, 2003) (holding that leadplaintiff should be appointed as soon as practicable after resolution of any motions to consolidate; also rulingthat parties may file to be lead plaintiff within sixty days of the time of the effective notice). Under the ReformAct, the notice should allow a potential class member to (1) determine whether she is eligible for lead plaintiffstatus based on the class period; (2) learn enough about the asserted claims to make an initial judgment as towhether to obtain a copy of the Complaint; and (3) contact the clerk’s office to obtain a copy of the Complaintand discover the procedures for filing the motion. The reader should be able to achieve these objectivesindependently, without being forced to contact noticing plaintiff’s counsel for additional information. Id. at *5. See also Marsden v. Select Med. Corp., No. CIV. A. 04-4020, 2005 WL 113128, at *3 (E.D. Pa. Jan. 18, 2005). The content of the published notice may be inadequate, moreover, if it fails to specify the bases for the reliefsought. See In re White Elec. Designs Corp. Sec. Litig., 416 F. Supp. 2d 754, 775 (2006) (holding that plaintiffslacked standing to pursue Securities Act claims because the required PSLRA notice did not mention SecuritiesAct claims or the bases for them).

a. Presumption Of Most Adequate Plaintiff

In a case where more than one complaint has been filed or a putative class member moves for appointment aslead plaintiff, the Reform Act further provides that the court “shall adopt a presumption that the most adequateplaintiff” is that person or group of persons possessing the largest financial interest in the relief sought whootherwise satisfies the requirements of Fed. R. Civ. P. Rule 23. 15 U.S.C. § 77z-1(a)(3)(B)(iii)(I); 15 U.S.C. §78u-4(a)(3)(B)(iii)(I). The Ninth Circuit has laid out a three-step process for identifying the lead plaintiff: (1)verification of proper notice posting; (2) the presumptive lead plaintiff is the one who has the largest financialinterest; and (3) provision to the other plaintiffs of an opportunity to rebut the presumptive lead plaintiff ontypicality and adequacy grounds. In re Cavanaugh, 306 F.3d 726, 729-30 (9th Cir. 2002).

b. Rebutting The Presumption

The presumption may be rebutted by proof that the presumptively most adequate plaintiff:

1. will not fairly and adequately protect the interests of the class; or

2. is subject to unique defenses that render such plaintiff incapable of adequately representing the class.

15 U.S.C. § 77z-1(a)(3)(B)(iii)(II); 15 U.S.C. § 78u-4(a)(3)(B)(iii)(II).

See In re Vonage IPO Sec. Litig., No. CIV A 07-177 FLW, 2007 WL 2683636, at *9-11 (D.N.J. Sept. 7, 2007)(finding the presumptively most adequate plaintiff inadequate because of a lack of familiarity with the litigationand because he “failed to demonstrate the willingness and ability to select competent class counsel;” by contrastthe group with the second-greatest losses also had a significant stake in the litigation, had executed a reasonableretainer agreement with counsel and otherwise showed adequacy under Rule 23). See also Levitt v. Rogers, 257F. App’x 450 (2d Cir. 2007) (remanding for determination of the appropriate lead plaintiff following therestatement of one defendant and the settlement of certain claims against other defendants, which resulted in thecurrent lead plaintiff not having the largest financial interest in the outcome of the remaining claims). Note,however, that this presumption is not rebutted simply because the plaintiff is unable to assert all of the claimsbrought by the class. That is, under the PSLRA, the selection of lead plaintiff is premised on the loss suffered,“not on the most adequate complaint filed.” In re WorldCom, Inc. Sec. Litig., 219 F.R.D. 267, 286 (S.D.N.Y.2003) (emphasis in original). Thus, although a lead plaintiff may be unable to personally assert every claimmade by the class, provided he can establish the largest financial stake in the litigation (and can show that atleast some class representatives are able to bring each of the claims), the presumption stands. Id. See also In reNat’l Golf Props. Inc., No. CV 02-1383 GHK (RZX), 2003 WL 23018761 (C.D. Cal. Mar. 19, 2003)(concluding that presumption for the lead plaintiff survived despite his lack of standing to assert a Section 11claim brought by other members of the class). Moreover, a court is under no obligation to accept a proposedlead plaintiff solely because the appointment is unopposed by other members of the putative class. Clair v.DeLuca, 232 F.R.D. 219 (W.D. Pa. 2005). See also Cordova v. Lehman Bros., Inc., 237 F.R.D. 471 (S.D. Fla.2006) (rejecting last-minute attempt to substitute new lead plaintiff); In re Flight Safety Techs., 231 F.R.D. 124(D. Conn. 2005) (ignoring plaintiffs’ stipulation in appointment of lead plaintiff). Finally, where the originallead plaintiff is determined to lack standing after the PSLRA lead plaintiff selection process is complete, thecourt may allow the plaintiffs to substitute a new lead plaintiff during the pleading stage. In re Impax Labs. Inc.Sec. Litig., No. C 04-04802 JW, 2008 WL 1766943, at *8 (N.D. Cal. April 17, 2008).

c. Single Largest Loss

Courts have typically appointed the single investor with the greatest individual loss who otherwise satisfied thestatutory criteria. See, e.g., Wenderhold v. Cylink Corp., 188 F.R.D. 577, 586-87 (N.D. Cal. 1999) (rejectinglead plaintiff application from aggregation of investors in favor of single investor with greatest individuallosses); Sakhrani v. Brightpoint, Inc., 78 F. Supp. 2d 845, 850-54 (S.D. Ind. 1999) (appointing as lead plaintiffthe single investor with the largest losses where no institutional investors sought lead plaintiff status); Janovici,2003 WL 22849604, at *4 (recognizing the rebuttable presumption that the most adequate plaintiff has the

largest financial interest in the litigation); In re Copper Mountain Sec. Litig., 305 F. Supp. 2d 1124, 1129-30(N.D. Cal. 2004) (holding that the presumptive lead plaintiff was the investor with the greatest financial stake inthe case). But see Sofran v. LaBranche & Co., 220 F.R.D. 398, 402 (S.D.N.Y. 2004) (appointing as leadplaintiff the investor group with the largest financial loss while fulfilling the remaining statutory requirementsof typicality and adequacy); In re Enron Corp. Sec. Litig., 206 F.R.D. 427, 455-59 (S.D. Tex. 2002) (rejectingthe plaintiff with the largest financial loss for the most adequate plaintiff); In re Gemstar-TV Guide Int’l, Inc.Sec. Litig., 209 F.R.D. 447 (C.D. Cal. 2002) (same). Cf. In re Bausch & Lomb Inc. Sec. Litig., 244 F.R.D. 169,173-74 (W.D.N.Y. 2007) (considering debt securities in evaluating potential plaintiffs’ largest financial interestand concluding that a “net seller” and “net gainer” is an inadequate lead plaintiff).

In Mayo v. Apropos Tech., Inc., No. 01 C 8406, 2002 WL 193393, at *3 (N.D. Ill. Feb. 7, 2002), the court listeda four-factor test, first promulgated in Lax v. First Merchants Acceptance Corp., No. 97 CIV. 2715, 1997 WL461036 (N.D. Ill. Aug. 11, 1997), to determine who has the largest loss. Per Mayo, the court should inquire asto “(1) the number of shares purchased; (2) the number of net shares purchased; (3) the total net funds expendedby the plaintiffs during the class period; and (4) the approximate losses suffered by the plaintiffs.” Id. See alsoIn re Milestone Scientific Sec. Litig., 183 F.R.D. 404, 413 (D.N.J. 1998) (same four factor test); PirelliArmstrong Tire Corp. v. LaBranche & Co., 229 F.R.D. 395 (S.D.N.Y. 2004) (describing four-factor “Lax test”).

d. Multiple Lead Plaintiffs Or Aggregation Of Numerous Plaintiffs

The Reform Act’s use of the singular term “plaintiff” does not preclude courts from appointing multiple personsto act as lead plaintiff. See Friedman v. Quest Energy Partners LP, 261 F.R.D. 607, 615 (W.D. Okla. 2009)(appointing two lead plaintiffs due to conflict between subclasses); In re Able Labs. Sec. Litig., 425 F. Supp. 2d562 (D.N.J. 2006) (permitting city employee retirement plan and foreign company to combine to form aninternational investors group and appointing them as lead plaintiff); Rozenboom v. Van Der Moolen Holding,No. 03 CIV. 8284 (RWS), 2004 WL 816440, at *5 (S.D.N.Y. Apr. 14, 2004) (allowing the appointment of twoco-lead plaintiffs in order to ensure the stability and control of the litigation); Ferrari v. Gisch, 225 F.R.D. 599,608 (C.D. Cal. 2004) (allowing a group of persons to serve as lead plaintiff so long as “the proposed plaintiffgroup can effectively manage the litigation and direct lead counsel”); In re Oxford Health Plans, Inc., Sec.Litig., 182 F.R.D. 42 (S.D.N.Y. 1998) (appointing three entities as co-lead plaintiffs, each with one vote overcontrol of the litigation); In re Advanced Tissue Scis. Sec. Litig., 184 F.R.D. 346, 352-53 (S.D. Cal. 1998)(designating six members of a group as co-lead plaintiffs out of a proposed unrelated group of 250; finding thatappointment of large amalgamations of unrelated persons as lead plaintiffs is contrary to the Reform Act andpotentially threatening to the interests of the class); In re Cephalon Sec. Litig., No. CIV. A. 96-CV-0633, 1996WL 515203 (E.D. Pa. Aug. 27, 1996) (appointing three plaintiffs as lead plaintiff); Greebel v. FTP Software,Inc., 939 F. Supp. 57 (D. Mass. 1996) (same). See also In re NYSE Specialists Sec. Litig., 240 F.R.D 128(S.D.N.Y. 2007) (holding, where co-lead plaintiffs have been appointed to adequately represent the interests ofthe class and one plaintiff is thereafter removed, the court need not appoint a replacement co-lead plaintiff ifsuch an appointment would be disruptive and the remaining lead plaintiff is capable of prosecuting the actionby itself). Consolidation of multiple plaintiffs’ claims may be improper where there is a conflict of interestamongst the plaintiffs as to some of the claims. See Horizon Asset Mgmt. Inc. v. H&R Block, Inc., 580 F.3d755, 768-69 (8th Cir. 2009) (holding that the district court abused its discretion in appointing sole lead plaintiffwhere it was clear that the appointed plaintiff would not pursue derivative claims asserted by other plaintiffs).

Other courts have rejected the option of appointing co-lead plaintiffs. See, e.g., In re Milestone Scientific Sec.Litig., 183 F.R.D. 404, 417-18 (D.N.J. 1998); Gluck v. CellStar Corp., 976 F. Supp. 542, 549-50 (N.D. Tex.1997). Where the appointment of multiple “lead plaintiffs” or “lead counsel” threatens investor control of thelitigation, courts have refused to appoint multiple lead plaintiffs in favor of a single qualified plaintiff. Id. at549; Tanne v. Autobytel, Inc., 226 F.R.D. 659, 672 (C.D. Cal. 2005) (reasoning that the co-lead plaintiffstructure is unnecessary, and might harm the class by dividing responsibility for the supervision of classcounsel); In re Enron Corp. Sec. Litig., 206 F.R.D. 427, 451 (S.D. Tex. 2002) (rejecting the theory of multipleplaintiffs because “the litigation should proceed as a unified class with [one] strong Lead Plaintiff”); In re Baan

Co. Sec. Litig., 186 F.R.D. 214, 217 (D.D.C. 1999) (allowing a twenty-member subgroup of the 466 investorplaintiffs to act as “lead plaintiff” and espousing the view that “where unrelated investors are to be leadplaintiff, a triumvirate is preferable”); In re Donnkenny Inc. Sec. Litig., 171 F.R.D. 156, 157-58 (S.D.N.Y.1997) (hoping that one lead plaintiff would seek out the lawyers, rather than having lawyers seek multipleplaintiffs to increase the financial stake and take control of the litigation). See also Cohen v. Dist. Court, 586F.3d 703, 711 n.4 (9th Cir. 2009) (in dicta, calling into doubt the practice of appointing “co-lead plaintiffs”).

Some courts have interpreted the Reform Act to permit the appointment of a group of unrelated persons to actas lead plaintiff. See, e.g., In re Nature’s Sunshine Prods., Inc. Sec. Litig., No. 2:06-CV-267 TS, 2006 WL2380965 (D. Utah Aug. 16, 2006) (concluding aggregation was appropriate on the facts of the case); In re XMSatellite Radio Holdings Sec. Litig., 237 F.R.D. 13 (D.D.C. 2006); In re Star Gas Sec. Litig., No. 3:04CV1766,2005 WL 818617, at *5 (D. Conn. Apr. 8, 2005) (allowing a group of unrelated investors to serve as leadplaintiffs when it would be most beneficial to the class under the circumstances of a given case); Ferrari v.Gisch, 225 F.R.D. 599, 608 (C.D. Cal. 2004) (“[The Reform Act] expressly authorizes the appointment of a‘group’ of persons to serve as Lead Plaintiffs.”); Funke v. Life Fin. Corp., No. 99 CIV. 11877 (CBM), 2003 WL194204, at *5 (S.D.N.Y. Jan. 28, 2003) (“[Group] is not too large a group to convene for the purpose ofreaching a decision and directing litigation.”); In re Ride, Inc., Sec. Litig., No. C 97-402 WD, 1997 WL33628677, at *1 (W.D. Wash. Aug. 5, 1997) (“On its face this language calls for aggregation. Any suggestionto the contrary, based on legislative history, cannot prevail against the statute’s plain wording.”). Cf. In reeSpeed, Inc. Sec. Litig., 232 F.R.D. 95 (S.D.N.Y. 2005) (where aggregation would not displace an institutionalinvestor as presumptive lead plaintiff, a small group of unrelated investors may serve as lead plaintiff).

However, a number of courts have rejected lead plaintiff applications from large, lawyer-solicited aggregationsof shareholders under the rationale that one of the primary purposes of the Reform Act was to eradicate“lawyer-driven” securities fraud litigation. See, e.g., In re Pfizer Inc. Sec. Litig., 233 F.R.D. 334, 337(S.D.N.Y. 2005) (rejecting a proposed group of investors as lead plaintiff because they had been artificiallygrouped by their counsel in an attempt to create the “highest possible” financial interest figure under thePSLRA); In re Bally Total Fitness Sec. Litig., No. 04C3530, 2005 WL 627960, at *3 (N.D. Ill. Mar. 15, 2005)(rejecting group of investors “who have nothing in common with one another beyond their investment”);Bowman v. Legato Sys., Inc., 195 F.R.D. 655, 658 (N.D. Cal. 2000) (“[G]iven the Court’s conclusion that theLegato Group was solicited and created by the Milberg firm solely for the purpose of obtaining appointment aslead plaintiff – and thus allowing the Milberg firm to obtain appointment as lead plaintiff’s counsel – the Courtremains convinced that the Legato Group is not within the definition of ‘group’ as that word is used in theReform Act.”); Sakhrani v. Brightpoint, Inc., 78 F. Supp. 2d 845, 853 (S.D. Ind. 1999) (rejecting group of 118individuals and businesses whose only connection was losing their investments); In re Donnkenny Inc. Sec.Litig., 171 F.R.D. 156, 157 (S.D.N.Y. 1997) (“To allow an aggregation of unrelated plaintiffs to serve as leadplaintiffs defeats the purpose of choosing a lead plaintiff.”); In re Gemstar-TV Guide Int’l., 209 F.R.D. at 451(rejecting an unrelated group of three institutional investors and four individuals brought together “for the solepurpose of aggregating their claims in an effort to become the presumptive lead plaintiff”). See also Miller v.Ventro Corp., No. 01-CV-1287, 2001 WL 34497752, at *7-8 (N.D. Cal. Nov. 28, 2001) (taking the approachthat the aggregation of a group of plaintiffs with no pre-litigation relationship is not dispositively allowed ordisallowed, and opting for the application of a third option “that finds no single factor dispositive, but requiresthe group to justify and explain its composition and structure in terms of adequacy to represent the class”).

In order to prevent “lawyer driven” litigation, some courts have adopted a “rule of reason” test in which theacceptability of the proposed group is tested against its ability to represent the interests of the class. The groupis then allowed to proceed as a group only if the court determines that “lawyer driven” litigation is not likely toresult. See, e.g., Barnet v. Elan Corp., 05 CIV. 2860 (RJH), 2005 WL 1902855 (S.D.N.Y. Aug. 8, 2005); In reBaan Co. Sec. Litig., 186 F.R.D. 214, 218-35 (D.D.C. 1999); Chill v. Green Tree Fin. Corp., 181 F.R.D. 398(D. Minn. 1998). In making this determination, courts have considered several factors, including: (1) the size ofthe class, (2) any evidence that the group was formed in bad faith, and (3) the relationship between parties. Inre Cendant Corp. Litig., 264 F.3d 201, 266-67 (3d Cir. 2001). See also Barnet, 2005 WL 1902855, at *4; IronWorkers Local No. 25 Pension Fund v. Credit-Based Asset Servicing and Securitization, LLC, 616 F. Supp. 2d461, 464 (S.D.N.Y. 2009) (rejecting as lead plaintiff a pension fund which rewarded its counsel for uncovering

fraud in its investments by retaining him to prosecute the fraud on its behalf; the court noted that this gavecounsel a “clear incentive” to discover “fraud” in the investments).

e. Institutional Investors

Immediately following passage of the Reform Act, non-institutional investors continued to dominate as leadplaintiffs in post-Reform Act cases. See P. Saparoff et al., “The Role of the Institutional Investors ClassActions Under the PSLRA-Are They Walking on a Slippery Slope? One Year Later,” Securities Reform ActLitigation Reporter, Vol. 5 No. 3 (June 1998) (“Of the 105 cases filed during the first year after the enactmentof the PSLRA, institutional investors appear to have moved to become lead plaintiffs in only eight cases. Notsurprisingly, institutional investors have identified the costs associated with fighting off other plaintiffs duringthe lead plaintiff appointment process as a substantial disincentive for seeking such an appointment.”). This haschanged in the post-Enron environment. Now, institutional investors have shown increasing willingness anddesire to serve as lead plaintiffs, even where they did not suffer the largest loss during the class period. See Inre Enron Corp. Sec. Litig., 206 F.R.D. 427 (S.D. Tex. 2002). In Malasky v. IAC/Interactivecorp, 04 Civ. 7447(RJH), 2004 U.S. Dist. LEXIS 25832, at *9-14 (S.D.N.Y. Dec. 20, 2004), the court appointed an institutionalinvestor as a co-plaintiff, because the institutional investor did not appear to have the largest financial loss. Thecourt reasoned that the co-plaintiffs could “pool financial resources, knowledge and experiences,” and couldalso reap the “benefits of joint decision-making” when pressed with difficult choices that may arise.” Id. at*13-14 (quoting In re Oxford Health Plans, Inc. Sec. Litig., 182 F.R.D. 42, 45 (S.D.N.Y. 1998)). Today,institutional investors are dominant in the lead plaintiff role, particularly in cases alleging large losses, and havebecome the favorite business development target of the major plaintiff’s class action firms.

f. Investment Advisors

Because investment advisors lack a proprietary interest in their clients’ funds, they generally lack standing toserve as lead plaintiff unless the client has assigned its claims to the investment advisor. In W.R. Huff AssetMgmt. v. Deloitte & Touche LLP, 549 F.3d 100, 107 (2d Cir. 2008), the Second Circuit held that an investmentadvisor did not have standing to serve as lead plaintiff because it had not obtained legal title to its clients’claims. The court expressly declined to decide whether an investment advisor could ever have standing to serveas lead plaintiff, but it emphasized that the named plaintiff in a class action “must allege and show that theypersonally have been injured.” Id. at 106 n.5. See also In re Herley Indus. Inc. Sec. Litig., No. 06-2596, 2009WL 3169888 at *8-9 (E.D. Pa. Sept. 30, 2009) (investment advisor did not have standing until client validlyassigned its claims); In re SLM Corp. Sec. Litig., 258 F.R.D. 112 (S.D.N.Y. 2009) (investment advisor did nothave standing). Cf. In re Bard Assocs., Inc., No. 09-6243, 2009 WL 4350780, at *2 (10th Cir. 1009) (districtcourt did not err in finding that assignment of claim after inception of lawsuit was insufficient to giveinstitutional investor standing).

g. Discovery Related To Purported Most Adequate Plaintiff

A competing plaintiff may conduct discovery regarding the adequacy of a class plaintiff by initiallydemonstrating a reasonable basis for a finding that the presumptively most adequate plaintiff will inadequatelyrepresent the class. 15 U.S.C. § 77z-1(a)(3)(B)(iv); 15 U.S.C. § 78u-4(a)(3)(B)(iv).

h. Restrictions On Professional Plaintiffs

Under the Reform Act, no party may serve as lead plaintiff, or as an officer, director, or fiduciary of a leadplaintiff, in more than 5 class actions during any 3-year period, “[e]xcept as the court may otherwise permit,consistent with the purposes of this section.” 15 U.S.C. § 77z-1(a)(3)(B)(vi); 15 U.S.C. § 78u-4(a)(3)(B)(vi).

See also In re Enron Corp. Sec. Litig., 206 F.R.D. 427, 456-57 (S.D. Tex. 2002) (denying motion to beappointed lead plaintiff by institutional investor who had been lead plaintiff in nine other securities fraud classactions in five prior years). Many courts, however, find that “experienced” lead plaintiffs, particularlyinstitutional plaintiffs with interest in pursuing class litigation, may benefit the class, even if there are concernsover the number of prior lead plaintiff positions. See, e.g., In re Cree, Inc. Sec. Litig., 219 F.R.D. 369(M.D.N.C. 2003) (granting motion for appointment of lead plaintiff despite “concern” regarding movant’sinvolvement in 14 other pending securities cases).

i. Filing Requirements

The Reform Act also requires that each plaintiff seeking to serve as a lead plaintiff file a sworn certificate withhis or her complaint that, in pertinent part: (1) sets forth all of the transactions of the plaintiff in the securitythat is the subject of the complaint during the class period specified in the complaint; and (2) identifies anyother action under the Securities Act or the Exchange Act in which the plaintiff has sought to serve or served asa class representative during the three years preceding the date of the certification. 15 U.S.C. § 77z-1(a)(2)(A)(iv-v); 15 U.S.C. § 78u-4(a)(2)(A) (iv-v).

2. Selection Of Lead Class Counsel

The Reform Act provides that, “[t]he most adequate plaintiff shall, subject to the approval of the court, selectand retain counsel to represent the class.” 15 U.S.C. § 77z-1(a)(3)(B)(v); 15 U.S.C. § 78u-4(a)(3)(B)(v). Courts have interpreted the Reform Act to allow various procedures for the selection of lead counsel, includingsealed bid auction (see, e.g., In re Bank One Shareholders Class Actions, 96 F. Supp. 2d 780, 784-85 (N.D. Ill.2000), and Wenderhold v. Cylink Corp., 188 F.R.D. 577, 586-87 (N.D. Cal. 1999)); competitive bidding (see,e.g., In re Lucent Techs. Inc. Sec. Litig., 194 F.R.D. 137, 156 (D.N.J. 2000), and In re Network Assocs., Inc.Sec. Litig., 76 F. Supp. 2d 1017 (N.D. Cal. 1999)); and selection by lead plaintiff with some court oversight(see, e.g., Sakhrani v. Brightpoint, Inc., 78 F. Supp. 2d 845 (S.D. Ind. 1999)).

The SEC has suggested that parties seeking lead plaintiff status should address the following five questions:

a. What procedures did the lead plaintiff follow to identify a reasonable number of counsel with the skill andability necessary to represent the class in the pending matter?

b. What procedures did the lead plaintiff follow in inviting competent counsel to compete for the right torepresent the class?

c. What procedures did lead plaintiff follow to negotiate a fee and expense reimbursement arrangement thatpromotes the best interests of the class?

d. On what basis can lead plaintiff reasonably conclude that it has canvassed and actively negotiated with asufficient number of counsel and obtained the most qualified representation at the lowest cost?

e. Did the lead plaintiff make inquiries into the full set of relationships between the proposed lead counsel,and the lead plaintiff and other members of the class, and did the lead plaintiff reasonably conclude eitherthat there are no such relationships or that they do not affect the exercise of plaintiffs’ fiduciary obligationsto the class?

Brief of the S.E.C. as Amicus Curiae In Support of Appellants on the Issues Presented at 11-12, In re CendantCorp. Litig., 264 F.3d 201 (3d Cir. 2001), noted in Craig v. Sears Roebuck & Co., 253 F. Supp. 2d 1046, 1049(N.D. Ill. 2003).

The lead plaintiff selection process has engendered some interesting rulings in district courts, as judges attemptto balance the best interests of the class against lead plaintiffs’ ability to choose their own lawyers. For

example, in In re Quintus Sec. Litig., 201 F.R.D. 475 (N.D. Cal. 2001), Judge Walker refused to appoint thenominal lead plaintiff’s choice of counsel and instead called upon interested firms to submit proposals settingforth such information as the firm’s experience with securities litigation cases, malpractice coverage, feestructure, and preliminary factual investigation of the case. Judge Walker later evaluated proposals from fivefirms and chose the firm he thought would charge the lowest fee and provide the best result to the class. In reQuintus Sec. Litig., 148 F. Supp. 2d 967 (N.D. Cal. 2001). See also Mayo v. Apropos Tech., Inc., No. 01 C8406, 2002 WL 193393, at *5 (N.D. Ill. Feb. 7, 2002) (requiring proposed lead counsel to submit evidence ofpast experience, agreed fees, hourly rates, anticipated staffing and ability to carry forward the efforts of anypotential class).

The Ninth Circuit reversed Judge Walker’s ruling and use of the auction process in In re Cavanaugh, 306 F.3d726 (9th Cir. 2002). The Ninth Circuit held that the district court erred in appointing lead counsel based on thefact that it was the cheapest in the field and the belief that “lawyers don’t make much difference in securitiesclass actions.” Id. at 735. The Ninth Circuit further held that the role of the district courts is to apply theReform Act, not to reduce the costs of securities class actions. Id. at 736. Further, according to the NinthCircuit in Cavanaugh, the selection of lead counsel, unless plainly inadequate, should not affect the court’sdecision in appointing a lead plaintiff. Id. at 732-33. See also Cendant, 264 F.3d at 266 (acknowledging that,generally, selection of lead counsel should be distinct from the court’s appointment of lead plaintiff); Craig,253 F. Supp. 2d at 1051-52 (concluding that the Ninth Circuit’s minimal scrutiny of the lead plaintiff’s choicefor counsel “more efficiently protect[s] the class” than an auction process or other court-directed procedure).

3. Legal Fees For Non-Lead Counsel

Simply doing work on behalf of the class does not create a right to compensation. The focus is on whether thatwork provided a benefit to the class. In most cases, the work that lead counsel does will ordinarily benefit andadvance the class’s interests. However, when dealing with non-lead counsel, the inquiry has to be moredetailed. Non-lead counsel will have to demonstrate that their work conferred a benefit on the class beyond thebenefit conferred by lead counsel. Work that is simply duplicative of the efforts of lead counsel will notordinarily be compensated. Further, the court – not the lead plaintiff – must decide what firms/counsel deservecompensation for work done on behalf of the class prior to the appointment of the lead plaintiff. In re Cendant Corp. Sec. Litig., 404 F.3d 173 (3d Cir. 2005).

a. Pre-appointment Work

Before lead counsel is appointed, if an attorney discovers grounds for a suit based on his/her own investigationand legitimately creates a benefit for the class, the attorney should be compensated out of the class’s recovery,even if the lead plaintiff does not choose the attorney to represent the class. In addition, any attorneys whosecomplaints contain factual research or legal theories that lead counsel did not discover, and upon which leadcounsel later relies, will have a claim for a share of the class’s recovery. In re Cedant Corp. Sec. Litig., 404F.3d at 194-96.

b. After Appointment Of Lead Counsel

After lead counsel is appointed, the primary responsibility for compensation shifts from the court to the leadplaintiff (subject to ultimate court approval). Under the PSLRA, the lead plaintiff is the decision-maker for theclass and has the responsibility of deciding which lawyers will represent the class and how they will be paid. There is a presumption of correctness afforded to lead plaintiff’s denial of fees to non-lead counsel. Thispresumption can be rebutted in two general ways. First, non-lead counsel can refute the presumption byshowing some failure in lead plaintiff’s fiduciary representation of the class. A fiduciary generally owes to itsprincipal the duty of loyalty and duty of due care. Thus, non-lead counsel can rebut this presumption bydemonstrating a failure in either duty: (1) by demonstrating that the lead plaintiff’s denial of fees was

motivated by some factor other than the best interest of the class, or (2) by showing that the lead plaintiff didnot carefully consider and reasonably investigate non-lead counsel’s request for fees. If non-lead counsel canrebut the presumption in this way, then the lead plaintiff is not entitled to any deference in the determination ofcounsel fees. At this point however, non-lead counsel will still have to demonstrate to the court that the workconferred a substantial benefit to the class. Id. at 197-200.

Second, non-lead counsel can refute the presumption by a showing that lead plaintiff’s denial of fees waserroneous. This can be done by proving that non-lead counsel performed work that independently benefited theclass. This standard is high, and non-lead counsel will need to prove by clear evidence that (1) they performedwork on behalf of the entire class; (2) they did so with some reasonable expectation of being compensated outof the class’s common-fund recovery; and (3) their work led to identifiable and substantial benefits to the classthat would not have been obtained by the work of lead counsel. Id.

c. Representation Of Individual Class Members

Non-lead counsel will not be compensated out of the class’s recovery solely for keeping abreast of the case onbehalf of their individual clients, or by duplicating the efforts of lead counsel. To be eligible for compensation,non-lead counsel’s work must improve the class’s recovery. Otherwise, if individual class members wish tohave the service of individual counsel, they should bear the expense themselves. See also In re Auction HousesAntitrust Litig., No. 00 Civ. 0648, 2001 WL 210697 (S.D.N.Y. Feb. 26, 2001).

d. Representation of Uncertified Subclasses

When non-designated counsel act on behalf of a putative but uncertified subclass (rather than an individualclient or an identifiable group of clients), the issue of this counsel’s compensation arises. In In re Cendant, theThird Circuit concluded that non-lead counsel deserved no special consideration for advocating for the interestsof an uncertified subclass. 404 F.3d at 182 (“[T]he presumption of correctness that [the court] awards to [thelead plaintiff’s] decision not to compensate an attorney will also extend to a decision not to compensateproposed counsel for an uncertified subclass.”). The court noted, however, that the presumption can be rebuttedif non-lead counsel can prove that the lead plaintiff violated its fiduciary duties by unfairly favoring some classmembers over others or if the non-lead counsel succeeds in effecting a significant change in the allocation ofdamages. Id.

4. Other Responsibilities And Rights Of Lead Plaintiff

While the PSLRA is explicit on the lead plaintiff’s authority to select and retain counsel, “it is silent on theother responsibilities and rights that lead plaintiffs have to control, direct, and manage class action securitieslitigation.” In re BankAmerica Corp. Sec. Litig., 350 F.3d 747, 751 (8th Cir. 2003). The Act does not addresswhether a lead plaintiff must approve a settlement, whether a lead plaintiff must be replaced before a districtcourt may review and approve a proposed settlement, or how a district court should deal with a fractured leadplaintiff group. Id. at 751. Therefore, the district court’s decisions in these matters will be reviewed only forabuse of discretion. Id. at 752. See also Feder v. Elec. Data Sys. Corp., 429 F.3d 125, 132 (5th Cir. 2005)(proposed class representative could hire outside attorney to oversee proposed class counsel).

5. Defendants’ Role In Appointment Of Lead Plaintiff

A defendant may have standing to object to certain issues on a motion for appointment of lead plaintiff. Adefendant can challenge the plaintiff’s motion to be appointed lead plaintiff if a named plaintiff fails to file therequired certification or to provide notice to the class as required by 15 U.S.C. § 78u-4(a)(3)(A), or if the noticeserved is inadequate. Greebel v. FTP Software, Inc., 939 F. Supp. 57, 60 (D. Mass. 1996). But see Bell v.Ascendant Solutions, Inc., No. CIV. A. 3:01-CV-0166, 2002 WL 638571, at *2 (N.D. Tex. Apr. 17, 2002)

(holding that a defendant does not have standing to object to a lead plaintiff’s appointment pursuant to theexpress terms of the PSLRA).

a. Multiple Lead Plaintiffs

Defendants have also objected that the appointment of multiple lead plaintiffs vitiates the Reform Act’s intentto place greater control of the litigation in the hands of investors, rather than those of plaintiffs’ counsel, despitethe fact that the “principal responsibility” for challenging the qualifications of proposed lead plaintiffs restswith other class members. D’Hondt v. Digi Int’l, Inc., No. CIV 97-5 JRT RLE, 1997 WL 405668, at *3-4 (D.Minn. Apr. 3, 1997). But see Gluck v. CellStar Corp., 976 F. Supp. 542, 549 (N.D. Tex. 1997) (holding onlyclass members, not defendants, have standing to challenge putative lead plaintiffs); In re Donnkenny Inc. Sec.Litig., 171 F.R.D. 156, 157-58 (S.D.N.Y. 1997) (same).

b. Statutory Criteria

Some courts have held that defendants lack standing to challenge whether a particular class member moving forappointment as lead plaintiff satisfies the criteria set forth in 15 U.S.C. § 78u-4(a)(3)(B)(iii)(I), at least at thelead plaintiff appointment stage. Greebel, 939 F. Supp. at 60. However, this question can be revisited on amotion for class certification. Id.

The Reform Act’s language of 15 U.S.C. § 78u-4(a)(3)(D)(iii) regarding “the most adequate plaintiff” alsohelps underscore other objections defendants frequently raise concerning proposed class representativesincluding:

1) The Representative Should Not Be Subject To Unique Defenses

In re Terayon Commc’ns Sys., Inc., No. C 00-01967 MHP, 2004 WL 413277, at *8 (N.D. Cal. Feb. 23,2004) (holding that while a short-seller is not per se disqualified from being a lead plaintiff, a shortseller who engages in a pattern of affirmative efforts to lower the stock prices is an inadequate classrepresentative); In re ML-Lee Acquisition Fund II, L.P. & ML-Lee Acquisition Fund (Ret. Accounts)II, L.P. Sec. Litig., 149 F.R.D. 506 (D. Del. 1993) (finding plaintiff’s investment history relevant todetermination as a “sophisticated investor” who could be subject to unique defenses); In re HarcourtBrace Jovanovich, Inc. Sec. Litig., 838 F. Supp. 109 (S.D.N.Y. 1993) (finding plaintiff’s investmenthistory relevant to determination of typicality); McNichols v. Loeb Rhoades & Co., Inc., 97 F.R.D. 331,335 (N.D. Ill. 1982) (finding plaintiff, subject to unique defense of non-reliance on market integrity,atypical and declining to certify class). But see Langner v. Brown, No. 95 CIV. 1981 (LBS), 1996 WL709757 (S.D.N.Y. Dec. 10, 1996) (certifying a major shareholder and former insider as the classrepresentative even though he might be subject to some unique defenses); and

2) The Lead Plaintiff Should Not Be A Professional Plaintiff

Greebel, 939 F. Supp. at 60 (recognizing Congress’ “concern” regarding the “problem” of aprofessional plaintiff); In re K Mart Corp. Sec. Litig., No. 95-CS-75584-DT, 1996 WL 924811 (E.D.Mich. Dec. 16, 1996) (holding that named plaintiff who participated in dozens of other actions couldnot represent the class but that a plaintiff who had been a class representative twice before couldrepresent the class).

Since the Reform Act specifically raises the issues of sufficiency of financial interest, prior experience as a

class representative, and vulnerability to unique defenses in reaching a determination of who shall serve as classrepresentative, these issues should be considered when the defendant is evaluating the proposed classrepresentative as lead plaintiff.

C. Motion To Dismiss

Cases not dismissed at the pleadings stage require defendants to face a long and expensive discovery process. Given the breadth of the issues in complex business litigation and its high dollar stake, cases that are notdismissed on their pleadings almost inevitably require large document productions and distract seniormanagement with internal fact investigations and depositions. Plaintiffs rely on these expenses anddistractions, in fact, to broker settlements. Dismissing the case at the outset is thus essential if defendants are tomaintain the upper hand.

Of course, the PSLRA does not affect all securities litigation equally. By its terms, the Reform Act applies itspleading requirements only to claims under the 1934 Act. 15 U.S.C. § 78u-4(a)(1) (limiting applicability ofAct’s provisions to private class actions “arising under this chapter”); In re Initial Pub. Offering Sec. Litig., 241F. Supp. 2d 281, 337-38 (S.D.N.Y. 2003) (holding that Congress intended the heightened pleading requirementsof the PSLRA to apply to securities fraud claims only under the 1934 Act). Therefore, while the heart of thissection focuses on the Reform Act’s innovations — and the courts’ interpretations of those innovations — italso addresses pleading standards required for all civil actions, including those under the 1933 Act.

1. Pleading Requirements For All Civil Actions

This section traces the development of pleading standards under Federal Rule 8(a), covering first the notice-pleading standard that applied up to the Supreme Court’s recent decisions in Bell Atlantic v. Twombly, 550 U.S.544 (2007), and Ashcroft v. Iqbal, 556 U.S. __, 129 S. Ct. 1937 (2009). It then touches on how the new fact-based pleading standard announced in these cases likely affects securities litigation practice.

a. Pleading Requirements Before Twombly And Iqbal

Since its adoption in 1937, Federal Rule of Civil Procedure 8(a) has required a pleading to contain a “short andplain statement of the claim showing that the pleader is entitled to relief.” Following its adoption and consistentwith the liberalization of the Federal Rules, the Supreme Court read 8(a) merely to require “notice pleading.” Under that standard, the complaint simply had to give the defendant fair notice of what law had been violatedand how the defendant was connected to the violation. See Conley v. Gibson, 355 U.S. 41, 47-48 (1957);Brownlee v. Conine, 957 F.2d 353, 354 (7th Cir. 1992). See generally 2 JEFFREY A. PARNESS & JERRY E. SMITH,MOORE’S FEDERAL PRACTICE § 8.04[1], at 8-21 to 8-24 (3d ed. 2009) (outlining development of notice pleadingand its standards and purposes).

Notice pleading was a distinct departure from 19th and early 20th century “code pleading” — technicalstandards where one misstep could be fatal to the claim. Conley, 355 U.S. at 48. “The Federal Rules of CivilProcedure do not require a claimant to set out in detail the facts upon which he bases his claim.” Id. at 47. Acomplaint should be dismissed for failure to state a claim only if “it appears beyond doubt that the plaintiff canprove no set of facts in support of his claim which would entitle him to relief.” Id. at 45-46.

At bottom, the purpose of this more liberal pleading standard was to use the discovery process, rather than themotion to dismiss, to ferret out unmeritorious claims. Swierkiewicz v. Sorema N.A., 534 U.S. 506, 512 (2002).

But as the nature of litigation changed over the latter half of the 20th century, and as discovery became moreexhaustive, expensive and sometimes abusive, the costs of allowing unmeritorious claims to proceed past themotion to dismiss stage cut against the benefits of giving every litigant his day in court. Over time, the courtsadded layers to the civil pleading standard without expressly raising it. They did so by, for example, requiring

more facts in complex cases, e.g., Desai v. Tire Kingdom, Inc., 944 F. Supp. 876, 879 (M.D. Fla. 1996) andrequiring plaintiffs to plead sufficient factual allegations to meet certain elements of a claim, DuraPharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 346-48 (2005). These developments presaged a wholesalechange to the pleading standard.

b. Twombly And Iqbal: To Survive A Motion To Dismiss, The Complaint Must Be“Plausible On Its Face”

That change finally came in the form of Bell Atlantic v. Twombly, an antitrust case brought under § 1 of theSherman Act. 550 U.S. 544, 570 (2007). Reversing the Second Circuit, the Court held the plaintiff’s complaintfailed to contain “enough facts to state a claim to relief that is plausible on its face.” Id. “Because plaintiffshere have not nudged their claims across the line from conceivable to plausible, their complaint must bedismissed.” Id.

In expressing the new “plausibility” pleading standard, the Court rejected Conley’s famous formulation,produced above, that a complaint should be dismissed for failure to state a claim only if “it appears beyonddoubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.” Id. at561 (quoting Conley, 355 U.S. at 45-46). Conley, the Court held, described the “breadth of opportunity toprove what an adequate complaint claims, not the minimum standard of adequate pleading to govern acomplaint’s survival.” Twombly, 550 U.S. at 562-63.

The Court did not make clear, however, whether Twombly’s new plausibility pleading standard applied (1) toonly antitrust actions, (2) to a broader subset of civil actions that were more complex in nature or involvedexpensive discovery, or (3) to all civil actions.

The Court answered this question in Ashcroft v. Iqbal, extending the Twombly plausibility standard to all civilactions. 556 U.S. __, 129 S. Ct. 1937, 1953 (2009).

Starting with Rule 8(a)(2), which requires pleadings to contain a “short and plain statement of the claimshowing that the pleader is entitled to relief” (Id. at 1949), the Court set forth a two-step analysis for districtcourts to determine whether Rule 8(a)(2) has been met. Id. at 1949-50.

First, while a court must accept as true all the allegations contained in a complaint, courts should disregardconclusory allegations. Id. at 1949-50 (“[T]he tenet that a court must accept as true all of the allegationscontained in a complaint is inapplicable to legal conclusions.”). Thus, a “threadbare” or “formulaic recitationof the elements” of a claim will not suffice. Id. at 1949.

Second, taking into account only those factual allegations surviving the first step, the court must then determinewhether the complaint states a claim for relief that is plausible on its face. Id. at 1950. Whether a claim isplausible is a “context-specific task that requires the reviewing court to draw on its judicial experience andcommon sense.” Id. The court advised that “[a] claim has facial plausibility when the plaintiff pleads factualcontent that allows the court to draw the reasonable inference that the defendant is liable for the misconductalleged. The plausibility standard is not akin to a ‘probability requirement,’ but it asks for more than a sheerpossibility that a defendant has acted unlawfully.” Id. at 1949.

The court also addressed the interplay between Rule 8 and Rule 9(b), which permits a plaintiff to pleadconditions of a person’s mind “generally.” While the court acknowledged that plaintiff need only plead“malice, intent, knowledge and other conditions of a person’s mind” generally, and not with particularity, that“does not give him license to evade the less rigid — though still operative — strictures of Rule 8.” Id. at 1954. “Rule 8 does not empower respondent to plead the bare elements of his cause of action, affix the label ‘generalallegation,’ and expect his complaint to survive a motion to dismiss.” Id. Rule 8 therefore stands as a floor forpleading requirements above which all complaints must rest.

c. Application to Securities Cases

Because the Iqbal standard applies to all civil actions, it necessarily applies to civil securities actions, includingfederal derivative actions. Commentators have identified three major ways in which Iqbal is likely to shift thelandscape of litigation at the motion to dismiss stage.

1) Iqbal Raises The Pleading Standards For SEC Civil Enforcement Actions

Iqbal’s biggest effect will be on the pleading standards in SEC civil enforcement actions. Because the PSLRAdoes not apply to SEC civil actions, the Commission has frequently relied on Rule 9(b)’s language permitting aplaintiff to plead state of mind generally. The SEC’s complaints often include threadbare and conclusoryassertions that the defendant acted with the requisite scienter. Two of Iqbal’s holdings — (1) that courts mustdisregard conclusory assertions and (2) that general allegations as to state of mind under Rule 9 cannotcircumvent Rule 8’s requirement that factual allegations be plausible — operate together to raise the SEC’spleading obligations in civil enforcement actions.

2) Iqbal May Give Courts Greater Latitude To Dismiss Securities Claims OutsideThe PSLRA’s Ambit

For claims subject to the PSLRA, see infra Subsection 3, Iqbal is unlikely to have any effect because thePSLRA raises pleading standards above those of Rule 8. Likewise, insofar as Rule 9(b) already applies tosecurities fraud actions, the particularity standard plaintiff’s allegations must satisfy is already higher than thatof the newly ratcheted up Rule 8. Where Iqbal discussed Rule 9(b), the discussion was limited to a plaintiff’sability to plead malice, intent, knowledge, or other conditions of the mind generally. The case should thus notbe read to disturb the higher pleading standards for scienter established under the PSLRA, 15 U.S.C. §78u-4(b)(2), or the Court’s interpretation of that standard in Tellabs v. Makor Issues & Rights, Ltd., 551 U.S.338 (2007).

However, Iqbal may give defendants greater latitude to attack pleadings as to misstatement or omission,materiality, reliance and loss causation. Previously, when plaintiffs’ founded their case on a fraud on themarket theory, courts would often deny a motion to dismiss without regard to whether the complaintsufficiently alleged reliance. Now, after Iqbal, defendants will be able to better target implausible theories ofreliance, using judicially noticeable documents and other materials to show, for example, that the market for thedefendant’s securities was inefficient. Iqbal will likewise buttress the Court’s prior holding in DuraPharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), enabling defendants to better attack plaintiffs’allegations regarding loss causation.

Iqbal will also affect cases that fall outside the PSLRA’s ambit. Courts are split as to whether Rule 9(b)’sparticularity standard applies to Section 11 claims sounding in fraud. See infra Subsection 2. In circuits thathave held Rule 9(b) does not apply to Section 11 claims, Iqbal now heightens plaintiffs’ pleading standards.

3) Iqbal Raises Pleading Standards For Federal Derivative Actions

Finally, Iqbal applies to derivative lawsuits filed in federal court. This has at least three implications. First,Iqbal affects plaintiffs’ ability to meet the threshold requirements for a derivative action. Although FederalRule of Civil Procedure 23.1 sets forth specific pleading requirements for stock ownership requirements anddemand futility, it does not address the pleading standards for those requirements. Iqbal sets a pleading“bottom” of plausibility.

Second, Iqbal applies with equal force to the underlying substantive claims brought on behalf of thecorporation.

Third, Iqbal’s elevated pleading standard brings the federal standard in line with many state standards, whichrequire a plaintiff to plead with particularly concrete facts demonstrating that tendering a demand would havebeen futile. E.g., Del. Ch. Ct. R. 23.1; Cal. Corp. Code § 800(b)(2) (West 2009); see infra Section V.C.2.b.2.

2. Pleading Requirements For Claims Sounding In Fraud

While Iqbal applies to civil actions generally, parties have long had to meet higher pleading standards whenalleging fraud. Federal Rule of Civil Procedure 9(b) requires that “[i]n alleging fraud or mistake, a party muststate with particularity the circumstances constituting fraud or mistake.” Fed. R. Civ. P. 9(b) (as amended,December 1, 2007).

Rule 9(b) clearly applies to claims under section 10(b) and Rule 10b-5. Tellabs v. Makor Issues & Rights, Ltd.,551 U.S. 308, 320 (2007) (citing Greenstone v. Cambrex Corp., 975 F.2d 22, 25 (1st Cir. 1992)). Less clear iswhether Rule 9(b) applies to claims in which scienter is not an element of the claim. Thus, the circuits are splitas to whether plaintiffs must meet 9(b) standards in pleading a section 11 or 12 claim. Compare ACA Fin.Guar. Corp. v. Advest, Inc., 512 F.3d 46, 69 (1st Cir. 2008) (applying Rule 9(b)’s heightened pleadingstandards to section 11 and 12 claims that “sound in fraud”) with In re NationsMart Corp. Sec. Litig., 130 F.3d309, 315 (8th Cir. 1997) (holding that Rule 9(b) does not apply to section 11 and 12 claims because proof offraud or mistake is not a prerequisite to liability). Although the Seventh Circuit has not conclusively decidedthe issue, at least one district court in that circuit has found that Rule 9(b) does not apply to section 11 or 12claims, reasoning that requiring a plaintiff to plead fraud and scienter with particularity is illogical when neitheris an element of the claim. In re Ulta Salon, Cosmetics & Fragrance, Inc. Sec. Litig., 604 F. Supp. 2d 1188,1193 (N.D. Ill. 2009).

Courts have also held that Rule 9(b) applies to claims under section 14(a) and Rule 14a-9, at least when theysound in fraud. See, e.g., Cal. Pub. Employees’ Retirement Sys. v. Chubb Corp., 394 F.3d 126, 144 (3d Cir.2004); Yourish v. Cal. Amplifier, 191 F.3d 983, 993 (9th Cir. 1999); In re JP Morgan Chase Sec. Litig., 363 F.Supp. 2d 595, 636 (S.D.N.Y. 2005).

3. Claims To Which The PSLRA Applies

Because the PSLRA applies to private class actions arising under the 1934 Act, courts have primarily appliedits pleading standards to claims under section 10(b) and Rule 10b-5. However, courts have also applied itsstandards to claims under sections 14(a), 14(d), and 14(e). See infra Section III.D.1.e, III.D.2.e, and III.D.3.e,respectively. Finally, most circuit courts have also applied its standards to claims under section 18(a). See,e.g., Teachers’ Retirement Sys. v. Hunter, 477 F.3d 162, 188 (4th Cir. 2007); Deephaven Private PlacementTrading, Ltd. v. Grant Thornton & Co., 454 F.3d 1168, 1172 (10th Cir. 2006); In re Stone & Webster, Inc. Sec.Litig., 414 F.3d 187, 194 (1st Cir. 2005); see infra Section III.F.

Because the lion’s share of securities class action practice is devoted to defending 10(b) and 10b-5 claims, theremainder of this section focuses on the application of the PSLRA to those claims.

4. The Reform Act’s Effect On Pleadings Standards

One of the Reforms Act’s principal aims was to heighten pleading standards for securities fraud claims. Asthey were designed to do, these heightened pleading requirements — and the circuit courts’ subsequentinterpretation of those requirements — give defendants a better chance of dismissing cases on the pleadings in asecurities fraud claim.

The discussion below addresses issues that routinely arise in a defendant’s motion to dismiss a securities classaction. It first addresses the Reform Act’s four major innovations with respect to pleading and the motion todismiss stage of litigation. It then focuses on the two requirements that have most often occupied the courts: increased specificity as to misstatements or omissions and particularity as to scienter.

a. The Reform Act’s Innovations

The Reform Act features four innovations that have significantly altered securities fraud pleadings and thelandscape of litigation at the motion to dismiss stage. These innovations are: (1) heightened pleading as to thedefendant’s allegedly misleading statement or omission; (2) heightened pleading of scienter; (3) stay ofdiscovery and proceedings during the motion to dismiss phase; and (4) mandatory consideration of Rule 11sanctions. 15 U.S.C. § 78u-4(b)(1)(B); id. § 78u-4(b)(2); id. § 78u-4(b)(3)(B); id. § 78u-4(c). In addition, theReform Act largely codified the federal common law doctrine of “bespeaks caution,” through safe harborprovisions for forward-looking statements.

1) Heightened Standard As To Statements And Omissions

With respect to heightened standards for misstatements or omissions, the Reform Act requires the complaint toset forth “each statement alleged to have been misleading, the reason or reasons why the statement ismisleading, and, if an allegation regarding the statement or omission is made on information and belief, thecomplaint shall state with particularity all facts on which that belief is formed.” Id. § 78u-4(b) (1)(B).

Even under the pre-PSLRA pleading standard, courts agreed that bare allegations of fraud were insufficient tosupport a securities fraud complaint. See, e.g., In re Navarre Corp. Sec. Litig., 299 F.3d 735, 742 (8th Cir.2002) (citing Parnes v. Gateway 2000, Inc., 122 F.3d 539, 549 (8th Cir. 1997)). Since the enactment of thePSLRA, the Circuits have differed on the degree of specificity they require and their interpretation of the “allfacts” requirement in the statute’s language.

2) Heightened Standard As To Scienter

As to heightened standards for scienter, the Reform Act requires the complaint to “state with particularity factsgiving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C. § 78u-4(b)(2). This requirement applies to “each act or omission alleged to violate this chapter.” Id. § 78u-4(b)(2).

The Reform Act mandates dismissal, upon the defendant’s motion, if the complaint fails to meet either of theserequirements. Id. § 78u-4(b)(3)(A).

Much of the debate surrounding the Reform Act was its intended interplay with Rule 9(b) of the Federal Rulesof Civil Procedure. Prior to the Reform Act, plaintiffs filing securities fraud lawsuits needed only to satisfyRule 9(b)’s particularity requirement. Fed. R. Civ. P. 9(b) (as amended, December 1, 2007); see supraSubsection 2. Because the Reform Act required plaintiffs “state with particularity facts giving rise to a stronginference that the defendant acted with the required state of mind,” courts wrestled with whether this standardwas coextensive with Rule 9(b) or had in fact supplanted it with a more stringent standard. 15 U.S.C. § 78u-4(b)(2) (emphasis added).

This debate led to a circuit split over what was required under the PSLRA to adequately plead a “stronginference” of scienter. Although most courts found that Congress intended for the Reform Act to heighten thepleading requirements in securities fraud cases above the Rule 9(b) standard, exactly what was required was asubject of some dispute. Compare Adams v. Kinder-Morgan, Inc., 340 F.3d 1083, 1096 (10th Cir. 2003) (“The

PSLRA supersedes . . . Rule 9(b), imposing a more stringent rule for pleading scienter.”) with Greebel v. FTPSoftware, Inc., 194 F.3d 185, 193 (1st Cir. 1999) (“The effect of [the PSLRA] is to embody in the Act itself atleast the standards of Rule 9(b) . . . .”). As Subsection 7.c discusses infra, the Supreme Court eventuallyresolved this split in Tellabs.

3) Stay Of All Proceedings

Another significant innovation of the PSLRA is the automatic stay on discovery and other proceedings before acourt has ruled on a motion to dismiss. The Reform Act provides: “In any private action arising under thischapter, all discovery and other proceedings shall be stayed during the pendency of any motion to dismiss,unless the court finds upon motion of any party that particularized discovery is necessary to preserve evidenceor to prevent undue prejudice to that party.” 15 U.S.C. § 78u-4(b)(3)(B). This is meant, in part, to prohibitplaintiffs from first suing without the requisite information to satisfy the Reform Act’s heightened pleadingrequirements and then using discovery to acquire information to “resuscitate an otherwise dismissiblecomplaint.” In re Comdisco Sec. Litig., 166 F. Supp. 2d 1260, 1263 (N.D. Ill. 2001). For a more completediscussion, see infra at Section II.E.2.

4) Mandatory Sanctions For Frivolous Securities Fraud Claims

The PSLRA’s final major innovation with respect to pleadings was to make frivolous securities law claimssanctionable. The PSLRA requires the court to make findings with respect to each party and attorney and mustimpose sanctions for violations of Rule 11. 15 U.S.C. § 78u-4(c). See infra at Subsection 9.b for a morecomplete discussion of the PSLRA’s sanction regime.

5. The PSLRA’s Pleading Requirements With Respect To Statements AndOmissions

The Reform Act introduced two major innovations with respect to statements and omissions. First, it elevatedthe degree of factual specificity and analysis required for each alleged misstatement or omission. Second, itcarved out an entire category of statements — forward-looking statements — that are not actionable. Thesestatements fall under the PSLRA’s safe harbor, discussed infra at Subsection 6. For now, we start with thePSLRA’s increased specificity for those statements that are actionable.

a. Increased Factual Specificity And Analysis Required

To determine whether facts plead in a complaint alleging securities fraud are adequate, a court must reviewthem in light of the PSLRA’s pleading standards. E.g., In re Initial Pub. Offering Sec. Litig., 241 F. Supp. 2d281, 337-38 (S.D.N.Y. 2003). In In re IPO, Judge Scheindlin parsed 15 U.S.C. § 78u-4(b)(1)(B), explainingthat “[a]ny claim that falls under paragraph (b)(1)’s purview must:

[1] specify each statement alleged to have been misleading;

[2] [specify] the reason or reasons why the statement is misleading; and

[3] if an allegation regarding the statement or omission is made on information and belief, the complaintshall state with particularity all facts on which that belief is formed.”

241 F. Supp. 2d at 329 (alterations in original).

Together, these requirements prohibit plaintiffs from either “generally aver[ring] that the defendant made amaterial misstatement or omission” or “merely copy[ing] the language of the statute.” Id.

b. Specification Of Each Allegedly Misleading Statement

As to the first requirement, plaintiff must identify specific statements or omissions that give rise to her cause ofaction. Id. Because the “pleadings . . . serve as binding judicial admissions that control the plaintiff’s casethroughout the course of the proceedings” and give defendants “fair notice of what the claim is and the groundsupon which it rests,” both the court and defendants must know what specific statements are at issue. Id.; BellAtl. Corp. v. Twombly, 550 U.S. 544, 570 (2007). Thus, courts have found that simply copying press releases,SEC filings, or transcripts from conferences calls into the complaint is insufficient. E.g., In re 2007 NovastarFin. Inc., Sec. Litig., 579 F.3d 878, 882-83 (8th Cir. 2009). Instead, the plaintiff must identify what statementswithin those communications were misleading. Id.; Tripp v. IndyMac Fin. Inc., No. CV-07-1635 GW (VBKx),2007 WL 4591930, *6 (C.D. Cal. Nov. 29, 2007) (granting defendants’ motion to dismiss with leave to amend,noting that plaintiff pled insufficiently particularized allegations, and requiring any amended complaint to“identify[] only those statements that are alleged to be false or misleading and (briefly, but specifically), stat[e]why”); Havenick v. Network Express, 981 F. Supp. 480, 526 (E.D. Mich. 1997) (“Nowhere in the Complaint doplaintiffs specify each statement that is allegedly false nor do they give a particular reason why a particularstatement is false. Rather, they have simply compiled a long list of block quotes, many of which containstatements that cannot seriously be regarded as false or misleading, and they line these statements up against aconclusory list of omissions and pronounce that fraud exists.”).

Although plaintiffs generally must tie a statement to a specific defendant, that is not always true when anaffirmative statement and omission occur simultaneously. Thus, if a two defendants participated in aconference call with analysts, with one making an allegedly false statement and another failing to correct it,plaintiffs have sufficiently pleaded the fraud as to each defendant even if they do not identify which of the twospoke and which remained silent. Barrie v. Intervoice-Brite, Inc., 409 F.3d 653, 655-56 (5th Cir. 2005).

c. The Reason Or Reasons Why The Statement Is Misleading

As to the second requirement, plaintiffs must then analyze each specific statement or omission by explainingwhy it is misleading. Simply reciting a laundry list of general reasons without an explanation as to why aparticular statement is misleading is not sufficient. Wenger v. Lumisys, Inc., 2 F. Supp. 2d 1231, 1243 (N.D.Cal. 1998) (“In violation of the Reform Act . . . the Complaint lumps all alleged misrepresentations together . . .and then follows that catalog with a three-page laundry list of reasons why all the statements were allegedlyfalse when made.”). In this regard, courts can be exacting in the degree of analysis required. See, e.g., In re CPShips, Ltd., Sec. Litig., 506 F. Supp. 2d 1161, 1167 (M.D. Fla. 2007) (dismissing a claim regarding cost under-accruals because plaintiffs failed to allege facts regarding the subject matter of the under-accruals, the mannerin which they were accomplished, the timing, who directed them and how they were directed). Courts will notlet plaintiffs “place the burden on the reader to sort out the statements and match them with the correspondingadverse facts.” In re Wash. Mut., Inc. Sec., Derivative & ERISA Litig., 259 F.R.D. 490, 502 (W.D. Wash. 2009)(granting motion to dismiss because plaintiff’s “puzzle pleading” failed to present allegations clearly and withenough specificity to give defendants notice of the claims against them).

d. “All Facts” Forming Basis For “Information And Belief”

The Federal Rules of Civil Procedure recognize two types of allegations ¾ those made with personalknowledge or those made on information and belief. Fed. R. Civ. P. 11(b). With respect to every allegationmade on information and belief, the PSLRA requires that a plaintiff must “state with particularity all facts onwhich that belief is formed.” 15 U.S.C. § 78u-4(b)(1)(B). This requirement has proved a fertile ground for

pleading challenges.

Interpreting this language, the Ninth Circuit has held that a plaintiff must include in the complaint literally allsources of information upon which the fraud allegations are based. In In re Silicon Graphics Inc., SecuritiesLitigation, 183 F.3d 970, 988 (9th Cir. 1999), the court found that it is not sufficient to allege the presumedexistence of “negative internal reports” and presumed “knowledge” of these reports by defendants simplybecause “every sophisticated corporation uses some kind of internal reporting system.” Rather, plaintiffs mustplead “the titles of the reports, when they were prepared, who prepared them, to whom they were directed, theircontent, and the sources from which plaintiffs obtained this information.” In re Silicon Graphics Inc., Sec.Litig., 970 F. Supp. 746, 767 (N.D. Cal. 1997); see also In re Silicon Storage Tech., Inc. Sec. Litig., No. C-05-0295, 2006 WL 648683, at *10-11 (N.D. Cal. Mar. 10, 2006) (dismissing complaint in part for failure to pleadwith particularity that each confidential informant occupied a position such that he/she would possess theinformation alleged; because none of the informants was employed at the company during the alleged classperiod; and because uncorroborated internal reports were insufficiently reliable); Fla. State Bd. of Admin. v. BayNetworks, Inc., No. 97-CV-2347, 1998 WL 34187566 (N.D. Cal. Sept. 15, 1998), cited with approval inSilicon Graphics, 183 F.3d at 988 n.19.

With respect to a complaint’s “sources,” the PSLRA’s requirements create special issues for both the: (1) use ofexperts or consultants in support of allegations, and (2) use of unnamed confidential witnesses.

1) Use Of Experts Or Consultants In Support Of Allegations

See In re Silicon Storage Tech., Inc., No. C-05-0295 PJH, 2007 WL 760535 (N.D. Cal. Mar. 9, 2007) (data andinformation obtained from “experts” are subject to the same stringent particularity requirements of the ReformAct as are facts alleged to have originated from confidential informants or other witnesses); plaintiff mustspecifically allege the expert’s qualifications, how his analysis was performed and/or upon what data he relied. (In re Textainer P’ship Sec. Litig., No. C-05-0969 MMC, 2006 WL 1328851, at *5 (N.D. Cal. May 15, 2006).

2) Use Of Unnamed Confidential Witnesses

Most courts allow claims to be founded on the testimony of confidential witnesses, if the witnesses aresufficiently identified.

Prior to the Supreme Court’s decision in Tellabs, see infra Subsection 7.c, the Second Circuit’s influentialdecision in Novak v. Kasaks, 216 F.3d 300, 313-14 (2d Cir. 2000) held that the Reform Act did not requireplaintiffs to identify all sources of information in the complaint as a general matter. Id. The court explained:

[i]n our view, notwithstanding the use of the word ‘all,’ [the Reform Act] does not require thatplaintiffs plead with particularity every single fact upon which their beliefs concerning false ormisleading statements are based. Rather, plaintiffs need only plead with particularity ‘sufficient’ factsto support those beliefs. Accordingly, where plaintiffs rely on confidential personal sources but alsoon other facts, they need not name their sources as long as the latter facts provide an adequate basisfor believing that the defendants’ statements were false.

Id.

Moreover, even if confidential sources must be identified, the Second Circuit did not require “that they benamed, provided they are described in the complaint with sufficient particularity to support the probability thata person in the position occupied by the source would possess the information alleged.” Id. Thus, according tothe Second Circuit, a complaint could meet the Reform Act’s pleading requirement “by providing documentary

evidence and/or a sufficient general description of the personal sources of the plaintiffs’ beliefs.” Id.

The Ninth Circuit also adopted a similar stance. In In re Daou Sys., Inc., 411 F.3d 1006, 1015-16 (9th Cir.2005), it applied the standards set forth by the Second Circuit, in conjunction with factors applied by the FirstCircuit, to assess the reliability of confidential witnesses. It held that naming sources is unnecessary so long asthe sources are described with sufficient particularity and the complaint contains “adequate corroboratingdetails.” Id. (citing Nursing Home Pension Fund, Local 144. v. Oracle Corp., 380 F.3d 1226, 1233 (9th Cir.2004) and In re Silicon Graphics Inc., Sec. Litig., 183 F.3d 970, 985 (9th Cir. 1999)); In re MetawaveCommc’ns Corp. Sec. Litig., 298 F. Supp. 2d 1056, 1068 (W.D. Wash. 2003) (allowing confidential witnessesto go unnamed but requiring enough particularity for the court to determine “how confidential witnesses ‘cameto learn of the information they provide in the complaint’ … The Court must be able to tell whether aconfidential witness is speaking from personal knowledge, or ‘merely regurgitating gossip and innuendo’”(citations omitted)).

Many other courts followed Novak’s approach to confidential witnesses. See, e.g., Adams v. Kinder-Morgan,Inc., 340 F.3d 1083, 1098-99 (10th Cir. 2003) (“[W]e agree with the courts that have concluded that‘notwithstanding the use of the word “all,” paragraph (b)(1) does not require that plaintiffs plead withparticularity every single fact upon which their beliefs concerning false or misleading statements are based.’”(quoting Novak, 216 F.3d at 313-14)); ABC Arbitrage Plaintiffs Group v. Tchuruk, 291 F.3d 336, 352 (5th Cir.2002) (“[The PSLRA] does not require that plaintiffs plead with particularity every single fact upon which theirbeliefs concerning false or misleading statements are based. Rather, plaintiffs need only plead withparticularity sufficient facts to support those beliefs.”); In re Cabletron Sys., Inc., 311 F.3d 11, 30-31 (1st Cir.2002) (determining whether an adequate basis exists for believing defendants’ statements were false byevaluating all facts alleged, including the level of detail provided by confidential sources, the corroborativenature of the other facts alleged, the coherence and plausibility of the allegations, the number of sources, andthe reliability of sources).

The Third Circuit also adopted the Novak standard, finding that as long as plaintiffs supplied sufficient facts tosupport their allegations, there is no reason to divulge confidential sources. Cal. Pub. Employees’ Ret. Sys. v.Chubb Corp., 394 F.3d 126, 146-47 (3d Cir. 2004); see In re Cigna Corp. Sec. Litig., No. Civ.A. 02-8088, 2006WL 263631, at *3 (E.D. Pa. Jan. 21, 2006) (reasoning that “requiring specific identification (to the defendant)of confidential sources . . . would chill informants from providing critical information”). The court requiredconsideration of “the detail provided by the confidential sources, the sources’ basis of knowledge, thecorroborative nature of other facts alleged, including from other sources, the coherence and plausibility of theallegations, and similar indicia.” Chubb, 394 F.3d at 146; see also Freed v. Universal Health Serv., Inc., No.04-1233, 2005 U.S. Dist. LEXIS 7789 (E.D. Pa. May 3, 2005) (holding that the complaint, which relied heavilyon confidential sources, must contain information describing when confidential source worked for defendantcorporation, dates on which information was acquired, and how they had access to that information).

Following the Supreme Court’s decision in Tellabs, see infra Subsection 7.c, the circuit courts had to decidewhether the Novak standard could survive that decision. The Seventh Circuit was the first appellate court toconsider the weight confidential witnesses’ statements should receive after Tellabs. In Higginbotham v. BaxterInt’l, Inc., 495 F.3d 753 (7th Cir. 2007), it held that anonymity frustrates courts’ abilities to weigh plaintiffs’favorable inferences against competing inferences. Id. at 757. Because plaintiffs must eventually providedefendants with the identity of persons with relevant information, see Fed. R. Civ. P. 26(a)(1)(A), concealingnames at the complaint stage “does nothing but obstruct the judiciary’s ability to implement the PSLRA.” Higginbotham, 495 F.3d at 757. Although the court refrained from completely ignoring allegations based oninformation provided by confidential witnesses, it held that such allegations must usually be steeply discountedin weighing competing inferences. Id. (“It is hard to see how information from anonymous sources could bedeemed ‘compelling’ or how we could take account of plausible opposing inferences. Perhaps theseconfidential sources have axes to grind. Perhaps they are lying. Perhaps they don’t even exist.”). But see In reNPS Pharms., Inc. Sec. Litig., No. 2:06-cv-00570, 2007 WL 1976589, at *5 (D. Utah July 3, 2007) (refusing toevaluate credibility of confidential witnesses on motion to dismiss).

Subsequent case law suggests, however, that courts must consider the context when determining how muchweight to accord confidential witnesses, paying special attention to the level of detail provided. The SeventhCircuit itself qualified Higginbotham when Judge Posner ruled on the remand of Tellabs. In Makor Issues &Rights, Ltd. v. Tellabs Inc., 513 F.3d 702 (7th Cir. 2008), the court acknowledged the difficulties of assessingallegations based on anonymous sources but noted that the confidential sources listed in the complaint “arenumerous and consist of persons who from the description of their jobs were in a position to know at first handthe facts to which they are prepared to testify . . . . The information that the confidential informants arereported to have obtained is set forth in convincing detail, with some of the information . . . corroborated bymultiple sources.” Id. at 712.

Most circuit courts to consider the issue since Tellabs have adopted a similar stance. See, e.g., InstitutionalInvestors Group v. Avaya, Inc., 564 F.3d 242, 261 (3d Cir. 2009) (summarizing pre- and post-Tellabs case lawand ultimately approving of the factors set forth in its earlier opinion, Cal. Pub. Employees’ Ret. Sys. v. ChubbCorp., 394 F.3d 126, 146-47 (3d Cir. 2004)); Ley v. Visteon Corp., 543 F.3d 801, 811 (6th Cir. 2008) (notingthat “anonymous sources are not altogether irrelevant to the scienter analysis” but applying Higginbotham’ssteep discount when plaintiffs not only withheld the names of employees who knew of defendant’s “allegedaccounting improprieties,” but also failed to allege “what, when, where, and how” the employees knew of thatinformation); Mizzaro v. Home Depot, Inc., 544 F.3d 1230, 1240 (11th Cir. 2008) (“[Although there are]reasons why courts may be skeptical of confidential sources cited in securities fraud complaints . . . ,[c]onfidentiality . . . should not eviscerate the weight given [to these sources] if the complaint otherwise fullydescribes the foundation or basis of the confidential witness’s knowledge, including the position(s) held, theproximity to the offending conduct, and the relevant time frame.”).

Still, some courts remain skeptical as to the vitality of confidential witness allegations after Tellabs. Forexample, the Ninth Circuit rejected fairly detailed confidential witness statements for failure to allege personalknowledge. Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 996 (9th Cir. 2009). Applying In re Daou,discussed supra, the court identified two hurdles plaintiffs must clear: (1) “the confidential witnesses whosestatements are introduced to establish scienter must be described with sufficient particularity to establish theirreliability and personal knowledge” and (2) “those statements which are reported by confidential witnesses withsufficient reliability and personal knowledge must themselves be indicative of scienter.” Id. at 995. Although itquestioned whether Tellabs requires a stricter standard for evaluating the sufficiency of securities fraudcomplaints relying on confidential witnesses, it left that question open, finding that the complaint failed evenunder In re Daou’s standards. Id. at 995 & n.2. See also Konkol v. Diebold, Inc., 590 F.3d 390, 399 (6th Cir.2009) (applying Higgenbotham’s “steep discount”); Campo v. Sears Holding Corp., 371 Fed. Appx. 212 (2dCir. 2010) (summary opinion – citable but without precedential effect – rejecting plaintiffs’ challenge to districtcourt’s allowing depositions to be taken of confidential witnesses to test good-faith basis for plaintiffs’compliance with Tellabs where witnesses on being deposed had disowned or contradicted many of thestatements attributed to them, since the anonymity of confidential witnesses frustrates the weighing ofcompeting inferences required by Tellabs).

Despite this uncertainty, complaints relying on confidential witnesses continue to survive the motion to dismissstage. E.g., In re Gilead Sciences Sec. Litig., 2009 WL 3320492, at *2 (N.D. Cal. Oct. 13, 2009) (finding aconfidential witness’s allegations sufficient as a pleading matter even though witness changed his story becausethe change in the allegations was “plausible,” supported by other confidential witnesses; “while the Court mustdetermine that confidential witness allegations are reliable as required by Zucco Partners . . . the Court does notfind it appropriate to engage in a more searching assessment of CW2’s credibility at this stage”); but see In reAccuray, Inc. Sec. Litig., 2010 WL 3447588 (N.D. Cal. Aug. 31, 2010) (dismissing complaint founded on CWallegations that lacked specific facts about specific contracts included in allegedly misstated backlog, werebased on opinion and hindsight and lacked personal knowledge or connection with the defendants).

Courts have rejected some plaintiffs’ attempts to have courts view information about confidential witnesses incamera rather than having to plead it. See, e.g., City of Livonia Emp. Ret. Sys. v. Boeing Co., 2010 U.S. Dist.LEXIS 52271 (N.D. Ill. May 26, 2010); Hubbard v. BankAtlantic Bancorp, Inc., 625 F. Supp. 2d 1267, 1284 n.13 (S.D. Fla. 2008); In re DOT Hill Syst. Corp. Sec. Litig., 594 F. Supp. 2d 1150, 1162 (S.D. Cal. 2008).

6. The Safe Harbor For Forward-Looking Statements

The Reform Act also sought to curb abusive private securities litigation through its “safe harbor” for “forward-looking statements.” Under the Safe Harbor, certain forward-looking statements are not actionable. See 15U.S.C. § 77z-2; id. § 78u-5; see also Harris v. Ivax, 182 F.3d 799, 803 (11th Cir. 1999). Congress’s intentbehind the safe harbor provision was “to loosen the ‘muzzling effect’ of potential liability for forward-lookingstatements, which often kept investors in the dark about what management foresaw for the company.” Id. at806 (citing H.R. Conf. Rep. 104-369, at 42 (1995)); see also Employers Teamsters Local Nos. 175 & 505Pension Trust Fund v. Clorox Co., 353 F.3d 1125, 1131 (9th Cir. 2004). However, even if the forward-lookingaspect of a statement is not actionable, that very same statement may be actionable because of other misleadingcontent. S. Ferry LP #2 v. Killinger, 399 F. Supp. 2d 1121 (W.D. Wash. 2005), vacated on other grounds, 542F.3d 176 (9th Cir. 2008).

a. Forward-Looking Statements

The Reform Act defines a forward-looking statement as follows:

1) a statement containing a projection of revenues, income (including income loss), earnings (includingearnings loss) per share, capital expenditures, dividends, capital structure, or other financial items;

2) a statement of plans and objectives of management for future operations, including plans or objectivesrelating to the products or services of the issuer;

3) a statement of future economic performance, including any such statement contained in a discussion andanalysis of financial condition by the management or in the results of operations included pursuant to therules and regulations of the Commission;

4) any statement of the assumptions underlying or relating to any statement described above insubparagraph [(1), (2) or (3)];

5) any report issued by an outside reviewer retained by an issuer, to the extent that the report assesses aforward-looking statement made by the issuer; or

6) a statement containing a projection or estimate of such other items as may be specified by rule orregulation of the Commission.

15 U.S.C. § 77z-2(i)(1); id. § 78u-5(i)(1).

Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” and “estimate” are examples offorward-looking language. Baron v. Smith, 380 F.3d 49, 53-54 (1st Cir. 2004). Courts have also held that apresent-tense statement can qualify as a forward-looking statement as long as the truth or falsity of thestatement cannot be discerned until some point in time after the statement is made. Harris, 182 F.3d at 803; Inre Aetna, Inc. Sec. Litig., 2009 WL 1619636, at *22-23 (E.D. Pa. June 9, 2009) (finding that the defendant-insurer’s statement that it practices “disciplined pricing” — meaning that defendant “expects that its pricingwill be in lined with its projected medical cost trend” — is a statement of future performance despite beingstated in the present tense, and therefore falls within the safe harbor); In re Kindred Healthcare, Inc. Sec. Litig.,299 F. Supp. 2d 724, 738 (W.D. Ky. 2004) (holding that management’s statements indicating a belief in theadequacy of current reserves and liability coverage of the health care company were necessarily predicated onprojections of future events that could only be verified when liability claims were actually filed, and thereforeconsidered forward looking under PSLRA).

b. Applicability Of The Safe Harbor

The safe harbor applies when a forward-looking statement is (1) identified as such and accompanied by“meaningful cautionary statements identifying important factors that could cause actual results to differmaterially from those in the forward-looking statement”; or (2) not material, without regard to the “actualknowledge” or state of mind of the issuer or executive. See 15 U.S.C. § 77z-2(c)(1)(A-B); id. § 78u-5(c)(1)(A-B). The Reform Act differentiates forward-looking statements made by natural persons from those made bybusiness entities. See id. § 77z-2(c)(1)(B); id. § 78u-5(c)(1)(B). Natural persons are insulated from liabilitywhen the plaintiff fails to prove the defendants actually knew the forward-looking statement was false ormisleading; business entities are insulated from liability where the plaintiff fails to prove that the forward-looking statement was “(I) made by or with the approval of an executive officer of that entity, and (II) made orapproved by such officer with actual knowledge by that officer that the statement was false or misleading.” Id.§ 77z-2(c)(1)(B); id. § 78u-5(c)(1)(B).

Subsection (A)’s safe harbor for forward looking-statements accompanied by meaningful cautionary languageoperates independently of subsection (B)’s requirement that plaintiff prove that the defendant communicatedthe forward-looking statement with actual knowledge that the statement was false or misleading. See In reCutera Sec. Litig., 610 F.3d 1102 (9th Cir. 2010) (the two subsections must be read in the disjunctive, such thatdefendant’s state of mind is irrelevant if statements identified as forward-looking are accompanied bymeaningful cautionary language); Miller v. Champion Enters. Inc., 346 F.3d 660, 672 (6th Cir. 2003); Harris v.Ivax Corp., 182 F.3d 799, 803 (11th Cir. 1999); see also In re See Beyond Techs. Corp. Sec. Litig., 266 F. Supp.2d 1150, 1164 (C.D. Cal. 2003) (“The statute, legislative history and courts interpreting the statute indicate thatif a defendant shows that a forward-looking statement is accompanied by meaningful cautionary language, acourt need not turn to subsection (B) and examine whether the plaintiff, nevertheless, has sufficiently allegedactual knowledge. In other words, these two prongs of the safe harbor provision are taken to be independent,alternative means by which a defendant may insulate itself from liability; the first prong, which comes into playwhen meaningful cautionary language is present, does not require looking at the defendant’s state of mind,while the second prong provides additional protection for a defendant where sufficient cautionary language isabsent.”); In re Midway Games, Inc. Sec. Litig., 332 F. Supp. 2d 1152, 1168 (N.D. Ill. 2004) (“For purposes of§ 78u-5(c)(1)(A), proof of knowledge of the falsity of a forward-looking statement is ‘irrelevant’ when thestatement is accompanied by meaningful cautionary language.”). But see Lormand v. U.S. Unwired, Inc., 565F.3d 228, 244 (5th Cir. 2009) (holding that the PSLRA’s safe harbor provision is not available to defendantswho have actual knowledge that their forward-looking statements are false at the time they are made).

The safe harbor does not protect statements that are no longer forward looking in character because they arealready known to be false when made. See, e.g., Rombach v. Chang, 355 F.3d 164, 173 (2d Cir. 2004)(“Cautionary words about future risk cannot insulate from liability the failure to disclose that the risk hastranspired.”); In re Nash Finch Co., Sec. Litig., 502 F. Supp. 2d 861, 873 (D. Minn. 2007) (finding defendants’“cautionary language” was not meaningful because they had actual knowledge that the potential risks identifiedhad in fact already occurred and thus the safe harbor rule did not apply); In re Sepracor, Inc. Sec. Litig., 308 F.Supp. 2d 20, 28, 31-34 (D. Mass. 2004) (holding that the safe-harbor provision does not apply to statementswhich were fact rather than conjecture at the time they were made and that cautionary statements cannotinsulate defendants from liability where plaintiff’s complaints raise a strong inference that defendants wereaware of, or recklessly disregarded, undisclosed material facts).

The mere fact that a statement contains some reference to projected future events does not bring the statementwithin the safe harbor if the alleged falsity relates to non-forward-looking aspects of the statement. In re Stone& Webster, Inc., Sec. Litig., 414 F.3d 187 (1st Cir. 2005). The safe harbor provision is intended to apply onlyto allegations of falsity relating to the forward-looking aspects of the statement. Id.

c. No Duty To Update

The safe harbor provisions in both the Securities Act and the Exchange Act specifically provide that neitherprovision imposes a duty to update a forward-looking statement. See 15 U.S.C. § 77z-2(d); id. § 78u-5(d).

d. Effect On Bespeaks Caution Doctrine

The safe harbor provisions of the Reform Act largely adopt the bespeaks caution doctrine. The JointExplanatory Statement of the Committee of Conference on the Private Securities Litigation Reform Act of1995, 27 Sec. Reg. & L. Rep. (BNA) 1894 (Dec. 1, 1995), specifically provides that the safe harbor provisionsare not intended to replace the bespeaks caution doctrine or further judicial development of the doctrine. Id. at1895.

Therefore, in situations where the safe harbor does not grant protection, defendants subject to securities fraudlawsuits based on materially “misleading” forward-looking statements may continue to invoke the “bespeakscaution” doctrine in attempting to have such suits dismissed as a matter of law. See P. Stolz Family P’ship v.Daum, 355 F.3d 92, 96-97 (2d Cir. 2004); see also Lin v. Interactive Brokers Group, 574 F. Supp. 2d 408(S.D.N.Y. 2008) (applying the common-law “bespeaks caution” doctrine to hold that optimistic statementsabout the potential of the offering company’s technology were accompanied by cautionary language disclosingpossible risks sufficient to put a reasonable investor on notice and making the offering document not materiallyfalse or misleading).

The Ninth Circuit has applied the bespeaks caution doctrine in situations where “optimistic projections coupledwith cautionary language . . . affect the reasonableness of reliance on and the materiality of those projections.” Livid Holdings Ltd. v. Salomon Smith Barney, Inc., 416 F.3d 940, 947 (9th Cir. 2005) (quoting In re Worlds ofWonder Sec. Litig., 35 F.3d 1407, 1414 (9th Cir. 1994)). The Ninth Circuit notes, however, that dismissal onthe pleadings under the bespeaks caution doctrine requires a stringent showing: “[t]here must be sufficient‘cautionary language or risk disclosure such that reasonable minds could not disagree that the challengedstatements were not misleading.’” Id. (quoting In re Stac Elec. Sec. Litig., 89 F.3d 1399, 1409 (9th Cir. 1996)(alterations in original)).

7. The PSLRA’s Pleading Requirements With Respect To Scienter

In addition to the PSLRA’s heightened pleading standard for statements and omissions, it also introducedheightened standards with respect to scienter. Much of the litigation following the PSLRA’s enactment focusedon its requirements for pleading scienter. This section first discusses the circuit split that developed over thoserequirements and the Supreme Court’s ultimate resolution of the issue. It then focuses on attempts to pleadscienter through different means, including Sarbanes-Oxley certifications and GAAP violations. See also,Section III.A.12 below for related discussion.

a. Heightened Pleading Standard

The Reform Act requires the complaint to “state with particularity facts giving rise to a strong inference that thedefendant acted with the required state of mind.” 15 U.S.C. § 78u-4(b)(2) (emphasis added). This requirementapplies to “each act or omission alleged to violate this chapter.” Id. § 78u-4(b)(2).

b. Following The PSLRA, The Circuits Split As To The Stringency Of The “StrongInference” Standard

Following the passage of the Reform Act in 1995, the Circuits interpreted the pleading requirements of thePSLRA in different ways. The Ninth Circuit adopted the strictest pleading requirements of the circuits, holdingthat the Reform Act significantly raised the pleading standards in securities fraud lawsuits both as to thespecificity required of fraud allegations and as to the scienter requirement. In In re Silicon Graphics Inc,Securities Litigation, 183 F.3d 970, 974 (9th Cir. 1999), the Ninth Circuit held that plaintiffs “must plead, ingreat detail, facts that constitute strong circumstantial evidence of deliberately reckless or conscious

misconduct” to satisfy the PSLRA. See also In re Read-Rite Corp., 335 F.3d 843, 846, 848 n.1 (9th Cir. 2003)(noting the Ninth Circuit’s continuing adherence to the pleading standards of In re Silicon Graphics Inc.).

By contrast, the Second Circuit took a more lenient approach, finding that the Reform Act’s scienter pleadingstandard simply codified the Second Circuit’s “motive and opportunity” standard used prior to the Reform Act. Levitt v. Bear Stearns & Co., Inc., 340 F.3d 94, 104 (2d Cir. 2003) (stating that the PSLRA scienter pleadingrequirement “is essentially a codification of [the Second Circuit’s] decisions interpreting Rule 9(b)”); Novak v.Kasaks, 216 F.3d 300, 313-14 (2d Cir. 2000). The Third Circuit followed this approach, finding that the “strong inference” language in the statute suggested that Congress intended to codify the Second Circuit’sapproach. In re Advanta Corp. Sec. Litig., 180 F.3d 525 (3d Cir. 1999).

The other circuits followed a middle ground – adopting stricter pleading requirements than those required bythe Second and Third Circuits but less strict than required by the Ninth Circuit. See, e.g., Greebel, 194 F.3d185; Nathenson v. Zonagen, Inc., 267 F.3d 400, 409-11 (5th Cir. 2001); Helwig v. Vencor, Inc., 251 F.3d 540,550 (6th Cir. 2001); Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir. 2006), vacated by 551U.S. 308 (2007); In re Navarre Corp. Sec. Litig., 299 F.3d 735, 745 (8th Cir. 2002); City of Philadelphia v.Fleming Cos. Inc., 264 F.3d 1245, 1262 (10th Cir. 2001); Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1283(11th Cir. 1999), rev’d sub nom., Bryant v. Dupree, 252 F.3d 1161 (11th Cir. 2001). Notably, courts in thesecircuits often found that what constitutes a “strong inference” of scienter depends on the facts andcircumstances of each case and thus emphasized the need to examine the “totality of the pleadings.” See, e.g.,Abrams v. Baker Hughes, Inc., 292 F.3d 424, 431 (5th Cir. 2002) (“The appropriate analysis . . . is to considerwhether all facts and circumstances ‘taken together’ are sufficient to support the necessary strong inference ofscienter on the part of the plaintiffs.”); Navarre, 299 F.3d at 745 (“[The scienter] standard is not satisfied by anyone particular method, such as the motive and opportunity formulation adopted by the Second Circuit, butrather through various criteria developed throughout the circuits that look for badges of fraud” (citationsomitted)). Even the courts following this “middle ground” disagreed with each other as to whether plaintiffswere entitled to the most plausible of competing inferences available from the facts in the complaint (see, forexample, Helwig) or, in the alternative, whether a court should allow the complaint to survive if it alleges factsraising merely a reasonable inference of fraudulent intent.

c. The Supreme Court Resolves The Split In Tellabs

The Supreme Court addressed the heightened standard for pleading scienter under the Reform Act and the splitthat had developed among the circuits in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007).

The Court laid out a three-step approach that should be followed in considering a motion to dismiss in asecurities class action case.

First, a court must accept all factual allegations in the complaint as true. Id. at 322.

Second, the court must consider the complaint in its entirety, as well as other sources courts ordinarily examinewhen ruling on Rule 12(b)(6) motions. “The inquiry is whether . . . all of the facts alleged, taken collectively,give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meetsthat standard.” Id. at 322-23.

Third, “in determining whether the pleaded facts give rise to a ‘strong’ inference of scienter, the court must takeinto account plausible opposing inferences.” Id. at 323.

As to this third requirement, “[t]o determine whether the plaintiff has alleged facts that give rise to the requisite‘strong inference,’ a court must consider plausible nonculpable explanations for the defendant’s conduct, aswell as inferences favoring the plaintiff.” Id. at 323-24. “The inference that the defendant acted with scienterneed not be irrefutable, . . . but it must be more than merely ‘reasonable’ or ‘permissible’ — it must be cogentand compelling, thus strong in light of other explanations.” Id. at 324. “A complaint will survive only if a

reasonable person would deem the inference of scienter cogent and at least as compelling as any plausibleopposing inference one could draw from the facts alleged.” Id.

Recent decisions applying Tellabs at both the district and appellate court levels suggest that pleading scienterwill be harder for plaintiffs in some circuits while potentially easier in others. The question of the properpleading standard for scienter post-Tellabs is discussed in detail at Section III.A.7, infra.

d. Statements Of Present Or Historical Fact

Plaintiffs must allege that defendants had the requisite scienter at the same time they made an allegedly false ormisleading statement or failed to disclose something material. GSC Partners CDO Funds v. Washington, 368F.3d 228, 239 (3d Cir. 2004); In re Navarre Corp. Sec. Litig., 299 F.3d 735, 743 (8th Cir. 2002) (explainingthat plaintiffs’ amended complaint failed to indicate why statements about a planned initial public offeringwould have been false or misleading when allegedly made); In re Sofamor Danek Group, Inc., 123 F.3d 394,401 n.3 (6th Cir. 1997) (noting that a violation of the federal securities laws cannot be premised upon acompany’s disclosure of accurate historical data); In re Vertex Pharms. Inc., Sec. Litig., 357 F. Supp. 2d 343(D. Mass. 2005) (holding that while motive evidence alone is insufficient to satisfy the scienter requirement,unusually strong financial incentives may be relevant when considered in combination with other factors toshow scienter); Menkes v. Stolt-Nielsen S.A., 2005 WL 3050970, at *11 (D. Conn. Nov. 10, 2005) (explainingthat without facts that show a flow of information from subsidiary to parent corporation or how parentmonitored subsidiary, plaintiffs cannot establish the requisite scienter of parent for subsidiary’s alleged fraud). Moreover, the accurate reporting of historic successes does not give rise to a duty to further disclosecontingencies that might alter the revenue picture in the future. McDonald v. Kinder-Morgan, Inc., 287 F.3d992, 998 (10th Cir. 2002).

e. Heightened Scienter Standard For Forward-Looking Statements

Even when a forward-looking statement lacks sufficient cautionary language to place it within the Reform Act’ssafe harbor, the statement will still receive the benefit of a heightened pleading standard. In such a case, unlessa plaintiff pleads specific facts demonstrating that defendants had actual knowledge of the falsity of challengedstatements, there is no liability as a matter of law. See 15 U.S.C. § 78u-5(c)(1)(B); id. § 77z-2(c)(1)(B)(finding no liability for any forward-looking statement “if … plaintiff fails to prove that [it] was made withactual knowledge … that the statement was false or misleading”); Johnson v. Tellabs, Inc., 303 F. Supp. 2d 941,955 (N.D. Ill. 2004) (stating that a forward-looking statement will be actionable against a corporation only ifplaintiffs plead with particularity facts that strongly indicate that defendants had actual knowledge that theirstatements were false or misleading when made); In re Globalstar Sec. Litig., No. 01 CIV. 1748 (SHS), 2003WL 22953163, at *9 (S.D.N.Y. Dec. 15, 2003) (finding the safe harbor inapplicable to projections of futureperformance that were not believed to be true by the speaker at the time they were made).

f. Use Of Sarbanes-Oxley Certifications To Plead Scienter

Because the Sarbanes-Oxley Act requires certification of financial statements and internal controls, suchcertifications provide convenient grounds for plaintiffs to allege that a given defendant must have known of analleged financial fraud. This has become an active area of litigation at the motion to dismiss stage. Thus far,these allegations have not fared well. See Cent. Laborers’ Pension Fund v. Integrated Elec. Servs. Inc., 497F.3d 546, 555 (5th Cir. 2007) (mere fact that officers signed a Sarbanes-Oxley Act certification did not establisha strong inference of scienter, “otherwise scienter would be established in every case where there was anaccounting error or an auditing mistake made by a publicly traded company, which would eviscerate the[PSLRA’s] pleading requirements for scienter”); Deephaven Private Placement Trading, Ltd. v. GrantThornton & Co., 454 F.3d 1168 (10th Cir. 2006) (holding that mere certification of financial statements is not a

material misstatement under 18(a) rendering an independent auditor liable); In re BearingPoint, Inc. Sec. Litig.,525 F. Supp. 2d 759 (E.D. Va. 2007) (explaining knowingly or recklessly signing Sarbanes-OxleyCertifications attesting to accuracy of information in SEC filings is not enough to demonstrate scienter; theremust be “other alleged facts establishing that the signor recklessly ignored ‘red flags’ that the attested-tofinancial statements contained material falsities”). But see In re Lattice Semiconductor Corp. Sec. Litig., No.CV04-1255-AA, 2006 U.S. Dist. LEXIS 262, *50-51 (D. Or. Jan. 3, 2006) (“Sarbanes-Oxley certifications, incombination with plaintiffs’ allegations of regular finance meetings, extensive access to databases, periodreports and special reports, and the allegations they were micromanagers, are sufficient to create a stronginference of actual knowledge or of deliberate recklessness.”).

g. Use Of GAAP Violations To Plead Scienter

Financial statements made in violation of GAAP may be found to be misleading or inaccurate under the federalsecurities laws. See In re Daou Sys., Inc. Sec. Litig., 411 F.3d 1006 (9th Cir. 2005). However, where allegedGAAP violations are the premise of a claimed violation of Rule 10b-5, plaintiffs must clear significant pleadinghurdles.

In most circuits, “allegations of GAAP violations or accounting irregularities, standing alone, are insufficient tostate a securities fraud claim. Only where such allegations are coupled with evidence that the violations orirregularities were the result of the defendant’s fraudulent intent to mislead investors may they be sufficient tostate a claim.” City of Phila. v. Fleming Cos., 264 F.3d 1245, 1261 (10th Cir. 2001) (citing Novak v. Kasaks,216 F.3d 300, 309 (2d Cir. 2000)); see also Stevelman v. Alias Research, Inc., 174 F.3d 79, 84 (2d Cir. 1999);Chill v. Gen. Elec. Co., 101 F.3d 263, 270 (2d Cir. 1996); Abrams v. Baker Hughes, Inc., 292 F.3d 424, 430(5th Cir. 2002); Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir. 1994); Kushner v. Beverly Enter., Inc., 317 F.3d820, 831 (8th Cir. 2003); In re K-Tel Int’l, Inc. Sec. Litig., 300 F.3d 881 (8th Cir. 2002); In re Navarre Corp.Sec. Litig., 299 F.3d 735, 745 (8th Cir. 2002); In re FVC.com Sec. Litig., 32 F. App’x 338, 341 (9th Cir. 2002);Colin v. Onyx Acceptance Corp., 31 F. App’x 359, 361 (9th Cir. 2002); In re Software Toolworks Inc., 50 F.3d615, 627-28 (9th Cir. 1994); In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994).

Various courts have elaborated on what is required to show scienter based on violations of GAAP.

1) Misapplication Of Accounting Principles

The Ninth Circuit has held:

Scienter requires more than a misapplication of accounting principles. The plaintiff must prove thatthe accounting practices were so deficient that the audit amounted to no audit at all, or an egregiousrefusal to see the obvious or to investigate the doubtful, or that the accounting judgments which weremade were such that no reasonable accountant would have made the same decisions if confrontedwith the same facts.

DSAM Global Value Fund v. Altris Software, Inc., 288 F.3d 385, 390 (9th Cir. 2002) (citing In re SoftwareToolworks Inc., 50 F.3d 615, 627-28 (9th Cir. 1994)); see also S.E.C. v. Sandifur, No. C05-1631C, 2006 WL538210 (W.D. Wash. Mar. 2, 2006) (holding that although violations of GAAP alone are insufficient to showscienter, the complaint satisfactorily alleged that, based on defendant’s training and position in the company, heknew or was reckless in not knowing of improper revenue recognition); Hughes v. Huron Consulting Group,Inc., 2010 U.S. Dist. LEXIS 100561 (N.D. Ill. Aug. 6, 2010) (scienter could be inferred as to allegations ofimproper accounting for goodwill where defendants were expert accountants and allegedly knew of side lettersregarding reallocations of goodwill disproportionate to ownership).

2) Red Flags

The Sixth Circuit held in In re Comshare Inc. Sec. Litig. that, to create a strong inference of recklessness,plaintiffs must allege “specific facts that illustrate ‘red flags’ that should have put Defendants on notice” ofaccounting errors. 183 F.3d 542, 553 (6th Cir. 1999). Other courts, however, have rejected the sufficiency ofsuch “red flags” in pleading scienter. See DSAM Global Value Fund v. Altris Software, Inc., 288 F.3d 385,389-91 (9th Cir. 2002) (although “red flags” should have put defendant on notice, allegations insufficient toestablish strong inference of deliberate recklessness); Chill v. Gen. Elec. Co., 101 F.3d 263, 266, 269-70 (2dCir. 1996) (alleged red flags may have been warnings to internal auditors or outside accountants but do notconstitute intentional, knowing or reckless activity); In re US Aggregates, Inc. Sec. Litig., 235 F. Supp. 2d1063, 1073 (N.D. Cal. 2002) (citing DSAM, 288 F.3d at 389) (“[E]ven an obvious failure to follow GAAP doesnot give rise to an inference of scienter. Appellants [must] allege … facts to establish that [the defendant] knewor must have been aware of the improper revenue recognition, intentionally or knowingly falsified the financialstatements, or that the audit was such an extreme departure from reasonable accounting practice that [thedefendant] knew or had to have known that its conclusions would mislead investors.”); Reiger v.PriceWaterhouseCoopers LLP, 117 F. Supp. 2d 1003 (S.D. Cal. 2000), aff’d, 288 F.3d 385 (9th Cir. 2002)(finding red flag allegations insufficient to raise an inference of scienter).

3) Magnitude Of The Restatement

Despite the rejection of “red flag” pleading by some courts, others have found that truly egregious GAAPviolations may compel an inference of scienter. See, e.g., In re MicroStrategy, Inc. Sec. Litig., 115 F. Supp. 2d620, 636-37 (E.D. Va. 2000) (“[T]he greater the magnitude of a restatement or violation of GAAP, the morelikely it is that such … violation was made consciously or recklessly … [S]ome violations of GAAP and somerestatements of financials are so significant that they, at the very least, support the inference that consciousfraud or recklessness as to the danger of misleading the investing public was present.”); In re The Baan Co. Sec.Litig., 103 F. Supp. 2d 1, 21 (D.D.C. 2000); Chalverus v. Pegasys., Inc., 59 F. Supp. 2d 226, 233-36 (D. Mass.1999).

Other courts have declined to find that a strong inference of scienter can be alleged through the magnitude ofthe restatement. See, e.g., Fidel v. Farley, 392 F.3d 220, 231 (6th Cir. 2004) (declining to follow cases whichhold that magnitude of accounting violations contributes to strong inference of auditor’s scienter; doing so“would eviscerate the principle that accounting errors alone cannot justify a finding of scienter”); In re RampNetworks, Inc. Sec., 201 F. Supp. 2d 1051, 1071-72 (N.D. Cal. 2002) (dismissing without leave to amend forfailure to establish scienter, despite plaintiff’s reliance on “indicia of scienter,” including the magnitude of theaccounting error at issue); Svezzese v. Duratek, Inc., No. 01-CV-1830, 2002 WL 1012967, at *7 (D. Md. Apr.30, 2002), aff’d, 67 F. App’x 169 (4th Cir. 2003) (“[The company] did not disguise a failing company or wipeyears’ worth of reported profits. Even after being restated, Duratek’s financials showed a profit during each ofthe three quarters at issue.”).

4) Misstated Earnings Figures

Some courts have distinguished GAAP violations where the allegations consist “merely of questionablebookkeeping practices” from inaccuracies in earnings figures, which “are vital aspects of ‘the total mix ofinformation’ [that] investors would consult.” In re Cabletron Sys., Inc., 311 F.3d 11, 35 (1st Cir. 2002). Specifically, some courts have found that significant overstatements in revenue provide the requisite inferenceof scienter. See, e.g., Malone v. Microdyne Corp., 26 F.3d 471, 478 (4th Cir. 1994); Chalverus v. Pegasys.,Inc., 59 F. Supp. 2d 226, 234 (D. Mass. 1999); Marksman Partners v. Chantal Pharm. Corp., 927 F. Supp.1297, 1314 (C.D. Cal. 1996).

5) Simplicity Of Accounting Rules Violated

The court in MicroStrategy also looked to the complexity of the accounting policies allegedly violated. Thecourt noted that misstated financials and repetitive GAAP violations “take[] on added significance if . . . theviolated GAAP rules are . . . relatively simple.” In re MicroStrategy, Inc. Sec. Litig., 115 F. Supp. 2d 620, 638(E.D. Va. 2000). In other words, “violations of simple rules are obvious, and an inference of scienter becomesmore probable as the violations become more obvious.” Id. But see, e.g., Svezzese v. Duratek, Inc., No. CIV.A. MJG-01-CV-1830, 2002 WL 1012967, at *5 (D. Md. Apr. 3, 2002) (distinguishing MicroStrategy becauseit involved insider trading allegations, which are highly probative of motive); In re Ramp Networks, Inc. Sec.,201 F. Supp. 2d 1051, 1071-72 (N.D. Cal. 2002) (dismissing complaint with prejudice even though plaintiff hadargued that the accounting principle at issue was simple).

6) Indicia Of Fraudulent Intent In General

Generally, GAAP violations alone are not sufficient to raise an inference of scienter. See, e.g., In re CeridianCorp. Sec. Litig., 542 F.3d 240 (8th Cir. 2008); DSAM Global Value Fund v. Altris Software, Inc., 288 F.3d385, 387 (9th Cir. 2002) (even an obvious failure to follow GAAP insufficient to raise scienter). Consequently,the admission of a failure to follow GAAP, usually in the form of a restatement of financials, is aloneinsufficient to raise the requisite inference of scienter. See Chill v. Gen. Elec. Co., 101 F.3d 263, 270 (2d Cir.1996); In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994); In re Peritus Software Servs.,Inc. Sec. Litig., 52 F. Supp. 2d 211, 223 (D. Mass. 1999); In re Orbital Scis. Corp. Sec. Litig., 58 F. Supp. 2d682, 687 (E.D. Va. 1999).

8. Non-Speaking Defendants And Group Pleading

a. Overview Of Tactics And the Doctrine

One goal of a motion to dismiss should be to narrow the number of individual defendants in the lawsuit. Plaintiffs typically name numerous officers and directors as defendants – including outside directors and lesssenior officers – simply because they sold stock during the alleged class period, in order to plead the greatestpossible amount of insider trading. To the extent that certain individual defendants did not make any of thealleged false or misleading statements in the complaint, defendants should consider moving to dismiss these“non-speaking” defendants. However, winning these dismissals can prove difficult. Consider In re SalomonAnalyst AT&T Litig., 350 F. Supp. 2d 455 (S.D.N.Y. 2004), where the CEO of Central Bank was held primarilyliable for misrepresentations even though he made no statement, but “orchestrated and directly ordered a falserepresentation.” Id. at 474.

Plaintiffs usually rely on the traditional “group pleading” doctrine to argue that all defendants — including non-speaking defendants — are liable for all of the corporate statements made. This doctrine presumes thatcorporate publications are the result of collective action, so that, at the pleading stage, a plaintiff may allege thatmisstatements in a group-published document, e.g., an SEC filing or press release, are attributable to the entiregroup of defendants. This doctrine is alternatively called the group published doctrine. In re Intelligroup Sec.Litig., 527 F. Supp. 2d 262, 281 n.8 (D.N.J. 2007). As discussed below, the Reform Act is in tension with the“group pleading” notion and arguably abolished it.

The group pleading doctrine was first established in the Ninth Circuit in Wool v. Tandem Computers, Inc.,which allowed plaintiffs to allege liability against several defendants based on group-published documents aslong as plaintiffs allege, “where possible[,] the roles of the individual defendants in the misrepresentation.” 818F.2d 1433, 1440 (9th Cir. 1987). Therefore, allegations that individuals signed a corporate statement may be

sufficient. See also In re GlenFed, Inc. Sec. Litig., 60 F.3d 591, 593 (9th Cir. 1995) (requiring complaint tosufficiently allege that outside directors or underwriters “either participated in the day-to-day corporateactivities, or had a special relationship with the corporation, such as participation in preparing orcommunicating group information at particular times”); S.E.C. v. Yuen, 221 F.R.D. 631, 637 (C.D. Cal. 2004)(because the group pleading doctrine is grounded in reasonableness, a court will consider the day-to-dayinvolvement of each defendant); Irvine v. ImClone Sys. Inc., No. 02 CIV 109 RO, 2003 WL 21297285, at *2(S.D.N.Y. June 4, 2003) (“This doctrine ‘is extremely limited in scope. And courts in the Second Circuit andelsewhere have construed the doctrine as applying only to clearly cognizable corporate insiders with activedaily roles in the relevant companies or transactions.’” (quoting Jordan (Bermuda) Inv. Co., Ltd. v. HunterGreen Inv. Ltd., 205 F. Supp. 2d 243, 253 (S.D.N.Y. 2002)).

A narrow exception to the group pleading doctrine “exists where the information necessary is uniquely withinthe defendants’ knowledge.” In re Marsh & McLennan Cos., Inc. Sec. Litig., 501 F. Supp. 2d 452 (S.D.N.Y.2006) (discussing what actions and statements can be attributed to the company based on actions of employees,and what actions and statements can be attributed to management based on actions of employees andsubsidiaries).

It should also be noted that at least some courts do not apply the group pleading doctrine in certaincircumstances. One involves distinct corporate entities. Thus, courts have rejected attempts to impute theknowledge of a subsidiary to its parent corporation or to aggregate the knowledge of two subsidiaries by virtueof common ownership. Defer LP v. Raymond James Fin., Inc., 654 F. Supp. 2d 204, 218-19 (S.D.N.Y. 2009);cf. Kahn v. Ran, 2009 WL 1138504, at *7 (E.D. Mich. Apr. 27, 2009) (finding plaintiffs pled sufficientparticularity in part because “even where group pleading is not permitted, it only applies to individuals, not tomultiple entities controlled by the same individual”).

Courts will not usually apply the group pleading doctrine with respect to an oral statement. Defer, 654 F. Supp.2d at 213-14; In re Vivendi Universal, S.A. Sec. Litig., 381 F. Supp. 2d 158, 191 (S.D.N.Y. 2003). Instead,courts have limited the doctrine’s application to “prospectuses, registration statements, annual reports, pressreleases, or other group-published information that may be presumed to be the collective work of corporateinsiders.” Id.; Elliot Assocs., LP v. Covance, Inc., 2000 WL 1752848, at *12 (S.D.N.Y. Nov. 28, 2000).

Finally, the group pleading doctrine is just that: a doctrine for determining the sufficiency of a plaintiff’spleading. Courts have almost unanimously rejected its application at the summary judgment phase. By thenplaintiffs will have had the opportunity to discover which specific defendants were liable for the allegedmisstatements. Bains v. Moores, 172 Cal. App. 4th 445, 474-76 (2009). Courts that have turned the doctrineinto substantive law, Golden v. Terre Linda Corp., 1996 WL 426760, at *6 (N.D. Ill. 1996), or an evidentiarypresumption, In re Silicon Graphics, Inc. Sec. Litig., 970 F. Supp. 746, 759 (N.D. Cal. 1997), have beenroundly criticized. Bains, 172 Cal. App. 4th at 475-76.

b. Did The Reform Act Abolish Group Pleading?

The Reform Act heightened the pleading standards for scienter, such that plaintiffs must now plead “withparticularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15U.S.C. § 78u-4(b)(2) (emphasis added). By focusing on each defendant’s intent, the Reform Act appears tooverride the group pleading presumption. But whether it did so went unanswered in most jurisdictions formany years. E.g., Selbst v. McDonald’s Corp., No. 04 C 2422, 2005 WL 2319936, at *5 (N.D. Ill. Sept 21,2005) (explaining that while the Seventh Circuit has not ruled on whether the group pleading doctrine survivesthe enactment of the PSLRA, the court is “unwilling to hold that the PSLRA abolished it”); In re AFC Enter.Inc. Sec. Litig., 348 F. Supp. 2d 1363, 1371 (N.D. Ga. 2004) (“The Eleventh Circuit has yet to take a firmposition on the continued vitality of the doctrine, [which] remains persuasive provided that application of thedoctrine is kept within proper bounds.”); In re Aetna Inc. Sec. Litig., 34 F. Supp. 2d 935, 949 n.7 (E.D. Pa.1999) (“[I]t is unclear whether the group pleading doctrine survives under the PSLRA.”). But see In re PfizerInc. Sec. Litig., 584 F. Supp. 2d 621, 641 (S.D.N.Y 2008) (holding that group pleading survived the PSLRA

despite the lack of a definitive Second Circuit decision on the issue).

The Fifth Circuit was the first federal appeals court to expressly reject the “group pleading doctrine” in light ofthe Reform Act. In Southland Securities Corp. v. INSpire Ins. Solutions Inc., 365 F.3d 353 (5th Cir. 2004), thecourt stated that:

The “Group Pleading” doctrine conflicts with the scienter requirements of the PSLRA . . . . [T]hePSLRA requires the plaintiffs to “distinguish among those they sue and enlighten each defendant as tohis or her particular part in the alleged fraud.” As such, corporate officers may not be held responsiblefor unattributed corporate statements solely on the basis of their titles, even if their general level of day-to-day involvement in the corporation’s affairs is pleaded.

Id. at 363-65; see also Fin. Acquisition Partners L.P. v. Blackwell, 440 F.3d 278 (5th Cir. 2006) (applyingSouthland to uphold dismissal of complaint);

This decision followed a number of district court decisions reaching the same conclusion. See In re EnronCorp. Sec. Deriv. & ERISA Litig., No. MDL-1446, 2003 WL 230688, at *7 (S.D. Tex. Jan. 28, 2003) (rejectinggroup pleading doctrine); Schiller v. Physicians Res. Group, Inc., No. CIV. A. 3:97-CV-3158-L, 2002 WL318441, at *5 (N.D. Tex. Feb. 26, 2002), aff’d, 342 F.3d 563 (5th Cir. 2003) (same).

The Third Circuit has also rejected the doctrine. It recently considered the group pleading doctrine in WinerFamily Trust v. Queen, 503 F.3d 319, 336-37 (3d Cir. 2007). Noting that “[t]he only courts of appeals to havedirectly addressed the survival of the group pleading doctrine post-PSLRA have abolished the doctrine,” thecourt expressly stated “[w]e agree and hold the group pleading doctrine is no longer viable in private securitiesactions after the enactment of the PSLRA.” Id. The court also pointed out that although the Supreme Court hadnot addressed the group pleading doctrine in Tellabs, neither did it “disturb” the Seventh Circuit’s holding that“the group pleading doctrine did not survive the enactment of the PSLRA.” Id. at 335 (citing Tellabs, Inc. v.Makor Issues & Rights, Ltd., 551 U.S. 308, 326 n.6 (2007)). But see Silverman v. Motorola, Inc., 2008 WL4360648, at *14 (N.D. Ill. Sept. 23, 2008) (finding a “strong inference” of scienter where plaintiffs pled thatbased on defendants’ high-ranking positions within the company, they “should have known” about delays andsetbacks associated with new product rollout, as it was “almost inconceivable these defendants were not awareof the production problems”).

Outside of these circuits, a majority of post-Reform Act district court cases appears to have rejected grouppleading. For example, courts in the Ninth Circuit have rejected the doctrine in light of the PSLRA. In Allisonv. Brooktree Corp., 999 F. Supp. 1342, 1350 (S.D. Cal. 1998), the court stated that “the continued vitality of thejudicially created group-published doctrine is suspect since the PSLRA specifically requires that untruestatements or omissions be set forth with particularity as to ‘the defendant’ and that scienter be plead in regardsto ‘each act or omission’ sufficient to give ‘rise to a strong inference that the defendant acted with the requiredstate of mind.’” Id. (citing 15 U.S.C. § 78u-4(b)). The court stated further that “[t]o permit a judicialpresumption as to particularity simply cannot be reconciled with the statutory mandate that plaintiffs must pleadspecific facts as to each act or omission by the defendant.” Id. Thus, the court directed that should the plaintiffdecide to file an amended complaint, he or she must plead specific facts regarding misleading statements andomissions by each defendant. Id. Similarly, in In re Dura Pharmaceuticals, Inc. Securities Litigation, 452 F.Supp. 2d 1005 (S.D. Cal. 2006), the court observed that, although the Ninth Circuit has not opined on the issue,courts in California have held that the group pleading doctrine does not survive the PSLRA. See also In reMarvell Tech. Group Ltd. Sec. Litig., 2008 WL 4544439, at *3 (N.D. Cal. Sept. 29, 2008) (following lines ofcases holding that “the group pleading doctrine can no longer be used in cases under the PSLRA”); In reNextcard, Inc. Sec. Litig., No. C 01-21029, 2006 WL 708663, at *3 (N.D. Cal Mar. 20, 2006) (holding thatgroup published pleading doctrine is no longer viable after the PSLRA and that it appears to be “totallyinconsistent with the particularity requirements of the PSLRA” (citing Southland Sec. Corp. v. INSpire Ins.Solutions Inc., 365 F.3d 353, 365 (5th Cir. 2004)).

Several district courts in other circuits have also rejected the doctrine. See, e.g., In re Huffy Corp. Sec. Litig.,

577 F. Supp. 2d 968, 986 (S.D. Ohio 2008) (group pleading doctrine is “antithetical” to the pleadingrequirements of the PSLRA); In re Cross Media Marketing Corp. Sec. Litig., 314 F. Supp. 2d 256, 262(S.D.N.Y. 2004) (“The [PSLRA’s] use of the singular ‘defendant’ counsels against group pleading in actionsarising in securities fraud cases since the enactment of the PSLRA.”); Bond Opportunity Fund v. Unilab Corp.,No. 99 CIV. 11074 (JSM), 2003 WL 21058251, at *4 (S.D.N.Y. May 9, 2003), aff’d, 87 F. App’x 772 (2d Cir.2004) (“[W]ith respect to the individual directors, the PSLRA has eliminated the ‘group pleading’ doctrine.Therefore, Plaintiffs may not impute knowledge to the individual Defendants solely on the basis of the positionsthey held.”); In re Cable & Wireless, PLC, Sec. Litig., 321 F. Supp. 2d 749, 773 (E.D. Va. 2004) (noting thatthe Fourth Circuit has held the group pleading doctrine goes against the grain of the particularity requirement ofthe PSLRA).

In courts that continue to allow group pleading, defendants can argue that plaintiffs must plead with greaterspecificity facts supporting application of the doctrine. See Molinari v. Symantec Corp., No. C-97-20021-JW,1998 WL 78120, at *11 (N.D. Cal. Feb. 17, 1998) (“Because Plaintiffs cannot satisfy even the presumptivelylower group pleading standard the Court need not consider at this time whether Congress implicitly rejected thegroup pleading standard by passing the Reform Act.”); see also In re Stac Elecs. Sec. Litig., 89 F.3d 1399, 1411(9th Cir. 1996) (finding factual allegations insufficient to support application of the group pleading doctrine); Inre Spiegel, Inc. Sec. Litig., 382 F. Supp. 2d 989, 1018 (N.D. Ill. 2004) (“Group pleading may be appropriate incertain circumstances notwithstanding the PSLRA, as long as the complaint sets forth facts demonstrating thateach defendant may be responsible for the fraudulent statements.”); Johnson v. Tellabs, Inc., 262 F. Supp. 2d937, 946-47 (N.D. Ill. 2003) (“Even if the group pleading doctrine survives the PSLRA in some form[,] . . .plaintiff is . . . required at least to include allegations in the complaint relating to an individual defendant’sduties or legal obligations that create a presumption that the company’s statement was somehow caused by orattributable to an individual defendant.”).

Despite what appears to be a consensus towards rejecting group pleading, some cases have nonetheless allowedit. In In re Sensormatic Electronics Corp. Sec. Litig., No. 018346, 2002 WL 1352427, at *4 (S.D. Fla. June 10,2002), the court held that, under the group pleading doctrine, a securities fraud plaintiff may impute false andmisleading statements appearing in annual reports, quarterly reports, press releases, or other “group published”information to all inside corporate officers and directors who are presumed to have knowledge of andinvolvement in the day-to-day affairs of the company. Id. (noting that the Eleventh Circuit has not yetaddressed whether the group pleading doctrine is viable under the PSLRA); In re Pegasus Wireless Corp. Sec.Litig., 657 F. Supp. 2d 1320, 1325 (S.D. Fla. 2009) (allowing group pleading doctrine provided “[p]laintiffsmake the specific factual allegation that [defendant], due to his high ranking position and direct involvement inthe everyday business of the Company, was directly involved in controlling the content of the statements atissue”); see also In re Take-Two Interactive Sec. Litig., 551 F. Supp. 2d 247, 267 n.10 (S.D.N.Y. 2008) (notingthat while the validity of the group pleading doctrine after the PSLRA has been questioned, “the majority ofcourts in this District has determined that the doctrine survived the PSLRA’s enactment”); McGuire v.Dendreon Corp., 2008 U.S. Dist. LEXIS 65436, at *6 (W.D. Wash. April 18, 2008) (reaffirming that the grouppleading doctrine survived enactment of the PSLRA); In re NPS Pharms., Inc. Sec. Litig., No. 2:06-cv-00570,2007 WL 1976589, at *5 (D. Utah July 3, 2007) (finding allegations sufficient under the “group-published”doctrine where plaintiff claimed all defendants had power to control the contents of market statements); Grubkav. WebAccess Int’l, 445 F. Supp. 2d 1259 (D. Colo. 2006); In re McLeodUSA, Inc., No. C02-001-MWB, 2004WL 1070570, at *4 (N.D. Iowa Mar. 31, 2004) (“The court concurs with the majority of courts that have heldthat the rationale behind the group pleading doctrine remains sound in the wake of the passage of the ReformAct.”); Schnall v. Annuity & Life re (Holdings), Ltd., No. 3:02 CV 2133 (GLG), 2004 WL 515150, at *4 (D.Conn. Mar. 9, 2004) (noting that the PSLRA does not affect the vitality of the group pleading doctrine); In reSprint Corp. Sec. Litig., 232 F. Supp. 2d 1193, 1225 (D. Kan. 2002) (noting that the Tenth Circuit recognizesthe group pleading doctrine); Benedict v. Cooperstock, 23 F. Supp. 2d 754, 763 (E.D. Mich. 1998) (noting thatthe group pleading doctrine applies only to official documents such as registration statements andprospectuses); Powers v. Eichen, 977 F. Supp. 1031, 1041 (S.D. Cal. 1997) (applying the group pleadingpresumption without discussion of the Reform Act); In re Health Mgm’t, Inc. Sec. Litig., 970 F. Supp. 192, 208(E.D.N.Y. 1997) (same).

9. Other Procedural Considerations At The Motion To Dismiss Stage

a. Documents The Court May Consider On A Motion to Dismiss

Courts will generally consider documents beyond the complaint in deciding motions to dismiss in securitiescases. For example, several circuits permit defendants to raise and rely on statements in a prospectus oroffering memorandum even if the plaintiff did not incorporate or annex the documents to the complaint. SeeCortec Indus., Inc. v. Sum Holding L.P., 949 F.2d 42, 47 (2d Cir. 1991); Kramer v. Time Warner Inc., 937 F.2d767, 774 (2d Cir. 1991) (stating that, in merger litigation, the court could judicially notice an Offer to Purchaseand Joint Proxy Statement because under the circumstances such documents, which are required to be filed withthe SEC, are “capable of accurate and ready determination by resort to sources whose accuracy cannotreasonably be questioned” (citing Fed. R. Evid. 201(b)(2))); Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1276(11th Cir. 1999), rev’d sub nom., Bryant v. Dupree, 252 F.3d 1161 (11th Cir. 2001) (approving of Cortec andKramer and taking judicial notice of SEC filings); In re Stac Elecs. Sec. Litig., 89 F.3d 1399, 1405 n.4 (9th Cir.1996) (“The district court considered the full text of the Prospectus, including portions which were notmentioned in the complaints. We note that such consideration is appropriate in the context of a motion todismiss.”); I. Meyer Pincus & Assocs., P.C. v. Oppenheimer & Co., 936 F.2d 759 (2d Cir. 1991). Other SECfilings, including Forms 3 and 4, are common subjects of judicial notice. See In re Silicon Graphics Inc. Sec.Litig., 970 F. Supp. 746, 768 (N.D. Cal. 1997) (taking judicial notice of Forms 3 and 4); Plevy v. Haggerty, 38F. Supp. 2d 816, 821 (C.D. Cal. 1998) (taking judicial notice of SEC filings).

Judicial notice in securities class actions often extends far beyond public filings. For example, the Ninth Circuithas held, on a motion for judgment on the pleadings, that a court may “take judicial notice that the market wasaware of the information contained in news articles submitted by the defendants.” Heliotrope Gen., Inc. v. FordMotor Co., 189 F.3d 971, 980-81 & n.18 (9th Cir. 1999). Also, if plaintiff clearly based its allegation onmaterials not cited in the complaint, then judicial notice of the materials may be available. See Iron WorkersLoc. 16 Pens. v. Hilb Rogal & Hobbs, 432 F. Supp. 2d 571 (E.D. Va. 2006) (finding it proper to consideranalyst reports in considering motion to dismiss because plaintiff clearly based allegations found in complainton a review of press releases, media reports, and general insider knowledge). But see Faulkner v. Beer, 463F.3d 130 (2d Cir. 2006) (vacating district court’s dismissal of complaint because court had considereddocuments outside the complaint that involved disputed issues of material fact).

b. Mandatory Sanctions Under PSLRA For Frivolous Securities Fraud Claims

Frivolous securities law claims are sanctionable under the PSLRA. See 15 U.S.C. § 78u-4(c). Following finaladjudication of the action, the district court must “record specific findings” regarding each party’s and eachattorney’s compliance with Rule 11(b). Id. § 78u-4(c)(1). “If the court makes a finding . . . that a party orattorney violated any requirement of Rule 11(b) . . . as to any complaint, responsive pleading, or dispositivemotion, the court shall impose sanctions . . . in accordance with Rule 11.” Id. § 78u-4(c)(2); see, e.g., De LaFuente v. DCI Telecomms., Inc., 82 F. App’x 723 (2d Cir. 2003) (sanctioning under PSLRA plaintiff’s frivolousarguments against defendant’s assertion of time-barred defense). But see Khan v. Park Capital Sec., LLC, No.C 03 00574, 2004 WL 1753385 (N.D. Cal. Aug. 5, 2004) (finding Rule 11 and Reform Act sanctions againstplaintiff’s counsel inappropriate notwithstanding dismissal of complaint completely devoid of any factualallegations). The Second Circuit has held that the standard for determining sanctions under the PSLRA is oneof “objective unreasonableness on the part of the attorney or client signing the papers.” ATSI Commc’ns, Inc. v.Shaar Fund, Ltd., 579 F.3d 143, 150-52 (2d Cir. 2009). The court need not find subjective bad faith. Id. at 52.

c. Leave To Amend

Federal Rule of Civil Procedure 15(a) provides that after a party has amended a pleading once as a matter of

course, it may amend further only by leave of court or consent of the adversary, but that “leave shall be freelygiven when justice so requires.” Foman v. Davis, 371 U.S. 178 (1962) is typically cited as guidance regardingthe factors a district court should consider in deciding whether to grant leave to amend.

In securities cases, both district courts and courts of appeal have created a broad spectrum of decisions on thequestion whether leave to amend should be granted or a denial of leave to amend should be affirmed. Forexample, the Ninth Circuit in Eminence Capital, LLC v. Aspeon, Inc., 316 F.3d 1048 (9th Cir. 2003) said that adistrict court’s failure to consider the Foman factors and articulate why dismissal should be with prejudice mayconstitute an abuse of discretion (id. at 1052) and that adherence to the principle of liberal amendment isespecially important in the context of the Reform Act because meeting the Act’s exacting pleading standards“can be a matter of trial and error.” Id. Interestingly, plaintiff in Aspeon was not ultimately helped by theopportunity to practice trial and error, inasmuch as the dismissal of its amended complaint on remand wasaffirmed by the memorandum opinion of a different Ninth Circuit panel. 168 Fed. Appx. 836.

Other courts, however, have held plaintiffs to a higher standard. In In re Novastar Financial Inc. Sec. Litig.,579 F.3d 878, 884-85 (8th Cir. 2009), for example, the court affirmed dismissal with prejudice of plaintiffs’initial complaint, on the ground that a party seeking leave to amend must offer a proposed amended complaintto the district court, since the district court is not required to engage in a “guessing game” as a result of theplaintiff’s failure to specify proposed new allegations.

In the wake of the Reform Act, dismissals with prejudice have become far more commonplace when securitiesplaintiffs have failed to persuade the court that amendment would not be futile.

D. Motions For Class Certification

To limit potential damages, defendants should challenge the size and definition of a class early and often. If adefendant is able to limit the size of the class (for example, by rebutting the presumption of reliance for one ormore subsets of the class or by shortening the class period), the damages – and the settlement value – of thecase may be dramatically reduced. Accordingly, class certification can be a critical battleground for securitieslitigation defendants. See Coopers & Lybrand v. Livesay, 437 U.S. 463, 476 (1978) (“Certification of a largeclass may so increase the defendant’s potential damages liability and litigation costs that he may find iteconomically prudent to settle and to abandon a meritorious defense.”).

Until fairly recently, class certification was rarely defeated in its entirety in a securities action. Certain classcertification rulings, however, suggest that going forward there may be more pressure on plaintiffs at the classcertification stage of the litigation. These recent rulings have: (1) increased the amount of evidence plaintiffsmust put forth to establish each Rule 23 factor, In re Initial Public Offering Sec. Litig., 471 F.3d 24, 42-43 (2dCir. 2006) (reversing district court’s order certifying class because it did not have sufficient evidence todetermine whether market for securities was efficient and thereby determine whether common questionspredominate over individual questions of reliance); (2) required plaintiffs to establish each Rule 23 requirementby a preponderance of the evidence, e.g., Teamsters Local 445 Freight Div. Pension Fund v. Bombardier, Inc.,546 F.3d 196, 202 (2d Cir. 2008); Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261, 269(5th Cir. 2007); (3) allowed courts to resolve factual disputes even if that requires some overlap with the merits,In re IPO, 471 F.3d at 41; and (4) allowed defendants to rebut presumptions of reliance, Oscar Private Equity,487 F.3d at 269; Regents v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372, 385 (5th Cir. 2007) (reversingdistrict court’s certification of class because defendants owed no duty to plaintiffs and therefore Affiliated Utepresumption could not lie).

Together, these class certification decisions may signal a trend towards increasing difficulty for plaintiffs incertifying classes, particularly if any facts call presumptions of reliance into question. But see Bombardier, 546F.3d at 202 (declining to require district court to conduct a full evidentiary hearing at the class certificationstage, emphasizing that class certification motion should not “become a pretext for a partial trial of the merits”).

1. Timing Of Certification Motion And Decision

Defendants should consider seeking an early deadline for plaintiff’s class certification motion. See, e.g., In reSystem Software Assoc., Inc., No. 97 C 177, 2000 WL 283099, at *17 (N.D. Ill. Mar. 8, 2000) (instructingplaintiffs to promptly file motion for class certification). Local rules govern and may require that the partybringing the class action seek certification within a fixed time period. See, e.g., Model Stipulation, N.D. Cal.Rule 23-1 (“Plaintiffs shall file a motion for class certification within thirty (30) days after service of theconsolidated complaint.”). However, class certification may conflict with the Reform Act’s stay of proceedingspending a motion to dismiss. (See discussion at Section II.E.2, “Reform Act’s Discovery Stay,” infra). Additionally, defendants should consider limiting pre-class certification discovery to class-related issues inorder to avoid the expenses associated with merits discovery, which may become moot should defendantssuccessfully oppose class certification. See, e.g., Krim v. BancTexas Group, Inc., 99 F.3d 775, 777-78 (5th Cir.1996).

a. Dispositive Motions

A defendant should take into account the status of class certification in conjunction with the filing of dispositivemotions. Rulings prior to class certification bind only the named plaintiffs, at least under pre-Reform Act law. Compare Wright v. Schock, 742 F.2d 541, 544 (9th Cir. 1984) with Frank v. United Airlines, Inc., 216 F.3d845, 853 & n.6 (9th Cir. 2000) (holding judgment on behalf of class binds those who subsequently come intoclass if included in certified class, unless not adequately represented); see also Schwarzschild v. Tse, 69 F.3d293 (9th Cir. 1995) (holding obtaining summary judgment prior to sending class notice waives defendant’sright to compel the class representative to send notice to the absent class members and finding absent classmembers were not bound by summary judgment).

b. Impact Of The Reform Act’s Stay Of Discovery

The Reform Act’s stay of “all discovery and other proceedings … during the pendency of any motion todismiss” could be read to preclude class certification during the pendency of a motion to dismiss. See 15U.S.C. § 78u-4(b)(3)(B). However, one court has held that this language does not bar certification of a classprior to the determination of a motion to dismiss. In re Diamond Multimedia Sys., Inc., Sec. Litig., No. C 96-2644 SBA, 1997 WL 773733 (N.D. Cal. Oct. 14, 1997). The Diamond court construed the statutory language“other proceedings” to refer in context only to other discovery-related proceedings and not to “all aspects of thelitigation.” Id. at *3 (citing Medhekar v. Dist. Court, 99 F.3d 325, 328 (9th Cir. 1996)). The court had todetermine class certification prior to ruling on the motion to dismiss to prevent prejudice to the defendants andthe inefficient use of judicial resources from serial lawsuits. Id.

2. The Lead Plaintiff And Class Must Have Article III And Statutory Standing

As a threshold inquiry, the plaintiffs must establish that the proposed class has both constitutional and statutorystanding to sue. As to Article III standing, the plaintiff must show, among other requirements, that the class hassuffered an injury in fact. Elk Grove Unified Sch. Dist. v. Newdow, 542 U.S. 1, 12 (2004). “[A] class will ofteninclude persons who have not been injured by the defendant’s conduct; indeed this is almost inevitable becauseat the outset of the case many of the members of the class may be unknown, or if they are known still the factsbearing on their claims may be unknown. Such a possibility or indeed inevitability does not preclude classcertification.” Kohen v. Pac. Inv. Mgm’t Co., 571 F.3d 672, 677 (7th Cir. 2009).

Courts have found that a class should not be certified for reasons of standing if (1) the class definition “is sobroad that it sweeps within it persons who could not have been injured by the defendant’s conduct” or (2) theclass “contains a great many persons who have suffered no injury at the hands of the defendant.” Id. In Kohen,

the court found that the class did have standing because it had no reason to believe that many of the classmembers were net gainers from the defendant’s alleged market manipulation and because the defendant had notsampled the class to prove that a high percentage were in fact net gainers. Id. at 678-79.

Likewise, the class must have express or implied standing under the securities laws. For more on statutorystanding, see, for example, infra Section III.A.4.

The lead plaintiff or other named plaintiffs may not rely on the standing of absent class members to bootstrapstanding for themselves that they otherwise lack. See, e.g., General Tel. Co. of the Southwest v. Falcon, 457U.S. 147, 156 (1982) (plaintiff must be a member of the class he seeks to represent, i.e., have the same interestand suffer the same injury); Warth v. Seldin, 422 U.S. 490, 502 (1975) (named plaintiffs in a class action mustshow that they personally have been injured, “not that injury has been suffered by other, unidentified membersof the class to which they belong and which they purport to represent”).

3. Required Elements: Federal Rule Of Civil Procedure 23

In addition to standing, the plaintiffs must satisfy all four of Rule 23(a)’s prerequisites for class action suits:

One or more members of a class may sue or be sued as representative parties on behalf of allonly if:

(1) the class is so numerous that joinder of all members is impracticable,

(2) there are questions of law or fact common to the class,

(3) the claims or defenses of the representative parties are typical of the claims or defenses ofthe class; and

(4) the representative parties will fairly and adequately protect the interests of the class.

(emphasis added).

Rule 23(b), concerning types of class actions, provides in pertinent part that:

A class action may be maintained if Rule 23(a) is satisfied and if

. . .

(3) the court finds that the questions of law or fact common to class members predominateover any questions affecting only individual members, and that a class action is superior toother available methods for fairly and efficiently adjudicating the controversy.

(emphasis added).

The party seeking class certification bears the burden of demonstrating that each of the four requirements ofRule 23(a) is met in addition to at least one Rule 23(b) requirement. For each of the four elements of Rule23(a), there must be more than “some showing” of their existence. In re Initial Pub. Offering Sec. Litig., 471F.3d 24 (2d Cir. 2006); see also Zinser v. Accufix Research Inst., Inc., 253 F.3d 1180, 1186, amended on othergrounds, 273 F.3d 1266 (9th Cir. 2001) (citing Hanon v. Dataproducts Corp., 976 F.2d 497, 508 (9th Cir.1992)); Applewhite v. Reichhold Chemicals, Inc., 67 F.3d 571, 573 (5th Cir. 1995); Gary Plastic PackagingCorp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 903 F.2d 176 (2d Cir. 1990); Scholes v. Tomlinson, 145F.R.D. 485 (N.D. Ill. 1992). The court must conduct a “rigorous analysis” to determine whether the partyseeking certification has met the prerequisites of Rule 23. Zinser, 253 F.3d 1180 (citing Valentino v. Carter-Wallace, Inc., 97 F.3d 1227, 1233 (9th Cir. 1996)).

The standard of proof for each element is generally preponderance of the evidence. Alaska Elec. Pension Fundv. Flowserve Corp., 572 F.3d 221, 228 (5th Cir. 2009) (finding that plaintiffs must prove loss causation as anissue of predominance by a preponderance of the evidence); In re Hydrogen Peroxide Antitrust Litig., 552 F.3d305, 320 (3d Cir. 2008); Teamsters Local 445 Freight Div. Pension Fund v. Bombardier, Inc., 546 F.3d 196,202 (2d Cir. 2008).

Finally, although the court may not decide the merits of plaintiffs’ claims at the class certification stage, it mayaddress issues that overlap with the merits if necessary for the class certification analysis. Vega v. T-MobileUSA, Inc., 564 F.3d 1256, 1266 (11th Cir. 2009); Vallario v. Vandehey, 554 F.3d 1259, 1265-67 (10th Cir.2009); In re Hydrogen Peroxide Antitrust Litig., 552 F.3d 305, 316-18 (3d Cir. 2008); Teamsters Local 445Freight Div. Pension Fund v. Bombardier Inc., 546 F.3d 196, 201-04 (2d Cir. 2008); In re New Motor VehiclesCan. Exp. Antitrust Litig., 522 F.3d 6, 17, 24-26 (1st Cir. 2008); Oscar Private Equity Invs. v. AllegianceTelecom, Inc., 487 F.3d 261, 267-69 (5th Cir. 2007); Blades v. Monsanto Co., 400 F.3d 562, 566-67 (8th Cir.2005); Gariety v. Grant Thornton, 368 F.3d 356, 364-65 (4th Cir. 2004); Szabo v. Bridgeport Machs., Inc., 249F.3d 672, 676-78 (7th Cir. 2001).

What degree of overlap is allowed has generated debate in the area of loss causation. Many courts havecriticized the Fifth Circuit’s decision in Oscar Private Equity Investments. v. Allegiance Telecom, Inc., 487 F.3d261 (5th Cir. 2007), which held that plaintiffs must prove at the class certification stage “that the defendant’snon-disclosure materially affected the market price of the security.” Id. at 265. Because this “essentially injectswhat is fundamentally a merits inquiry into the class certification inquiry through the back door” by requiring“the plaintiff to prove loss causation . . . to avail itself of the . . . fraud-on-the-market presumption” many courtshave declined to follow Oscar. In re LDK Solar Sec. Litig., 255 F.R.D. 519, 530-31 & n.6 (N.D. Cal. 2009)(declining to require proof of loss certification as a prerequisite to Rule 23 class certification, noting Oscar’s“striking breadth,” and citing numerous cases outside of the Fifth Circuit to reject it); Ross v. Abercrombie &Fitch Co., 257 F.R.D. 435, 454-55 (S.D. Ohio 2009) (refusing to follow Oscar’s requirement that plaintiffsprove loss causation at the class certification stage to plead the fraud-on-the-market theory because losscausation is a “merits inquiry”); In re Micro Techs., Inc. Sec. Litig., 247 F.R.D. 627, 633-34 (D. Idaho 2007)(“It is unlikely that [Oscar] would be adopted in this Circuit because it misreads Basic”). Not persuaded, theFifth Circuit has maintained its position. Fener v. Operating Eng’rs Constr. Indus. & Misc. Pension Fund(Local 66), 579 F.3d 401, 408-11 (5th Cir. 2009) (affirming that an inquiry into loss causation is appropriate atthe class certification stage); Alaska Elec. Pension Fund v. Flowserve Corp., 572 F.3d 221, 228 (5th Cir. 2009)(same).

4. Class Certification – Prerequisites Of Rule 23(a)

a. Numerosity

This element is not frequently the subject of class certification motions in securities class actions, and courtsrarely deny certification on this basis. See In re First Capital Holdings Corp. Fin. Prods. Sec. Litig., No. MDL901, 1993 WL 144861, at *5 (C.D. Cal. Feb. 26, 1993) (holding failure to allege number of individuals in classdoes not defeat numerosity when millions of shares were outstanding); Farley v. Baird, Patrick & Co., Inc.,No. 90 CIV. 2168 (MBM), 1992 WL 321632 (S.D.N.Y. Oct. 28, 1992) (finding numerosity requirement met byfifty members whose identities were known); Scholes v. Tomlinson, 145 F.R.D. 485 (N.D. Ill. 1992) (holding129 to 300 geographically dispersed individuals met numerosity requirement). But see Griffin v. GK IntelligentSys., Inc., 196 F.R.D. 298, 301 (S.D. Tex. 2000) (finding plaintiffs did not satisfy the numerosity requirementby merely alleging the existence of 458 shareholders of record); Schwartz v. Upper Deck Co., 183 F.R.D. 672(S.D. Cal. 1999) (finding too speculative plaintiffs’ assertion that the numerosity requirement was met based onsales records of the defendant’s trading cards showing thousands of people bought the cards); PrimaveraFamilienstiftung v. Askin, 178 F.R.D. 405 (S.D.N.Y. 1998) (finding joinder of parties superior to certifying aclass of approximately 125 plaintiffs who were sophisticated investors with adequate financial resources tomaintain their own actions and whose identity and whereabouts were known).

b. Commonality And Predominance

As a precondition to certification, Rules 23(a)(2) and 23(b)(3), when read together, require “one or morequestions of law or fact common to the class [to] predominate over any questions affecting only individualmembers.” One method of showing commonality is to allege a “common course of conduct” indicatingcommon questions of law or fact. Harris v. Palm Springs Alpine Estates, Inc., 329 F.2d 909, 914 (9th Cir.1964). In a fraud on the market case, a course of repeated misrepresentations will satisfy this requirement. Hoxworth v. Blinder, Robinson & Co., Inc., 980 F.2d 912 (3d Cir. 1992) (finding allegation that securitiesdealer charged its customers more than the NASD maximum markup on customers’ trades and failed to disclosethe markups satisfied the commonality requirement); Blackie v. Barrack, 524 F.2d 891, 902 (9th Cir. 1975). However, some courts have rejected class certification in fraud cases alleging oral misrepresentations becauseof the predominance of individual reliance issues. See Gibbs Props. Corp. v. CIGNA Corp., 196 F.R.D. 430,440 (M.D. Fla. 2000) (citations omitted); In re GenesisIntermedia, Inc. Sec. Litig., 232 F.R.D. 321 (D. Minn.2005) (holding fact that some plaintiffs seemed to be relying on fraud on the market theory while others did notrely on market efficiency was fatal to motion for class certification because there was no basis for class-widepresumption of reliance).

Commonality is not required as to every issue raised in a securities class action. Realmonte v. Reeves, 169 F.3d1280, 1285 (10th Cir. 1999); In re Visa Check/Mastermoney Antitrust Litig., 280 F.3d 124, 140 (2d Cir. 2001)(“The predominance requirement calls only for predominance, not exclusivity, of common questions.”(citations omitted)); see also Hanlon v. Chrysler Corp., 150 F.3d 1011, 1019 (9th Cir. 1998). Rule 23 issatisfied when the legal question linking the class members is substantially related to the resolution of thelitigation. Id.; DeBoer v. Mellon Mortgage Co., 64 F.3d 1171, 1174 (8th Cir. 1995). Some courts have heldthat the commonality requirement is satisfied if the complaint pleads at least one question of fact or lawcommon to the class. Mathews v. Kidder, Peabody & Co., 947 F. Supp. 180 (W.D. Pa. 1996), aff’d, 161 F.3d156 (3d Cir. 1998).

If issues common to the class do not predominate over issues not common to the class, certification is properlydenied. Mayer v. Mylod, 988 F.2d 635, 640 (6th Cir. 1993); Schwartz v. Upper Deck Co., 183 F.R.D. 672 (S.D.Cal. 1999) (finding no commonality where individual questions of fact exist and the court must apply differentlaw from each state). Although plaintiffs regularly establish the predominance requirement in securities cases,there is no presumption of predominance. In re Constar Int’l Inc. Sec. Litig., 585 F.3d 774, 781-82 (3d Cir.2009) (noting that while the Supreme Court has suggested that the predominance requirement of Rule 23(b) is“readily met in certain cases alleging consumer or securities fraud,” the district court should not relax itscertification analysis or presume a requirement for certification is met merely because the claim is a securitiesclaim). Rather than denying certification, the court may exclude certain members from the class if the presenceof a particular group in a class would make issues not common to the rest of the class predominant.

Once the court determines that common issues predominate, the plaintiff still must show that a class action is asuperior method of proceeding with the litigation. Infra at Subsection 4.e. If a large number of individualissues appears to affect the manageability of the class action — such as requiring the application of multiplestate laws — the burden is on the plaintiff to present a manageable trial plan. Zinser v. Accufix Research Inst.,Inc., 253 F.3d 1180, 1189 (9th Cir. 2001), amended on other grounds, 273 F.3d 1266 (9th Cir. 2001). But seeVisa Check/Mastermoney, 280 F.3d at 140 (“[F]ailure to certify an action under Rule 23(b)(3) on the soleground that it would be unmanageable is disfavored.”); In re Initial Pub. Offering, 399 F. Supp. 2d 261(S.D.N.Y. 2004) (holding in a section 11 claim, a class must be restricted to those periods prior to the release ofunregistered shares).

c. Adequacy Of Representation

For lead plaintiffs and their counsel to be adequate class representatives, they must “not have interestsantagonistic to those of the class”; the plaintiffs must “vigorously pursue the litigation on behalf of the class”;

and “their chosen attorney must be qualified, experienced, and able to conduct the litigation.” Scholes v.Tomlinson, 145 F.R.D. 485, 490 (N.D. Ill. 1992); see also Hanlon v. Chrysler Corp., 150 F.3d 1011, 1020 (9thCir. 1998); In re Initial Public Offering Sec. Litig., No. 21 MC 92 (SAS), 2008 U.S. Dist. LEXIS 38768, at *13(S.D.N.Y. May 13, 2008) (dismissing claims because the plaintiffs failed to identify a class representative whowas actually part of the alleged class after being given years to locate an appropriate representative); Griffin v.GK Intelligent Sys., Inc., 196 F.R.D. 298, 301 (S.D. Tex. 2000) (finding plaintiffs failed to carry the burden ofshowing they were adequate representatives of the class); In re United Telecomms., Inc. Sec. Litig., No. CIV. A90-2251-O, 1992 WL 309884 (D. Kan. Sept. 15, 1992) (noting that neither the allegedly excessive number ofattorneys nor the alleged failure of plaintiff’s counsel to conduct pre-filing investigation bears on the adequacyof representation).

Factors to consider in determining the adequacy of a proposed representative include the putative plaintiff’s:(1) knowledge of the case, (2) ability to supervise counsel, (3) credibility, and (4) resources to finance thelitigation. See Berger v. Compaq Computer Corp., 257 F.3d 475, 481-83 (5th Cir. 2001) (requiring plaintiffs tobe highly knowledgeable about claims because of “Congress’s emphatic command that competent plaintiffs,rather than lawyers, direct such cases”); In re Vivendi Universal, S.A., 242 F.R.D. 76, 88 (S.D.N.Y. 2007)(finding class representative adequate because he understood his obligations to represent the class and supervisethe class counsel, knew the claims and nature of the action, and expressed desire to “vigorously” pursue thecase); cf. In re Monster Worldwide Inc. Sec. Litig., 251 F.R.D. 132, 135-36 (S.D.N.Y. 2008) (finding aproposed lead plaintiff’s lack of knowledge about basic case facts, such as the defendants’ names, illustrated“an inadequate familiarity with, and concern for, the litigation” on the part of the representative and renderedhim unfit to be a class representative); Shiring v. Tier Techs., Inc., 244 F.R.D. 307, 313-17 (E.D. Va. 2007)(finding plaintiff inadequate because he (1) lacked credibility by virtue of his erroneous sworn certifications, (2)allowed counsel to control the litigation, and (3) was unfamiliar with basic aspects of the litigation); In reTheragenics Corp. Sec. Litig., 205 F.R.D. 687, 696 (N.D. Ga. 2002) (holding “the alleged deficiencies of theproposed class representative are irrelevant in a fraud on the market case such as this which is prosecuted byable and experienced counsel”); Zemel Family Trust v. Philips Int’l Realty Corp., 205 F.R.D. 434 (S.D.N.Y.2002) (holding that plaintiff could not be designated as class representative because he “lacked honesty andtrustworthiness” by falsely representing himself to be CFO, which made him an unacceptable candidate as afiduciary who would adequately represent the class); In re THQ Inc. Sec. Litig., No. CV 00-1783AHM(EX),2002 WL 1832145, at *7 (C.D. Cal. Mar. 22, 2002) (holding that although some representatives wereunfamiliar with some details of the case and were unaware that they might be liable for costs and fees if theclaim was unsuccessful, their level of unfamiliarity with the class action was not sufficient to defeat classcertification).

If a conflict exists between class members on the issue of damages or appropriate relief, it may precludecertification on the basis of adequacy. Morris v. Wachovia Sec., Inc., 223 F.R.D. 284, 299 (E.D. Va. 2004)(“Because the conflict of interests over appropriate relief in this case is fundamental, it defeats the adequacy ofrepresentation requirement.”); cf. LaGrasta v. First Union Sec., Inc., No. 2:01-cv-251-FTM-29DNF, 2005WL 1875469, at *7 (M.D. Fla. Aug. 8, 2005) (holding evidence of direct reliance by plaintiffs on oralrepresentations made by the First Union broker “does not destroy typicality or commonality [and] . . . does notrender the named plaintiffs unqualified to serve as class representatives,” because the complaint pleaded fraudon the market).

Persuading courts that a conflict should preclude certification, however, can be difficult. In many cases, aperceived conflict can arguably be addressed by the use of subclasses or other methods. E.g., In re FlagTelecom Holdings, Ltd. Sec. Litig., 574 F.3d 29, 35-37 (2d Cir. 2009) (affirming class certification becausepotential conflict between ‘34 Act and ‘33 Act plaintiffs as to whether defendant’s deceptive acts caused bothgroups’ losses would not become an actual conflict until the jury awarded damages, at which point districtcourt’s case management tools, including subclasses, could protect each class’s interests); Kohen v. Pac. Inv.Mgm’t Co. LLC, 571 F.3d 672, 679-80 (7th Cir. 2009) (in a Commodity Exchange Act case involving short-seller plaintiffs, affirming class certification in relevant part because intra-class conflict between plaintiffs as towhen defendant’s alleged acts artificially bid up prices was merely hypothetical and could be dealt with at alater stage through subclasses); In re Tyco Int’l, Ltd., 236 F.R.D. 62, 68-70 (D.N.H. 2006) (finding that conflict

between “equity holders” and “non-equity holders” can be addressed in ways other than denial of certification,including use of subclasses, exercise of opt-out right or divestiture of stock by class members).

d. Typicality

Typicality requires that the class representatives’ interests be aligned with those of the class so that the namedplaintiffs’ claim truly represents those of absent class members. The individual circumstances, claims, anddefenses of the class representative should not differ significantly from the class as a whole, but the claims neednot be identical. Realmonte v. Reeves, 169 F.3d 1280, 1286-87 (10th Cir. 1999) (finding differences in methodand timing of stock acquisition do not preclude class certification, where allegedly fraudulent statements weremade in common to all class members); Hanon v. Dataproducts Corp., 976 F.2d 497, 508 (9th Cir. 1992);Weiss v. York Hosp., 745 F.2d 786, 809 (3d Cir. 1984); Lapin v. Goldman Sachs & Co., 254 F.R.D. 168(S.D.N.Y. 2008) (certifying a major shareholder and former insider as the class representative even though hemight be subject to some unique defenses); In re Vivendi Universal, S.A., 242 F.R.D. 76, 85-86 (S.D.N.Y.2007) (allowing a class representative who did not trade shares based on alleged misstatements but rather,obtained shares through a merger); Schlagel v. Learning Tree Int’l, No. CIV 98-6384 ABC, 1999 WL 672306(C.D. Cal. Feb. 23, 1999) (holding that in the securities context, the fact that class representatives may havereviewed different documents or purchased different amounts of stock than other members of the class does notmean that claims are not typical of the class); Mathews v. Kidder, Peabody & Co., 947 F. Supp. 180 (W.D. Pa.1996) (finding that plaintiff meets typicality requirement even though he owned only one of three funds atissue).

1) Damages

Uniformity of damages is not required to establish typicality. See In re Scorpion Techs. Inc., C 93-20333 RPA,1994 WL 774029, at *4 (N.D. Cal. Aug. 10, 1994) (citing Blackie v. Barrack, 524 F.2d 891, 902 (9th Cir.1975)).

2) Reliance

Similarity of reliance on the part of the class representative and class members is not necessary to establishtypicality. Thus, a plaintiff who purchased stock after adverse news and a stock price decline as part of aninvestment strategy may serve as a class representative. See Yamner v. Boich, No. C-92-20597 RPA, 1994 WL514035, at *6 (N.D. Cal. Sept. 15, 1994) (citing Blackie v. Barrack, 524 F.2d 891, 905-06 (9th Cir. 1975)); seealso In re Technical Equities Fed. Sec. Litig., No. C-86-20157(A) WAI, 1988 WL 147607, at *4 (N.D. Cal.Oct. 3, 1988).

3) Time Of Purchase

A majority of courts have declined to find a conflict between a plaintiff and the class sufficient to deny classcertification simply because some class members purchased after the date of plaintiff’s purchase. Searls v.Glasser, No. 91 C 6796, 1993 WL 28746, at *5 (N.D. Ill. Feb. 3, 1993).

4) Unique Defenses

A court can deny class certification if defenses unique to the class representative will become the focus of the

litigation to the detriment of the class members. Hanon, 976 F.2d at 508; Gary Plastic Packaging Corp. v.Merrill Lynch, Pierce, Fenner & Smith, Inc., 903 F.2d 176, 179-80 (2d Cir. 1990); Zemel Family Trust v.Philips Int’l Realty Corp., 205 F.R.D. 434 (S.D.N.Y. 2002) (finding unique defenses available to plaintiffbecause he had been subject to SEC investigations resulting from failure to disseminate material information);Schaefer v. Overland Express Family of Funds, 169 F.R.D. 124, 128 (S.D. Cal. 1996) (holding it is appropriateto deny class certification if defendants show that unique defenses will shape litigation in a way that may harmclass). The focus of the inquiry is not whether the defense will ultimately be successful but rather whether theplaintiff will have to devote considerable time to rebut the claimed defense. Beach v. Healthways, Inc., 2009WL 3245393, at *4 (M.D. Tenn. Oct. 5, 2009).

Even so, the appearance of a unique defense may not be sufficient to deny a motion for class certification. SeeIn re Vivendi Universal, S.A., 242 F.R.D. 76, 89-90 (S.D.N.Y. 2007) (finding that a familial relationship with adirector and majority shareholder of defendant company, without more, is insufficient to conclude that the classrepresentative would be subject to unique defenses); In re THQ Inc. Sec. Litig., No. CV 00-1783AHM(EX),2002 WL 1832145, at *5 (C.D. Cal. Mar. 22, 2002) (finding typicality where the “unusually speculativeinvestments” of the putative class representatives were insufficient to raise a unique defense with the potentialto become the center of litigation); Neuberger v. Shapiro, No. CIV. A. 97-7947, 1998 WL 826980, at *2 n.7(E.D. Pa. Nov. 25, 1998) (holding that unique defenses which go to the merits are not properly addressed in amotion for class certification but may be sufficient to subdivide or modify the class).

Several particular situations may give rise to unique defenses:

(a) In-And-Out Traders

In In re Organogenesis Sec. Litig., 241 F.R.D. 397 (D. Mass. 2007), the court found that during the class periodone of the proposed class representatives “sold almost six times as many shares as he purchased.” Under thelast-in, first out (“LIFO”) methodology of assessing damages adopted by the court, these trades resulted in theinvestor making a profit on his trading during the class period and rendered him an unsuitable classrepresentative. But see Serafimov v. Netopia, Inc., No. C-04-03364 RMW, 2004 U.S. Dist. LEXIS 25184, at*19-20 (N.D. Cal. Dec. 3, 2004) (finding plaintiff’s status as a combination in-and-out and retention traderminimized the impact of potential unique defenses on the other class members); In re Scott Paper Co. Sec.Litig., 142 F.R.D. 611, 615 (E.D. Pa. 1992) (holding in-and-out trades met typicality requirement). But seeDura v. Broudo Pharmaceuticals, discussed in Section III.A.10.c below (suggesting that in-and-out tradersshould be excluded from class because of inability to prove loss causation).

(b) Professional Plaintiffs

Courts have also denied class certification because the proposed class representative was found to be a“professional plaintiff” and therefore atypical. Shields v. Smith, No. C-90-0349 FMS, 1991 WL 319032, at *4(N.D. Cal. Nov. 4, 1991) (“Plaintiff’s purchasing of stock in troubled companies … to possibly pursuelitigation, is a serious defense likely to become the focus of the litigation to the detriment of the class.”). Aprofessional plaintiff may be subject to a unique defense because the presumption of reliance on the integrity ofthe market is rebutted; neither the misrepresentation nor the price of the stock affected that individual’s decisionto buy. See Hanon v. Dataproducts Corp., 976 F.2d 497, 508 (9th Cir. 1992) (“Hanon’s reliance on theintegrity of the market would be subject to serious dispute as a result of his extensive experience in priorsecurities litigation, his relationship with his lawyers, his practice of buying a minimal number shares of stockin various companies, and his uneconomical purchase of only ten shares of stock in Dataproducts.”); Schaefer v.Overland Express Family of Funds, 169 F.R.D. 124, 129 (S.D. Cal. 1996) (recognizing professional plaintiffs

may hurt class); Greebel v. FTP Software, Inc., 939 F. Supp. 57, 61 (D. Mass. 1996) (recognizing Congress’“concern[]” regarding the “problem” of a professional plaintiff); Kline v. Wolf, 88 F.R.D. 696, 699 (S.D.N.Y.1981), aff’d, 702 F.2d 400 (2d Cir. 1983) (finding stock speculator plaintiff would be subject to unique defenseson issue of reliance). Thus, the number of times a plaintiff has been involved in other class actions may beimportant. In re K Mart Corp. Sec. Litig., No. 95-CS-75584-DT, 1996 WL 924811 (E.D. Mich. Dec. 16, 1996)(holding named plaintiff who participated in dozens of other actions could not represent the class but that aplaintiff who had been a class representative twice before could represent the class).

(c) Impact Of “Fraud On The Market” Theory

Plaintiffs frequently argue that by asserting the “fraud on the market” theory, they obviate any need to inquireinto defenses unique to the named class representative. (For a detailed discussion of fraud on the market theory,see infra Section III.A.6.a., “Fraud on the Market Presumption of Reliance.”) This argument fails, however,because defendants can rebut the presumption.

The fraud on the market presumption involves plaintiffs’ reliance on the false or misleading statements allegedin the complaint. The theory is that “in an open and developed securities market the price of a company’s stockis determined by the available material information regarding the company and its business,” and that investorsrely on “the integrity of [the market] price.” Basic Inc. v. Levinson, 485 U.S. 224, 241, 247 (1988). In Basic,the Court concluded “[m]isleading statements will therefore defraud purchasers of stock even if the purchasersdo not directly rely on the misstatements.” Id. at 241-42; accord Blackie v. Barrack, 524 F.2d 891, 906 (9thCir. 1975) (finding individual questions of reliance did not deter class certification in a 10b-5 action because“proof of subjective reliance on particular misrepresentations is unnecessary to establish a 10b-5 claim for adeception inflating the price of stock traded in the open market”). But see West v. Prudential Sec., Inc., 282F.3d 935, 938 (7th Cir. 2002) (holding plaintiffs must show a causal link between non-public statements andsecurities prices prior to certification of a class that includes purchasers who did not personally hearmisrepresentations, and the mere fact that both sides have support of reputable financial economists does notestablish the causal link).

Most courts have permitted inquiry into reliance on the integrity of the market at the class certification stage. The Second Circuit requires courts to determine the issue. In re Initial Pub. Offering Sec. Litig., 471 F.3d 24(2d Cir. 2006); accord Luskin v. Intervoice-Brite Inc., 261 F. App’x 697 (5th Cir. 2008) (vacating the districtcourt’s class certification on the basis that Fed. R. Civ. P. 23 mandates a complete analysis of fraud-on-the-market indicators, including loss causation, prior to class certification). See also Section II.D.7 below.

Although the fraud on the market presumption applies to plaintiffs in Rule 10b-5 actions, this presumption isrebuttable. Blackie, 524 F.2d at 906. Rebutting the presumption requires an evidentiary showing. Basic, 485U.S. at 241, 247; Hanon v. Dataproducts Corp., 976 F.2d 497, 508 (9th Cir. 1992); McNichols v. LoebRhoades & Co., 97 F.R.D. 331 (N.D. Ill. 1982). Because a defendant must make an “evidentiary” showing torebut the fraud-on-the-market presumption, discovery into the class representative’s trading history in generaland purchases of the stock of the defendant company in particular is essential. See Hanon, 976 F.2d at 508-09(analyzing plaintiffs’ entire investment history to determine propriety as class representative); In re Fed. Nat’lMortgage Ass’n, 247 F.R.D. 32, 42 (D.D.C. 2008) (noting option traders are afforded the rebuttable fraud-on-the-market presumption because “trading on the belief that the stock price will fluctuate does not necessarilymean that option traders do not rely on the integrity of the market information to predict those fluctuations”);Shields v. Smith, No. C-90-0349 FMS, 1991 WL 319032, at *4 (N.D. Cal. Nov. 4, 1991) (same); see alsoDegulis v. LXR Biotechnology, Inc., 176 F.R.D. 123, 125-27 (S.D.N.Y. 1997) (granting motion to compelproduction of plaintiff’s brokerage statements and investment records in part because evidence of a speculativeinvestment strategy would be relevant to a pending class certification motion); In re ML-LEE Acquisition FundII, L.P. & ML-LEE Acquisition Fund (Retirement Accounts) II, L.P. Sec. Litig., 149 F.R.D. 506, 508 (D. Del.

1993) (finding that information concerning plaintiffs’ entire investment history is “relevant to the Court’sdetermination of whether Plaintiffs satisfy the typicality requirement of Fed. R. Civ. P. 23(a)(3)”); In re SciMedLife Sec. Litig., CIV. No. 3-91-575, 1992 WL 413867, at *3 (D. Minn. Nov. 20, 1992) (recognizing “theimportance of the Defendant’s need to conduct discovery concerning plaintiffs entire investment history andbackground” for class certification issues).

The defendant need not show that he will be able to rebut the presumption at trial. Indeed, even if the defendantcan show the potential to rebut the presumption, this alone may be sufficient to find the plaintiff atypical. Forexample, if the defendant can show that the plaintiff may have relied on non-market information that wasunavailable to other class members, the potential for factual issues — such as whether plaintiff did rely on thatinformation — to dominate the litigation may support a finding that lead plaintiff is atypical. Beach v.Healthways, Inc., 2009 WL 3245393, at *5-6 (M.D. Tenn. Oct. 5, 2009).

Finally, when plaintiffs rely on the Affiliate Ute presumption to establish class-wide reliance, plaintiffs mustestablish the defendants owed a duty to the named class representative. Otherwise, the presumption does notapply, and certification may be unavailable. Newby v. Enron Corp., 446 F.3d 585 (5th Cir. 2006).

Although courts have generally applied the fraud-on-the-market presumption to issuers, it is not limited to thosetypes of cases. In In re Salomon Analyst Metromedia Litig., 544 F.3d 474 (2d Cir. 2008), the Second Circuitconcluded that no bright-line rule bars application of the doctrine to suits involving third-partymisrepresentations, such as those in analyst reports. Thus, plaintiffs are not required to make a heightenedshowing in analyst report cases. Id. at 480. Just as in issuer cases, however, defendants are entitled to presentevidence rebutting the presumption at the class certification stage. Id. at 484-85.

(d) The La Mar Doctrine

Generally, class representatives must have claims against the same defendants as other members of the class. Inthe seminal case of La Mar v. H & B Novelty & Loan Co., 489 F.2d 461, 465 (9th Cir. 1973), the Ninth Circuitheld typicality is “lacking when the plaintiff’s cause of action, although similar to that of other members of theclass, is against a defendant with respect to whom the class members have no cause of action.” La Mar hasbeen followed by other courts in various contexts. See, e.g., Thompson v. Bd. of Educ., 709 F.2d 1200, 1204-05(6th Cir. 1983); Barker v. FSC Sec. Corp., 133 F.R.D. 548 (W.D. Ark. 1989); Vulcan Soc. of WestchesterCounty, Inc. v. Fire Dep’t of White Plains, 82 F.R.D. 379, 399 (S.D.N.Y. 1979).

Exceptions to La Mar. The La Mar Court recognized two exceptions to its requirement that the classrepresentatives and class members have claims against the same defendants:

(A) The La Mar rule does not apply when “all injuries are the result of a conspiracy or concerted schemesbetween the defendants.” La Mar, 489 F.2d at 465; see also Brown v. Cameron-Brown Co., 92 F.R.D. 32, 39-40 (E.D. Va. 1981).(B) The La Mar rule does not apply when “all defendants are juridically related in a manner that suggestsa single resolution of the dispute would be expeditious.” La Mar, 489 F.2d at 466; see also In re Itel Sec.Litig., 89 F.R.D. 104, 121-23 (N.D. Cal. 1981) (applying the “juridical link” exception to justify classcertification in securities action against underwriters who sold securities using identical documents); Barker v.FSC Sec. Corp., 133 F.R.D. at 553; State ex rel. Erie Fire Ins. Co. v. Madden, 515 S.E.2d 351 (W. Va. 1998)(reversing the trial court’s application of the “juridical link” doctrine, finding that insurance companies did nothave the common scheme required).

5) Limiting The Class In A Multiple Offering Case

In Hudson v. Capital Management, International, Inc., 565 F. Supp. 615 (N.D. Cal. 1983), the court appliedLa Mar to limit the scope and size of a class certified against attorney, accountant, broker, issuer, and officerand director defendants. In that case, plaintiffs alleged an integrated scheme of intrastate and private placementofferings to thousands of investors over several years. The offering materials varied by partnership andincluded expertized materials from different attorneys and accountants. The court held:

the Rule 23(b)(3) requirement that questions of law or fact predominate over questions affecting onlyindividual members of the class is met only if the class is limited to those who invested in the samepartnerships as the named plaintiffs, because the representations varied from partnership topartnership. Similarly, the requirement that the claims of the representative parties be typical of theclaims of the class, Fed. R. Civ. P. 23(a), permits plaintiffs to represent only those who invested in thesame partnerships as plaintiffs did.

Id. at 629.

The Hudson Court relied on the Advisory Committee’s Note to Rule 23(b)(3). That note observed: “a fraudperpetrated on numerous persons by the use of similar misrepresentations may be an appealing situation for aclass action, and it may remain so despite the need, if liability is found, for a separate determination of thedamages suffered by individuals within the class. On the other hand, although having some common core, afraud case may be unsuited for treatment as a class action if there was material variation in the representationsmade or in the kinds or degrees of reliance by the persons to whom they were addressed.” Id. at 629; AdvisoryCommittee’s Note, Proposed Amendments to the Rules of Civil Procedure for the United States District Court,39 F.R.D. 69, 103 (1966). But see Blackie v. Barrack, 524 F.2d 891, 904 (9th Cir. 1975) (holding commonalityand typicality requirements met despite multiple offering documents when each contained similarmisrepresentation concerning improper reserve accounts); In re W. Union Sec. Litig., 120 F.R.D. 629 (D.N.J.1988) (finding stock purchasers allegedly defrauded over a period of time by similar misrepresentations wereunited by common interest which was not defeated by slight differences in class members’ position and holdingit is not fatal to class certification that plaintiffs may have actually relied on many documents spread out over aperiod of time).

e. Superiority Of Class Action Treatment

The superiority requirement requires courts to balance the advantages of class action treatment against those ofalternative methods of adjudication. SEE Fed. R. Civ. P. 23(b)(3) Advisory Committee Notes, 1966Amendment. In considering whether a class action is “superior to other available methods for the fair andefficient adjudication of the controversy,” courts should examine several factors:

(A) the interest of members of the class in individually controlling the prosecution or defense of separateactions; (B) the extent and nature of any litigation concerning the controversy already commenced by or againstmembers of the class; (C) the desirability or undesirability of concentrating the litigation of the claims in theparticular forum; (D) the difficulties likely to be encountered in the management of a class action.

Fed. R. Civ. P. 23(b)(3); see, e.g., In re Genesisintermedia, Inc. Sec. Litig., No. CV 01-9024-SVW, 2007 WL1953475, at *14 (C.D. Cal. June 28, 2007) (“A class action is not a superior method of resolving a securitiesfraud action where individual issues of reliance predominate [over] any common issues.”); Siemers v. WellsFargo & Co., 243 F.R.D. 369, 376 (N.D. Cal. June 1, 2007) (finding a class that included all purchasers over afive year period in over one hundred mutual funds to be unmanageable).

One particular application of the superiority requirement is noteworthy in light of the increased globalization ofsecurities class action litigation. In weighing the factors, although the defendant may already be defending

shareholder suits in another country, the advantages of class certification may still outweigh shareholderinterests in conducting separate lawsuits. See In re Vivendi Universal, S.A. Sec. Litig., 242 F.R.D. 76, 92(S.D.N.Y. 2007). If there is a possibility of foreign suits, courts should consider the res judicata effects in theforeign countries when evaluating the superiority requirement. “Where plaintiffs are able to establish aprobability that a foreign court will recognize the res judicata effect of a U.S. class action judgment, plaintiffswill have established this aspect of the superiority requirement.” Id. at 95. However, if plaintiffs are unable toshow that recognition in a foreign court is more likely than not, that factor weighs against finding superiorityand may lead to the exclusion of foreign claimants. Id. at 95-106 (analyzing probability of recognition ofjudgment in France, England, Germany, Austria, and the Netherlands and concluding that plaintiffs failed toestablish that Germany and Austria would probably grant res judicata effect to judgment).

5. Alternatives To Denial When Prerequisites Are Not Met

a. Subclasses

If a court finds it cannot certify a single class in an action, it may certify multiple subclasses for particularissues or claims. Harden v. Raffensperger, Hughes & Co., Inc., 933 F. Supp. 763 (S.D. Ind. 1996); In reLILCO Sec. Litig., 111 F.R.D. 663, 670 (E.D.N.Y. 1986) (certifying eight different subclasses based on thedifferent securities at issue); Wolfson v Solomon, 54 F.R.D. 584, 588 (S.D.N.Y. 1972) (allowing class action oftwo classes of plaintiffs pursuing different claims). But see In re Celaphon Sec. Litig., No. CIV. A. 96-0633,1998 WL 470160, at *5 (E.D. Pa. Aug. 12, 1998) (refusing to create subclasses where the class members werenot shown to have antagonistic or divergent interests); In re Cendant Corp. Litig., 182 F.R.D. 476, 480 (D.N.J.1998) (refusing plaintiff’s request to create a subclass because it would detract from the Reform Act’s goal ofclient control by delegating more control to the attorneys for each class); In re Vivendi Universal, S.A. Sec.Litig., 242 F.R.D. 76, 109 (S.D.N.Y. 2007) (refusing to create subclasses to determine domestic and foreigndamages where foreign market for shares was “highly integrated” with NYSE and the prices were “almostalways effectively equivalent”).

A number of cases have discussed the possibility of certifying subclasses in cases involving a series of partialcurative disclosures. See Blackie v. Barrack, 524 F.2d 891, 911 (9th Cir. 1975); In re Unioil Sec. Litig., 107F.R.D. 615, 622 (C.D. Cal. 1985); Koenig v. Smith, 88 F.R.D. 604 (E.D.N.Y. 1980); see also SectionII.D.5.b(1), “Length of Class Period: Partial Curative Disclosures,” infra (discussing partial curativedisclosures). However, as discussed in detail in In re Seagate Technology II Securities Litigation, 843 F. Supp.1341 (N.D. Cal. 1994), if the court also accounts for the divergent interests of in-and-out trading (shareholderswho buy and sell the stock), an average of two subclasses a day could be required, thus making the concept ofsubclasses unworkable. Id. at 1361. Faced with the question of class certification when there had been a seriesof partial curative disclosures, the court in Seagate II ordered the plaintiffs to provide evidence that the conflictswere not so serious as to preclude certification. Id. at 1365. As a result, plaintiffs voluntarily limited the classto those persons who purchased stock before the first partial curative disclosure. In re Seagate Tech. II Sec.Litig., 156 F.R.D. 229, 230 (N.D. Cal. 1994).

b. Length Of Class Period

1) Court’s Discretion

A court has discretion to modify the class period alleged in the complaint in deciding a class certificationmotion. Schaefer v. Overland Express Family of Funds, 169 F.R.D. 124, 131 (S.D. Cal. 1996).

2) Variance In Factual Issues

Variance in factual issues and distinctive time periods within the class period can defeat typicality. Asdiscussed below, purchasers after a curative public announcement are subject to unique factual defenses andtherefore are not typical of purchasers prior to such an announcement. In re LTV Sec. Litig., 88 F.R.D. 134, 148(N.D. Tex. 1980). Differing issues of proof over time can also defeat certification. J.H. Cohn & Co. v. Am.Appraisal Assocs., Inc., 628 F.2d 994, 998 (7th Cir. 1980) (refusing to certify a class because of “different proof[at different times] concerning the defendants’ willfulness or recklessness in issuing or omitting to issuematerial information”); Katz v. Comdisco, Inc., 117 F.R.D. 403, 411 (N.D. Ill. 1987) (“[D]ue to the shiftingfactual scenarios [over time], each class member will face different issues of proof.”); Kohntopp v. Butcher,98 F.R.D. 551, 553 (E.D. Tenn. 1983) (denying certification where plaintiffs made purchases over time, indifferent amounts, and based upon a variety of information).

3) Curative Disclosures

The timing of the disclosure of curative information may determine the end of the class period. Once allegedlyfalse or misleading statements are made to the public, the ability of a class of purchasers to claim that they didnot know the true facts is limited. Liability under the federal securities laws is terminated when “curativeinformation is publicly announced or otherwise effectively disseminated.” In re Sun Microsystems, Inc. Sec.Litig., No. C-89-20351-RPA, 1990 WL 169140, at *8 (N.D. Cal. Aug. 20, 1990); see also Klein v. A.G. BeckerParibas, Inc., 109 F.R.D. 646, 652-53 (S.D.N.Y. 1986) (denying certification of a proposed extended class fornon-typicality where named plaintiffs, unlike members of proposed extended class, purchased securities beforenews reports and a press release revealed compatibility, workforce and financial problems). But see Feldman v.Motorola, No. CIV. A. 90 C 5887, 1993 WL 497228, at *5 (N.D. Ill. Oct. 14, 1993) (declining to limit the classperiod at the certification stage based on timing of curative announcement because “there are fact questions asto the appropriate limits of the class period”). Sections 11(a) and 12(2) impose liability in favor of purchaserswho did not know of the alleged misstatement or omission in the registration statement. Section 10(b) andRule 10b-5 require proof of reliance. Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511U.S. 164, 180 (1994). If “curative information” has been disseminated, a purchaser may have actual knowledgeof the false or misleading nature of prior information.

(a) Partial Curative Disclosures

After a defendant publicly announces information that “cures” deficiencies in prior public statements,subsequent purchasers are not properly included within the class. McFarland, 96 F.R.D. at 364-65; see Gen.Tel. Co. of Sw. v. Falcon, 457 U.S. 147, 152-53 (1982) (holding typicality requirement only met if classrepresentatives and class members suffered same injury under similar circumstances); see also In re CypressSemiconductor Sec. Litig., No. C-92-20048-RMW, 1992 WL 394927 (N.D. Cal. Sept. 23, 1992).

Cases involving a series of partial curative disclosures have created particularly difficult class certificationproblems. A number of decisions have discussed the possibility of the certification of subclasses. (Seediscussion supra at Subsection 5.a, “Alternatives to Denial When Prerequisites Are Not Met: Subclasses”) Inaddition, if a substantial question of fact exists as to whether the release cured the misrepresentation or wasitself misleading, then the broader time period may be certified; however, if facts are uncovered in the course ofdiscovery suggesting that the curative disclosure had been assimilated by the market, defendants may move todecertify the appropriate portion of the class. In re Sunrise Sec. Litig., No. MDL 655, 1987 WL 19343, at *3(E.D. Pa. July 7, 1987).

(b) Effectiveness Of Curative Statements

An announcement can effectively cure the alleged earlier misrepresentations. This issue involves considerationof the type and extent of alleged misrepresentations and the character of information said to cure suchmisrepresentations. In re Unioil Sec. Litig., 107 F.R.D. 615, 621 (C.D. Cal. 1985) (holding court could notdetermine on class certification motion whether wide range of allegedly fraudulent information was cured by aseries of public disclosures by defendant); In re Memorex Sec. Cases, 61 F.R.D. 88, 97 (N.D. Cal. 1973)(finding curative statement candidly explained prior misleading statements); In re Sunrise, 1987 WL 19343, at*3 (noting that in analyzing whether the disclosure of the information was curative, the court should considerthe content of the disclosures in question and their effect on the market price).

If the curative statement is itself ambiguous, a court may be reluctant to find that it has cured earliermisrepresentations. In re AM Int’l Inc. Sec. Litig., 108 F.R.D. 190, 193 (S.D.N.Y. 1985); see S.E.C. v. RanaResearch Inc., 8 F.3d 1358, 1362-63 (9th Cir. 1993) (noting that curative press releases containing a “grain oftruth” are insufficient); Marksman Partners, L.P. v. Chantal Pharms. Corp., 927 F. Supp. 1297, 1307 (C.D.Cal. 1996) (holding that an appendix attached to Form 10-K is not a disclosure sufficient to neutralize allegedlymisleading effect of accounting statements especially if unclear that addendum directly addresses themisleading information).

(c) Whether Statement Was Curative May Merit Inquiry

Some courts have held that an inquiry into whether and when public announcements cured prior misstatementsis a determination of the merits of the case, which is impermissible at the class certification stage. In re SeagateTech. II Sec. Litig., 843 F. Supp. 1341, 1345, 1365 (N.D. Cal. 1994) (requiring “detailed factual analysis” todetermine whether Rule 23 prerequisites have been satisfied); In re Victor Techs. Sec. Litig., 102 F.R.D. 53, 58(N.D. Cal. 1984), aff’d, 792 F.2d 862 (9th Cir. 1986) (explaining whether announcement of the company’sexpectation of quarterly loss, rather than later announcement of actual loss, effectively cured omissions inregistration statement is a merits decision); see Morse v. Abbott Labs., 756 F. Supp. 1108 (N.D. Ill. 1991).

Several circuits, however, have permitted inquiry into the merits where such an inquiry is relevant todetermining the sufficiency of class allegations. Hanon v. Dataproducts Corp., 976 F.2d 497, 509 (9th Cir.1992) (“[The court is] at liberty to consider evidence which goes to the requirements of Rule 23 even thoughthe evidence may also relate to the underlying merits of the case.”). Many courts, including the Supreme Court,have approved the examination of facts beyond the “four corners of the complaint” when considering classcertification and definition. See, e.g., Gen. Tel. Co. v. Falcon, 457 U.S. 147, 160 (1982) (explaining “it may benecessary for the court to probe behind the pleadings” to resolve class certification issues); In re Initial Pub.Offering Sec. Litig., 421 F.3d 24, 42 (2d Cir. 2006) (analyzing facts from discovery as well as complaint);Sirota v. Solitron Devices, Inc., 673 F.2d 566, 571 (2d Cir. 1982) (noting that a court should allow discovery onclass certification issues and hold a hearing to determine whether Rule 23 prerequisites met); Doctor v.Seaboard Coast Line R.R. Co., 540 F.2d 699, 707-09 (4th Cir. 1976) (holding that in conducting classcertification analysis, court must go beyond the complaint and consider the character or type of eachrepresentative plaintiff’s claim); In re Vivendi Universal, S.A. Sec. Litig., 242 F.R.D. 76, 92 (S.D.N.Y. 2007);Schaefer v. Overland Express Family of Funds, 169 F.R.D. 124, 127 (S.D. Cal. 1996) (finding that a court canconsider evidence relevant to a class certification motion even if it is also related to the action’s merits);Friedlander v. Barnes, 104 F.R.D. 417, 420 (S.D.N.Y. 1984).

Defendants should consider both pressing for consideration of curative statements at the early phase of classcertification and re-opening the question of the class period if it is possible to subsequently argue a curativeannouncement has cut off the scope of the class as previously defined.

6. Statute Of Limitations Considerations On Dismissal

Under the American Pipe tolling doctrine, “filing a class action tolls the statute of limitations as to all assertedmembers of the class.” Crown, Cork & Seal Co., Inc. v. Parker, 462 U.S. 345, 350 (1983) (clarifying the scopeof American Pipe’s holding); Am. Pipe & Constr. Co. v. Utah, 414 U.S. 538, 552-53 (1974). The SupremeCourt explained that efficiency and economy are the primary purpose of the class action procedure. Am. Pipe,414 U.S. at 553. In the absence of a tolling doctrine, litigants would be forced to file duplicative motions toguard against the risk that the class might not be certified. The Court considered such a result undesirablebecause it would defeat the purpose of the class action procedure. Id. at 553-54; see also Catholic SocialServs., Inc. v. I.N.S., 232 F.3d 1139, 1147 (9th Cir. 2000) (en banc) (allowing plaintiffs to aggregate theirclaims in a subsequent class action if their individual claims would be timely under American Pipe).

However, “no court of appeals has yet applied tolling to subsequent class claims where certification in the priorclass action had been denied on the basis of the lead plaintiffs’ deficiencies as class representatives, [although] anumber of district courts have done so.” Yang v. Odom, 392 F.3d 97, 107 n.7 (3d Cir. 2004) (collecting cases). In Yang v. Odom, the Third Circuit addressed this very issue, and held the American Pipe tolling applies to thefiling of a new class action where the certification was denied by the prior suit based on the lead plaintiff’sdeficiencies as class representatives. Id. at 104. However, the tolling doctrine will not apply if the court deniedcertification based on deficiencies in the purported class itself. Id. at 104-06 (citing Korwek v. Hunt, 827 F.2d874, 876 (2d Cir. 1987); Basch v. Ground Round, Inc., 139 F.3d 6, 8 n.4 (1st Cir. 1998); Andrews v. Orr, 851F.2d 146, 149 (6th Cir. 1988); Salazar-Calderon v. Presidio Valley Farmers Ass’n, 765 F.2d 1334, 1350 (5thCir. 1985)); see also In re Tyco Int’l, Ltd., MDL No. 02-1335-B, 2007 WL 1703023, at *3 (D.N.H. June 11,2007) (dismissing claims brought after the statute of repose period that did not share facts of prior class action).

7. Rule 23(f) Interlocutory Appeal

Rule 23(f) of the Federal Rules of Civil Procedure, adopted in 1998, permits the appellate courts to grantdiscretionary review of district court orders granting or denying class certification under Rule 23. Withincreasing regularity, defendants have used Rule 23(f) to seek interlocutory review of class certificationdecisions, often on the ground that plaintiffs cannot meet the reliance or loss causation requirements of a 10b-5claim on a classwide basis. Historically, plaintiffs have urged that these questions must be left for meritsdeterminations that are inappropriate at the class certification stage. Recent decisions, however, have clearlyestablished that courts must look at merits-related issues that are relevant to plaintiffs’ meeting their burden ofestablishing each of Rule 23’s requirements.

The most frequent argument raised in Rule 23(f) petitions is that plaintiffs will be unable to meet thepredominance requirement because the absence of an efficient market prevents them from being able to takeadvantage of the “fraud on the market” presumption of reliance, with the result that individual issues of reliancewill predominate. Cases in which courts have either reversed class certification or affirmed a denial of classcertification on this basis in Rule 23(f) appeals include In re Polymedica Corp. Sec. Litig., 432 F. 3d 1 (1st Cir.2005); In re Initial Public Offering Sec. Litig., 471 F. 3d 24 (2d Cir. 2006); Hevesi v. Citigroup, Inc., 366 F. 3d70 (2d Cir. 2004); In re Salomon Analyst Metromedia Litig., 544 F.3d 474 (2d Cir. 2008) (defendants must haveopportunity to rebut FOM presumption prior to class certification); West v. Prudential Securities, Inc., 282 F.3d935 (7th Cir. 2002); Teamsters Local etc. Pension Fund v. Bombardier Inc., 546 F.3d 196 (2d Cir. 2008);Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F. 3d 154 (3d Cir. 2001); Gariety v. AdvantaMortgage Corp. USA, 368 F. 3d 356 (4th Cir. 2004); Oscar Private Equity Invs. v. Allegiance Telecom, Inc.,487 F. 3d 261 (5th Cir. 2007); Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F. 3d372 (5th Cir. 2007); Bell v. Ascendant Solutions, Inc., 422 F. 3d 307 (5th Cir. 2005); Unger v. Amedisys, Inc.,401 F. 3d 316 (5th Cir. 2005); West v. Prudential Securities, Inc., 282 F. 3d 935 (7th Cir. 2002). In a relatedvein, the court in Malack v. BDO Seidman, LLP, 617 F.3d 743 (3d Cir. 2010) affirmed a denial of classcertification based on the district court’s rejection of the “fraud created the market” theory for presumingreliance.

The court in Oscar Private Equity also rested its vacation of class certification on Rule 23(f) appeal on theplaintiff’s failure to establish loss causation. Similarly, the Second Circuit in In re Flag Telecom Holdings, Ltd.Sec. Litig., 574 F.3d 29 (2d Cir. 2009) reversed a class certification insofar as the class included “in and out”traders who could not prove loss causation. But see Alaska Elec. Pension Fund v. Flowserve Corp., 572 F.3d221 (5th Cir. 2009) (vacating denial of class certification on Rule 23(f) review and remanding for a new classcertification hearing where the district court had applied the wrong standard for assessing loss causation);Schleicher v. Wendt, 618 F.3d 679 (7th Cir. 2010) (rejecting Oscar and affirming class certification). See alsoArchidiocese of Milwaukee Supporting Fund v. Halliburton Co., 597 F.3d 330 (5th Cir. 2010) (although notexpressly referencing Rule 23(f), court affirmed denial of class certification, presumably under that rule, forfailure to show loss causation; court reconciled Oscar and Flowserve).

E. Class And Merits Discovery Issues

1. Class Discovery

To test a plaintiff’s assertions concerning the propriety of class certification, defendants should seek discoveryfrom the representative plaintiff to see whether Rule 23 requirements will be met. Hanon v. DataproductsCorp., 976 F.2d 497, 508-09 (9th Cir. 1992) (analyzing named plaintiff’s investment history to determinepropriety as a named plaintiff in a securities case); Degulis v. LRX Biotechnology, Inc., 176 F.R.D. 123(S.D.N.Y. 1997) (finding discovery of named plaintiff’s investment records, sophistication and tradingstrategies was relevant to pending class certification motions); In re SciMed Life Sec. Litig, CIV. No. 3-91-575,1992 WL 413867, at *3 (D. Minn. Nov. 20, 1992) (“This Court recognizes the importance of the Defendant’sneed to conduct discovery concerning Plaintiffs’ entire investment history.”); Feldman v. Motorola, Inc., No. 90C 5887, 1992 WL 137163 (N.D. Ill. June 9, 1992) (permitting discovery of plaintiffs’ brokerage accountstatements for past four years as relevant to the class certification inquiry); Shields v. Smith, No. C-90-0349FMS, 1991 WL 319032 (N.D. Cal. Nov. 4, 1991) (allowing review of plaintiff’s investment history in ruling onmotion for class certification).

Expert discovery may also be permitted where appropriate. Fogarazzo v. Lehman Bros., Inc., No. 03 CIV.5194 (SAS), 2005 WL 361205 (S.D.N.Y. Feb. 16, 2005) (allowing use of “class certification” expert “todescribe and explain a methodology that the ultimate fact-finder can use to determine central factual issues on acommon basis” such as “whether the plaintiff’s purported class satisfies Rule 23 requirements,” and allowingdefendants to depose expert regarding inquiries “bearing directly on the propriety of class certification”).

Defendants should also seek a stay of merits discovery in appropriate cases while class discovery proceeds,inasmuch as a denial of class certification may well end the case as a practical matter.

2. The Reform Act’s Discovery Stay

a. Automatic Stay Of Discovery

The Reform Act provides:

In any private action arising under this chapter, all discovery and other proceedings shall be stayedduring the pendency of any motion to dismiss, unless the court finds upon motion of any party thatparticularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party.

15 U.S.C. § 78u-4(b)(3)(B).

The Reform Act thus provides for an automatic stay of discovery pending a defendant’s motion to dismiss. This stay is available to both parties and non-parties. See In re Carnegie Int’l Corp. Sec. Litig., 107 F. Supp. 2d

676, 679 (D. Md. 2000) (holding non-party accounting firm could invoke protection under the stay provisionsof the Reform Act); see also In re Adelphia Commc’ns Corp., 294 B.R. 39, 43-44 (S.D.N.Y. 2003) (applyingCarnegie International in holding a non-party non-subpoenaed witness who is a prospective target in state courtproceedings has standing to seek the PSLRA automatic stay of discovery). If defendants are unable to prevailon the pleadings, the Reform Act discovery stay will be lifted and plaintiffs will begin pursuing discovery,especially the production of documents. Once the stay is lifted, plaintiffs may seek documents under the initialdisclosure provisions of Federal Rule of Civil Procedure 26(a), which eliminated local deviations from theRule. For example, in the Northern District of California, local rules previously exempted securities classactions from initial disclosures. Once plaintiffs have obtained initial disclosures, they will seek production of awide array of documents and then begin taking depositions of senior management and other employees orformer employees. Some issues that arise during the discovery process are discussed below.

Congress enacted the automatic stay provision of the PSLRA to address concerns that plaintiffs would usediscovery to find new claims or to coerce a settlement from defendants seeking to avoid the high cost ofdiscovery. H.R. Conf. Rep. No. 104-369, at 37 (1995); S. Rep. No. 104-98, at 14 (1995). While the SecondCircuit has not directly spoken to the issue, its district courts have suggested that the stay should only be liftedin cases “where defendants might be shielded from liability in the absence of the requested discovery.” Forexample, in one decision, the court denied the plaintiff’s motion to lift the stay of discovery because plaintiffshad failed to establish they suffered undue prejudice from the discovery stay. Taft v. Ackermans, No. 02 CIV.7951 (PKL), 2005 WL 850916 (S.D.N.Y. Apr. 13, 2005); see also In re Worldcom, Inc. Sec. Litig., No. 02 CIV3288 (DLC), 2002 WL 31628566, *4 (S.D.N.Y. Nov. 21, 2002) (permitting discovery before motion to dismisswas decided under “unique circumstances” where documents had already been produced in other litigation andcomplaint was “clearly not” a fishing expedition).

b. Cases Interpreting The Discovery Stay

In SG Cowen Securities Corp. v. District Court, 189 F.3d 909 (9th Cir. 1999), the Ninth Circuit held theReform Act’s discovery stay provision was “intended to prevent unnecessary imposition of discovery costs ondefendants.” Id. at 911. Addressing the propriety of relief from the discovery stay, the court held the districtcourt had improperly “granted plaintiffs leave to conduct discovery so that they might uncover facts sufficientto satisfy the [Reform] Act’s pleading requirements.” Id. at 912. The Ninth Circuit found that lifting of thediscovery stay was not proper “unless exceptional circumstances exist.” Id.

In Medhekar v. District Court, 99 F.3d 325, 328 (9th Cir. 1996), the Ninth Circuit reviewed the questionwhether the initial disclosures required by Federal Rule of Civil Procedure 26(a)(1) and the accompanying localrules constitute “discovery” or “other proceedings” for purposes of the Reform Act’s stay provisions. TheNinth Circuit held the initial disclosures are a subset of discovery and, as such, are included in the Reform Act’sdiscovery stay. Id. at 328. The court noted “Congress clearly intended that complaints in these securitiesactions should stand or fall based on the actual knowledge of the plaintiffs rather than information produced bythe defendants after the action has been filed.” Id. In dicta, the Medhekar court interpreted the term “otherproceeding” to include “litigation activity related to discovery.” Id. At least one district court has disagreedwith the Ninth Circuit’s holding in Medhekar regarding initial disclosures. In In re Comdisco SecuritiesLitigation, 166 F. Supp. 2d. 1260, 1261-62 (N.D. Ill. 2001), the Northern District of Illinois, following thedistinction made in Rule 26, distinguished between “disclosure” and “discovery.” In that case, the courtgranted plaintiffs’ motion to compel production of defendant directors’ and officers’ insurance policies becausesuch policies are expressly provided for under the mandatory initial disclosures of Rule 26(a)(1)(D). Id.

Courts also disagree as to whether a motion for class certification falls within the purview of “otherproceedings.” A ruling on a motion to dismiss prior to a class certification would bind only the namedplaintiffs; defendants, therefore, sometimes prefer to have a class certified before a ruling on the motion todismiss to prevent other members of a putative class from refiling identical claims in the event that the motionto dismiss is granted. The court in In re Diamond Multimedia Systems, Inc., No. C 96-2644 SBA, 1997 WL773733, at *3 (N.D. Cal. Oct. 14, 1997), relying on the Ninth Circuit’s language in Medhekar, held that a

motion for class certification does not fall into the category of “other proceedings” because it does not relate todiscovery matters. The court rejected plaintiffs’ contention that they were barred from seeking classcertification prior to resolution of defendants’ motion to dismiss. Id. In contrast, other courts have found thatruling on a motion to dismiss prior to considering class certification is appropriate. See Abrams v. Van KampenFunds, Inc., No. 01 C 7538, 2002 WL 1989401, at *1 (N.D. Ill. Aug. 27, 2002), Winn v. Symons Int’l Group,Inc., No. IP 00-0310-C-B/S, 2001 WL 278113, at *2 (S.D. Ind. Mar. 21, 2001).

Other district courts have provided context to the terms “discovery and other proceedings.” See In re JDSUniphase Corp. Sec. Litig., 238 F. Supp. 2d 1127, 1134 (N.D. Cal. 2002) (finding plaintiffs’ proposedvoluntary interviews with former employees did not fall within the scope of “discovery”).

c. Exceptions To The Discovery Stay

The statutory language provides that the discovery stay will not be in effect if discovery is necessary to“preserve evidence or to prevent undue prejudice” to a party. 15 U.S.C. § 78u-4(b)(3)(B). The SouthernDistrict of New York has defined “undue prejudice” as “improper or unfair treatment amounting to somethingless than irreparable harm.” See In re Bank of America Corp. Sec., Derivative, and ERISA Litig., No. 09 MDL2058(DC), 2009 WL 4796169, at *2 (S.D.N.Y. Nov. 19, 2009) (citing Brigham v. Royal Bank of Canada, No.08 Civ. 4331(WHP), 2009 WL 935684, at *1 (S.D.N.Y. Apr. 7, 2009)). In In re WorldCom, Inc. SecuritiesLitigation, 234 F. Supp. 2d 301 (S.D.N.Y. 2002), a district court lifted the discovery stay, ordering defendantWorldCom to produce documents to a group of plaintiffs. The court held that plaintiffs would be undulyprejudiced if they were denied access to documents that had already been made available to public authoritiesand defendant WorldCom’s creditor committee. Id.; see also In re LaBranche Sec. Litig., 333 F. Supp. 2d 178,184 (S.D.N.Y. 2004) (“The requested discovery is essential to determine [the plaintiff’s] strategy and to assistin formulating an appropriate settlement demand . . . . The Defendants have not demonstrated any burdenimposed by complying now with the inevitable discovery.”); In re Royal Ahold N.V. Sec. & ERISA Litig., 220F.R.D. 246, 251-2 (D. Md. 2004) (lifting discovery stay to preserve evidence and prevent undue prejudicebecause volume of request was not unreasonable, corporate reorganization and divesture of subsidiaries bydefendant could lead to loss of documents, and separate civil and criminal actions regarding the same issuewere not subject to the same discovery stay). But see In re Asyst Techs., Inc. Derivative Litig., No. C-06-04669EDL, 2008 WL 916883, at *2 (N.D. Cal. Apr. 3, 2008) (denying request to lift discovery stay where plaintiffsclaimed “undue prejudice” simply because they lacked access to documents which the DOJ and SEC alreadypossessed).

In Canada, Inc. v. Aspen Technology, Inc., No. 07 CIV 1204, 2007 WL 2049738 (S.D.N.Y. July 18, 2007), thecourt refused to lift the PSLRA’s discovery stay, stating that the “unique circumstances” of WorldCom were notpresent because here plaintiffs were not “competing with non-PSLRA plaintiffs for the limited assets ofinsolvent defendants.” Id. at *4. The court noted “courts have refused to lift the discovery stay if the narrowstatutory exceptions of evidence preservation or undue prejudice have not been met.” Id. at *2 (citing In reVivendi Universal S.A. Sec. Litig., 381 F. Supp. 2d 129, 129 (S.D.N.Y. 2003)). The decision in In re AmericanFunds Securities Litigation, 493 F. Supp. 2d 1103 (C.D. Cal. 2007), also distinguished WorldCom on the basisthat WorldCom involved court ordered global settlement discussions. Id. at 1106 (denying plaintiffs’ motion tolift stay because government’s possession of documents did not create undue prejudice against plaintiffs).

While no circuit courts have specifically addressed the scope of the discovery stay, several district courts haverejected attempts to carve out exceptions to the discovery stay. See, e.g., In re CFS-Related Sec. Fraud Litig.,179 F. Supp. 2d 1260 (N.D. Okla. 2001), motion granted in part by 213 F.R.D. 435 (N.D. Okla. 2003) (denyinga plaintiff’s motion to compel discovery against a non-moving defendant while another defendant made amotion to dismiss); In re Carnegie Int’l Corp. Sec. Litig., 107 F. Supp. 2d 676 (D.Md. 2000) (granting thirdparty accountant’s motion to quash a defendant’s subpoena duces tecum because the defendant had not yet fileda motion to dismiss nor had the time to file a motion to dismiss run; noting that the PSLRA intended to staydiscovery until the sufficiency of the complaint had been tested by a motion to dismiss or unless a party would

be unduly burdened by a discovery stay); In re Tyco Int’l, Ltd. Sec. Litig., No. 00MD1335, 2000 WL 33654141(D.N.H. July 27, 2000) (denying plaintiff’s request for preservation order directed at defendants after theimplementation of stay of discovery pursuant to the PSLRA because defendants were already on notice of thetypes of documents plaintiffs would seek during discovery).

During a concurrent investigation, the stay of discovery does not apply to documents the government did notoriginally produce. Seippel v. Sidley, Austin, Brown & Wood, No. 03 CIV. 6942 (SAS), 2005 WL 388561(S.D.N.Y. Feb. 17, 2005).

d. Applicability Of The Discovery Stay On Renewed Motions To Dismiss

A denial of a defendant’s motion to dismiss does not automatically and indefinitely lift the discovery stay. Forexample, in In re Salomon Analyst Litigation, 373 F. Supp. 2d 252 (S.D.N.Y. 2005), the district courtreimposed the automatic stay for renewed motions to dismiss, even after the first motion was denied, becausethe second motion was clearly not frivolous but was prompted by a recent decision that might impact thevalidity of the case. Similarly, in Selbst v. McDonald’s Corp., No 04 C 2422, 2006 WL 566450 (N.D. Ill. Mar.1, 2006), the district court re-imposed the discovery stay, even though plaintiff’s original complaint survived amotion to dismiss, because plaintiff chose to file an amended complaint, which defendants moved to dismiss.

e. The Discovery Stay And Related State Actions

1) Motions To Stay Discovery Brought In Federal Court

Plaintiffs sometimes seek to skirt the constraints of the Reform Act’s discovery stay by filing one or moreparallel actions in state court, either as shareholder derivative actions or as individual actions. To preventplaintiffs from such improper circumvention, defendants should bring a motion to stay discovery in federalcourt pursuant to the Securities Litigation Uniform Standards Act of 1998 (the “Uniform Standards Act”). TheUniform Standards Act expressly provides that, upon a proper showing, a court may stay discovery proceedingsin any private action in state court “as necessary in aid of its jurisdiction, or to protect or effectuate itsjudgments.” 15 U.S.C. § 78u-4(b)(3)(D); see also Angell Inv. v. Purizer Corp., No. 01 C 6359, 2001 WL1345996 (N.D. Ill. Oct. 31, 2001) (granting defendants’ motion to stay discovery of both federal securitiesclaims and related state law claims, prior to the outcome of the defendant’s motion to dismiss); Newby v. EnronCorp., 338 F.3d 467, 473 (5th Cir. 2003) (holding the discovery stay provisions of the Reform Act “apply tostays of discovery in any private, class or nonclass, action in state court”); In re Countrywide Fin. Corp.Derivative Litig., 524 F. Supp. 2d 1160, 1179 (C.D. Cal. 2008) (holding Reform Act’s discovery stay applied toderivative actions arising under the Securities and Exchange Act of 1934). But see Tobias Holdings, Inc. v.Bank United Corp., 177 F. Supp. 2d 162, 169 (S.D.N.Y. 2001) (holding automatic discovery stay does notprohibit discovery on non-fraud common law claims arising under court’s diversity jurisdiction).

At least one court has held that the procedural safeguards created by the Reform Act are so important thatefforts by state court plaintiffs to circumvent its protections could be enjoined by a federal court even in caseswhere the Uniform Standards Act does not apply. See In re BankAmerica Corp. Sec. Litig., 263 F.3d 795 (8thCir. 2001). The Eighth Circuit upheld a ruling of the district court staying parallel state court proceedings intheir entirety, reasoning that “the PSLRA expressly authorized an injunction against the state proceedings …based upon the tortuous path the state court litigation had taken, [it] was but an end run around the PSLRA.” Id. at 804.

2) Motions To Stay Discovery Brought In State Court

Defendants may find it necessary to file a motion to stay discovery in the related state court action or file amotion to coordinate discovery and pretrial proceedings with the federal litigation. Both federal and state courtsare equipped to mitigate inefficiencies of parallel actions by coordinating discovery. See Carpenter v. WichitaFalls Indep. Sch. Dist., 44 F.3d 362, 371 (5th Cir. 1995).

California courts have recognized that trial courts should play a larger role in managing modern discovery. See,e.g., Calcor Space Facility, Inc. v. Superior Court, 53 Cal. App. 4th 216, 221, 223, 225 (1997) (explainingCalifornia Code of Civil Procedure vests the court with authority to craft reasonable discovery procedures,forestall unnecessary discovery, and impose reasoned case management objectives). Coordination of state andfederal actions falls within statutory authority and the court’s inherent power to control its docket and regulateproceedings. See, e.g., Lewis v. County of Sacramento, 218 Cal. App. 3d 214 (1990). But see David v. Wolfen,Minute Order, No. 01 CC0390 (Cal. Super. Ct. Dec. 12, 2001) (denying defendants’ motion to stay discovery ina state derivative action pending defendants’ challenge to plaintiffs’ standing and pending resolution of motionto dismiss in federal court).

3) Motions To Stay Proceedings Brought In State Court

Defense counsel may also find it necessary to file a motion to stay the entire proceedings in the related statecourt action. In such cases, state law may provide ample support. For example, in California, courts havebroad discretion to stay a state court proceeding to “avoid a multiplicity of suits and prevent vexatiouslitigation, conflicting judgments, confusion and unseemly controversy between litigants and courts.” Simmonsv. Superior Court, 96 Cal. App. 2d 119, 125 (1950).

In California, when an earlier action, including a federal action, has been filed covering the same subject matter,the relevant factors for issuing a stay are: (1) “the importance of discouraging multiple litigation designedsolely to harass an adverse party;” (2) the importance “of avoiding unseemly conflicts with the courts of otherjurisdictions;” (3) “whether the rights of the parties can best be determined by the court of the other jurisdictionbecause of the nature of the subject matter, the availability of witnesses, or the stage to which the proceedingsin the other court have already advanced;” and (4) whether “the federal action is pending in California not someother state.” Caiafa Prof. Law Corp. v. State Farm Fire & Cas. Co., 15 Cal. App. 4th 800, 804 (1993) (quotingFarmland Irr. Co., Inc. v. Dopplmaier, 48 Cal. 2d 208, 215 (1957)); see also Schimmel Family Trust v.Morgenthaler, No. 842137 (Cal. Super. Ct. Nov. 7, 2001) (following Caiafa and granting defendants’ motion tostay the entire proceedings in a consolidated derivative action until the earlier of the filing of an answer bydefendants in the federal action or dismissal of that action “because the damages, if any, to the corporation areto be determined in the federal action”).

California courts have also recognized that it is “unreasonable and illogical” to litigate the same issuessimultaneously in two separate forums. See Bancomer, S.A. v. Superior Court, 44 Cal. App. 4th 1450, 1462(1996); see also Schneider v. Vennard, 183 Cal. App. 3d 1340, 1348 (1986) (dismissing state class action infavor of federal class action because principles of “[j]udicial economy and efficiency” are violated when theresources of two already “overtaxed” courts are devoted to the resolution of a single dispute). To avoid thiswaste of judicial resources, California courts have held that an action should be stayed if the parties and issuesinvolved are “substantially identical” to those in another action. Thomson v. Cont’l Ins. Co., 66 Cal. 2d 738,746 (1967); see also Berg v. MTC Elec. Techs., 61 Cal. App. 4th 349, 356 (1998) (granting stay in favor offederal cases where both actions were based on allegations of fraud and misrepresentations in connection withthe sale of securities). A stay “conserve[s] judicial and other resources which would otherwise be consumed inlitigation of some issues which will likely be resolved by [the federal court].” Pac. Bell v. Superior Court, 187Cal. App. 3d 137, 140 (1986).

In determining the appropriate length of the stay, at least one court looked to effectuate the purposes of theReform Act and the Uniform Standards Act by staying proceedings in a state derivative action until theresolution of a motion to dismiss a previously filed federal securities action. See Schimmel Family Trust v.

Morgenthaler, No. 842137 (Cal. Super. Ct., Nov. 7, 2001).

3. Depositions

Much of the early discovery period in securities class actions will focus on defendants’ production ofdocuments, often involving motion practice regarding the proper scope of relevant documents in light of theallegations in the case. Plaintiffs will typically wait until after they have received the majority of defendants’production before noticing the depositions of defendants and company employees.

However, plaintiffs may depose (and seek documents from) third parties such as analysts, customers, suppliersor competitors in the interim. Plaintiffs may also use corporate depositions under Rule 30(b)(6) to obtaintestimony on specific substantive areas when they are not sure who might have the requisite information andwhen they do not feel compelled to have all the relevant documents prior to obtaining testimony. Plaintiffs willoften seek to expand the statutory limit of ten depositions per side early in the case so that they will not beconstrained in scheduling depositions. Defendants should seek to limit the number of depositions allowed atthe outset.

a. Ten Deposition Statutory Limit

Fed. R. Civ. P. 30(a)(2)(A)(i) imposes a ten-deposition limit on parties in federal court. A party seeking toexceed the statutory limit must seek leave of court and justify its request “consistent with the principles stated inRule 26(b)(2).” Rule 26(b)(2) requires inquiry into three factors: (1) whether the discovery sought iscumulative or duplicative or is obtainable from another source that is more convenient, less burdensome, or lessexpensive; (2) whether the party seeking discovery has had ample opportunity to obtain the information sought;and (3) whether the burden or expense of the proposed discovery outweighs its likely benefit given the contextof the case. See Bell v. Fowler, 99 F.3d 262, 271 (8th Cir. 1996) (upholding denial of plaintiff’s request to takeadditional depositions because plaintiff failed to justify why additional depositions were necessary and notcumulative); Siegel v. Truett-McConnell Coll., Inc., 13 F. Supp. 2d 1335, 1338 (N.D. Ga. 1994), aff’d, 73 F.3d1108 (11th Cir. 1995) (finding plaintiff’s request to take additional depositions that were unnecessary to resolvelitigation burdensome); Archer Daniels Midland Co. v. Aon Risk Servs., Inc. of Minn., 187 F.R.D. 578, 587 (D.Minn. 1999) (denying a motion to expand the permissible number of depositions from twenty to forty-sevenbecause “[a]t a minimum, Aon should appropriately exhaust its current quota of depositions, in order to makean informed request for an opportunity to depose more witnesses, before seeking leave to depose a legion ofothers”); Barrow v. Greenville Indep. Sch. Dist., 202 F.R.D. 480, 483 (N.D. Tex. 2001) (finding positing ingeneral and conclusory terms the materiality of a desired deponent is insufficient); DiBartolo v. City ofPhiladelphia, No. CIV. A. 99-1734, 2001 WL 872835, at *1-2 (E.D. Pa. June 26, 2001) (finding plaintiff’srequest for additional depositions premature because it could not be known at the early stages of discoverywhether additional discovery was necessary).

b. Rule 30(b)(6) Depositions

Rule 30(b)(6) states that:

[a] party may in the party’s notice and in a subpoena name as the deponent a public or privatecorporation . . . and describe with reasonable particularity the matters on which examination isrequested. In that event, the organization so named shall designate one or more officers, directors, ormanaging agents, or other persons who consent to testify on its behalf, and may set forth, for each persondesignated, the matters on which the person will testify. . . . The persons so designated shall testify as tomatters known or reasonably available to the organization.

1) Speaking For The Corporation

The testimony elicited at the Rule 30(b)(6) deposition represents the knowledge of the corporation, not of theindividual deponent. The designated witness is “speaking for the corporation,” and this testimony must bedistinguished from that of a “mere corporate employee” whose deposition is not considered that of thecorporation and whose presence must be obtained by subpoena. 8A Charles Alan Wright, Arthur R. Miller &Richard L. Marcus, Federal Practice & Procedure § 2103, at 36-37 (West 2007); Lapenna v. Upjohn Co., 110F.R.D. 15, 21 (E.D. Pa. 1986); Toys “R” Us, Inc. v. N.B.D. Trust Co., No. 88 C 10349, 1993 WL 543027, at *2(N.D. Ill. Sept. 29, 1993); United States v. Mass. Indus. Fin. Agency, 162 F.R.D. 410, 412 (D. Mass. 1995). Moreover, the designee must not only testify about facts within the corporation’s knowledge, but also about itssubjective beliefs and opinions. Lapenna, 110 F.R.D. at 20. The corporation must provide its interpretation ofdocuments and events. Ierardi v. Lorillard, Inc., No. CIV. A. 90-7049, 1991 WL 158911 (E.D. Pa. Aug. 13,1991).

Testimony by a Rule 30(b)(6) designee, although binding on the corporation, is not tantamount to a judicialadmission. As with deposition testimony of individuals, Rule 30(b)(6) testimony is only a statement of thecorporate person which, if altered, may be explained and explored through cross-examination as to why theopinion or statement was altered. W.R. Grace & Co. v. Viskase Corp., No. 90 C 5383, 1991 WL 211647 (N.D.Ill. Oct. 15, 1991). However, defense counsel should be aware that the designee can make an admission againstinterest which, under Federal Rule of Evidence 804(b)(3), is binding on the corporation. Ierardi, 1991 WL158911, at *3.

2) Designation Of Knowledgeable Persons

A corporation must “make a conscientious good-faith endeavor to designate the persons having knowledge ofmatter sought by [the discovering party] and to prepare those persons in order that they could answer fully,completely, and unevasively, the questions posed by [the discovering party] as to the relevant subject matter.” Mitsui & Co. v. P.R. Water Res. Auth., 93 F.R.D. 62, 67 (D.P.R. 1981); see also F.D.I.C. v. Butcher, 116 F.R.D.196 (E.D. Tenn. 1986) (explaining corporation must not only produce such number of persons as will satisfythe request, but more importantly, prepare them so that they may give complete, knowledgeable, and bindinganswers on behalf of the corporation), aff’d, 116 F.R.D. 203 (E.D. Tenn. 1987). If no current employee hassufficient knowledge to provide the requested information, the party is obligated to prepare one or morewitnesses, to the extent possible, so that they may give complete, knowledgeable, and binding answers onbehalf of the corporation. Also, if during the course of a deposition the designee becomes obviously deficient,the corporation is obligated to provide a substitute. See Dravo Corp. v. Liberty Mut. Ins. Co., 164 F.R.D. 70 (D.Neb. 1995).

F. Privilege Considerations

1. Public Policies Supporting The Attorney-Client Privilege And Work ProductDoctrine

A plaintiff is likely to argue that a court should grant a motion to compel production of privileged materialbecause of policies supporting discovery of relevant information concerning the facts in dispute. In response, adefendant should emphasize the important public policy considerations underlying the attorney-client privilege. See, e.g., Trammel v. United States, 445 U.S. 40, 51 (1980) (“The lawyer-client privilege rests on the need forthe advocate and counselor to know all that relates to the client’s reasons for seeking representation if theprofessional mission is to be carried out.”); Upjohn Co. v. United States, 449 U.S. 383, 389 (1981) (noting thatas the “oldest of the privileges for confidential communications known to the common law,” the attorney-clientprivilege aims “to encourage full and frank communication between attorneys and their clients” and “thereby to

promote broader public interests in the observance of law and administration of justice”); Saito v. McKessonHBOC, Inc., No. CIV. A. 18553, 2002 WL 31657622, at *6 (Del. Ch. Nov. 13, 2002) (“[P]ublic policy seems tomandate that courts continue to protect the confidentially disclosed work product in order to encouragecorporations to comply with law enforcement agencies.”).

2. Attorney-Client Privilege Issues

One of the most important issues during discovery for defendants is preserving the attorney-client privilege andany attorney work product from discovery by plaintiffs. Both in producing documents and in preparingwitnesses for depositions, counsel should be acutely aware of any potential attorney-client privilege issues thatmay arise with in-house or outside counsel and the names of those lawyers.

a. Immunity From Disclosure

It is well settled under both state and federal law that confidential attorney-client communications are immunefrom discovery by an adverse party. See, e.g., In re Grand Jury Subpoena Duces Tecum, 731 F.2d 1032, 1036(2d Cir. 1984) (setting forth elements of attorney-client privilege).

b. Relevance Of Communications And Challenges To Privilege

Confidential attorney communications with a client may be relevant to discovering the accuracy of informationin an offering document, the results of due diligence investigations, the exercise of reasonable care underSections 11 or 12(2), the existence of scienter under Rule 10b-5, the absence of culpable knowledge orparticipation under Section 15, and good faith under Section 20(a). Therefore, these privileges may not survivein public offering litigation. Maintenance of the privilege can be tested when: (1) a client asserts a reliance-on-counsel defense; (2) privileged communications or work product of an attorney are disseminated to thirdpersons (e.g., a tax opinion included in offering materials); or (3) a plaintiff asserts a right to the privilegedmaterial under the “crime-fraud” exception to the attorney-client privilege and succeeds in making the requisiteshowing.

3. Reliance On Counsel Defense

a. Asserting Defense Waives Privilege

Several courts have held that asserting a reliance-on-counsel defense waives the attorney-client privilege as tocommunications on which the defense is based. See, e.g., In re von Bulow, 828 F.2d 94, 103 (2d Cir. 1987)(ruling attorney-client privilege cannot be used as both “a sword and a shield”); Joy v. North, 692 F.2d 880,893-94 (2d Cir. 1982) (holding that party waived the attorney-client privilege over a committee report when itused the report as the basis for a motion for summary judgment); Multiform Dessicants, Inc. v. Stanhope Prods.Co., Inc., 930 F. Supp. 45, 47 (W.D.N.Y. 1996) (“[D]eliberate injection of the advice of counsel into a casewaives the attorney-client privilege.”); Connell v. Bernstein-Macaulay, Inc., 407 F. Supp. 420, 423 (S.D.N.Y.1976) (ruling that the attorney-client privilege is waived when a litigant seeks to avoid a statutory protectionwhich has been established for his adversary’s benefit by a claim that his adversary is estopped to assert theprotection, and where there is a good-faith basis for believing that waiving the privilege would reveal thevalidity of the estoppel claim); Hearn v. Rhay, 68 F.R.D. 574, 581 (E.D. Wash. 1975) (noting assertion of goodfaith defense based on advice of counsel in a civil rights action impliedly waived the attorney-client privilegebecause “party asserting the privilege placed information protected by it in issue through some affirmative actfor his own benefit, and to allow the privilege to protect against disclosure of such information would have beenmanifestly unfair to the opposing party”); Garfinkle v. Arcata Nat’l Corp., 64 F.R.D. 688, 689 (S.D.N.Y. 1974)

(holding defendant waived privilege when he asserted as a defense that he had relied on an opinion of counselthat securities need not be registered despite contractual agreement to do so).

b. Limitation Of Implied Waiver

The Sixth Circuit in In re Grand Jury Proceedings, 78 F.3d 251 (6th Cir. 1996), rejected the argument that theassertion of a reliance on counsel defense resulted in a broad waiver of the attorney-client privilege. Rather, thecourt held that fairness required that the waiver be limited to communications on the same subject matter. Thecase was remanded to the district court with instructions to determine the scope of the waiver on a question-by-question basis. Id. at 256. Many courts have similarly taken a limited view of “implied waivers” in othercourts, including inadvertent disclosure. In Weil v. Investment/Indicators, Research & Management, Inc., 647F.2d 18 (9th Cir. 1981), the court refused to hold that a single, inadvertent disclosure of attorney-clientcommunications – that defendant had been advised by its Blue Sky counsel to register certain securities –waived the privilege as to all attorney-client communications. Instead, the court held that because thedisclosure occurred early in the case, was made to opposing counsel rather than the court, and did not prejudiceplaintiff, defendant “waived its privilege only as to communications about the matter actually disclosed.” Id. at25.

c. Assertion Of Defense Waives Accountant-Client Privilege

Several courts have held that by asserting reliance on a public accountant’s audit report as a defense inlitigation, a defendant waives the right to insist that the audit report was privileged and not subject todiscovery. See, e.g., Nashville City Bank & Trust Co. v. Reliable Tractor, Inc., 90 F.R.D. 709, 712 (M.D. Ga.1981); Savino v Luciano, 92 So. 2d 817 (Fla. 1957).

4. Dissemination Of Information To Third Parties

a. No Privilege, Or Implied Waiver

Several courts have held that the attorney-client privilege does not protect communications concerningmaterials disseminated or proposed to be disseminated to third persons. However, when considering whetherthe privilege was waived, courts have found that revealing the general topic of discussion between an attorneyand client does not waive the privilege, unless the revelation also reveals the substance of the protectedcommunication. See New Jersey v Sprint Corp., 258 F.R.D. 421, 426 (D. Kan. 2009) (finding that individualclass action defendants did not waive the attorney-client privilege by partially disclosing legal advice duringtheir deposition because individuals did not testify as to the substance of any legal advice). While some courtstreat third party communications as an implied waiver of otherwise privileged information, others held that noprivilege attaches to the communications at all.

In In re Grand Jury Proceedings, the Fourth Circuit held that the attorney-client privilege did not extend to thecommunication of information intended to be used in preparing a prospectus that “was to be published to othersand was not intended to be kept in confidence.” 727 F.2d 1352, 1358 (4th Cir. 1984). The court therefore heldthat the privilege never attached to such communications in the first place. The court reasoned that privilegedcommunications were limited to those that the client expressly made confidential or would reasonably assumeunder the circumstances would be understood by the attorney as so intended. Id. at 1355-56.

In United States v. Jones, the Fourth Circuit held that the attorney-client privilege did not apply to“correspondence and instructions or directions, written or verbal … [and] any documents and research notesused in preparation of [tax law opinions]” where:

[t]he success of appellants’ business venture depended upon convincing potential investors thatpurported tax benefits existed in fact, and this rested on interpretations of the tax laws. The appellantsnot only obtained the tax law opinions for the ultimate use of persons other than themselves, but alsopublicized portions of the legal opinions in brochures and other printed material. They cannot nowassert a right to quash the subpoenas (1) to block the grand jury’s access to documents substantialportions of which the appellants have published to the public at large, or (2) to prevent the revelationof the factual communications between the appellants and their attorneys underlying the publishedopinion letters.

696 F.2d 1069, 1071, 1073 (4th Cir. 1982).

In United States v. Cote, the Eighth Circuit held that the attorney-client privilege was waived as to accountantwork papers prepared at the direction of counsel, which reflected the entries later appearing in a non-confidential tax return. 456 F.2d 142 (8th Cir. 1972). The court observed that any dispute “as to whetherparticular work papers contain detail of unpublished expressions which are not part of the data revealed on thetax returns, should be submitted to the district court for an in camera ruling.” Id. at 145 n.4 (emphasis added). The Eighth Circuit treated the issue as one of waiver of privilege.

In Ryan v. Gifford, No. Civ. A. 2213-CC, 2007 WL 4259557 (Del. Ch. Nov. 30, 2007), the Delaware Court ofChancery held that the defendant company’s special committee – i.e., not a special litigation committee underZapata – waived the attorney-client privilege as to all communications between the special committee and itscounsel by making a presentation at a meeting for the board of directors where some of the board memberspresent were individual defendants “whose interests are not common with the client.” Id. at *3. The courtordered that the company, its special committee and the committee’s counsel produce to plaintiffs all materialrelated to the committee’s options backdating investigation that was previously withheld on the basis ofattorney-client privilege. See id. at * 2-3.

The company subsequently sought certification for interlocutory appeal of the Chancery Court’s order toproduce all communications between the special committee and its counsel. In Ryan v. Gifford, No. Civ. A.2213-CC, 2008 WL 43699 (Del. Ch. Jan. 2, 2008), the Chancery Court denied the application. The courtemphasized that the work product of the special committee’s counsel had been used by defendant directors todefend themselves, the directors obtained the information in their individual as opposed to fiduciary capacities,and the special committee lacked the power to act independently, but was required to report back to the fullboard. See id. at *5-7.

b. No Implied Waiver

Other courts have looked closely at the substance and circumstances of the information shown to third partiesand concluded that dissemination of such information did not constitute a waiver of confidentialcommunications.

In In re Grand Jury Subpoena Duces Tecum, the Second Circuit rejected the proposition that disclosure to athird person of documents prepared by an attorney for his client destroys the confidentiality of all otherattorney-client communications relating to the same subject matter. 731 F.2d 1032 (2d Cir. 1984). The courtheld that documents relating to a company’s request for tax advice were covered by the attorney-client privilegeeven though some of the information contained in the documents might be given to non-control groupemployees or to outsiders. Id. at 1037. The court observed that:

the attorney-client privilege protects communications rather than information; the privilege does notimpede disclosure of information except to the extent that the disclosure would reveal confidentialcommunications. Thus, the fact that certain information in the documents might ultimately bedisclosed to AG employees did not mean that the communications to [the company’s attorney] wereforeclosed from protection by the privilege as a matter of law. Nor did the fact that certain

information might later be disclosed to others create the factual inference that the communicationswere not intended to be confidential at the time they were made.

Id. The court stressed that the privilege analysis must focus on the communication rather than the subjectmatter:

For example, although some of the documents appear to be drafts of communications … which mighteventually be sent to other persons, and as distributed would not be privileged, we see no basis in therecord for inferring that AG did not intend that the drafts – which reflect its confidential requests forlegal advice and were not distributed – to be confidential.

Id.; see also United States v. Ackert, 169 F.3d 136, 139 (2d Cir. 1999) (holding that attorney-client privilege canprotect communications with a third party only where the third party assists in translating or interpretinginformation between the attorney and client).

In Sylgab Steel & Wire Corp. v. Imoco-Gateway Corp., the court rejected the argument that, because plaintiff’sattorney in a patent infringement action had sent an “opinion letter” to the defendant stating that the plaintiff’spatent was valid, the attorney-client privilege as to all confidential communications concerning the subjectmatter of the opinion letter was waived. 62 F.R.D. 454 (N.D. Ill. 1974), aff’d, 534 F.2d 330 (7th Cir. 1976). The court observed:

a party cannot waive its privilege merely if its lawyer, bargaining on its behalf, contends vigorouslyand even in some detail that the law favors his client’s position on a point in issue – whether that pointis the contested validity of a patent or the contested validity of a contract or some other matter.… Clients and lawyers should not have to fear that positions on legal issues taken during negotiationswaive the attorney-client privilege so that the confidential facts communicated to the attorney and theprivate opinions and reports drafted by an attorney for his client become discoverable.

Id. at 458. The court noted that the specifics of the confidential communications were not disclosed in theopinion letter. Id. As such, the attorney-client privilege was not waived. Id.

In Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc., 229 F.R.D. 441, 458 (S.D.N.Y. 2004), the court heldthat the reports of an investigation conducted by counsel did not lose work product protection simply becausetheir contents had been disclosed to the company’s independent auditors. The court observed:

any tension between an auditor and a corporation that arises from an auditor’s need to scrutinize andinvestigate a corporation’s records and book-keeping practices simply is not the equivalent of anadversarial relationship contemplated by the work product doctrine. [T]o construe a company’sauditor as an adversary and find a blanket rule of waiver of the applicable work product privilegeunder these circumstances could very well discourage corporations from conducting a critical self-analysis and sharing the fruits of such an inquiry with the appropriate actors.

Id. at *6-7. But see United States v. Ruehle, 83 F.3d 600 (9th Cir. 2009) (ruling that statements made by theCFO to attorneys conducting an internal investigation on option backdating were not privileged because theCFO failed to establish that the statements were “made in confidence.”

In Duplan Corp. v. Deering Milliken, Inc., 397 F. Supp. 1146, 1191 (D.S.C. 1974), the court observed “[t]hevoluntary waiver by a client, even without limitation, of one or more nonprivileged documents passing betweenthe same attorney and the same client discussing the same subject does not waive the privilegedcommunications between the same attorney and the same client on the same subject.” Id (emphasis added);accord Champion Int’l Corp. v. Int’l Paper Co., 486 F. Supp. 1328, 1330 n.2 (N.D. Ga. 1980).

In Chase Manhattan Bank N.A. v. Drysdale Sec. Corp., 587 F. Supp. 57 (S.D.N.Y. 1984), the court rejected theargument that an implied waiver of the attorney-client privilege occurs whenever protected confidential

communications relate to an issue in litigation. The court denied defendant’s motion to compel discovery ofprivileged, confidential communications between plaintiff and its counsel concerning a securities transactioneven though “justifiable reliance” by plaintiff was an issue in the litigation. The court dismissed defendant’scontention that by filing a securities fraud action, plaintiff placed all communications relating to the reliancequestion in issue and subject to discovery: “While it may be useful [for defendant] to know the substance of theadvice [plaintiff] received concerning its liability on the transaction, I do not believe that the communicationsare essential to establish of what a reasonably prudent bank should have known and should have done under thecircumstances.” Id. at 58; accord Tribune Co. v. Purcigliotti, No. 93 CIV. 7222 LAP THK, 1997 WL 10924(S.D.N.Y. Jan. 10, 1997), modified, 1998 WL 175933 (S.D.N.Y. Apr. 14, 1998).

c. Prejudice

Several courts have refused to find an implied waiver unless a party is able to show prejudice resulting from theassertion of the privilege. S.E.C. v. Lewis, No. CIV-2-83-228, 1984 WL 2451 (E.D. Tenn. May 31, 1984);accord Champion Int’l, 486 F. Supp. at 1333; Hearn v. Rhay, 68 F.R.D. 574, 581 (E.D. Wash. 1975).

d. Joint Defense Privilege

Courts will extend the attorney-client privilege to legal communications with third parties where a communityof interests exists between the parties. See, e.g., United States v. Aramony, 88 F.3d 1369, 1391 (4th Cir. 1996);United States v. Bergonzi, 214 F.R.D. 563 (N.D. Cal. 2003), amended on other grounds, 216 F.R.D. 487 (N.D.Cal. 2003) (holding the claimed common interest between company and the government to determine ifcompany’s employees violated securities laws was not the same as the common interest shared by alliedlawyers and clients who are working together); See also Louisiana Mun. Police Employees Ret. Sys. v. SealedAir Corp., 253 F.R.D. 300, 310 (D.N.J. 2008) (holding although “parties were on adverse sides of a businessdeal” the common interest doctrine still protects their communications because “the weight of case law suggeststhat, as a general matter, privileged information exchanged during a merger between two unaffiliated businesseswould fall within the common-interest doctrine”) (internal citations omitted).

e. Dissemination To Regulatory Agencies

Defense attorneys in securities litigation often find themselves dealing with regulatory agencies and criminalauthorities as well as with civil plaintiffs. An issue often arises as to whether responses to informalinvestigative requests by regulatory agencies will be subsequently discoverable by plaintiffs.

1) Waiver Of Privilege?

In In re Steinhardt Partners, L.P., the Second Circuit held that the voluntary submission of material to the SECwaived the protection of the work-product doctrine. 9 F.3d 230 (2d Cir. 1993). The Court of Appeals upheldthe finding of the lower court that the SEC stood in an adversarial position, and thus no common interestexisted. Id. at 234. Any material handed over to the SEC could be obtained by private litigants. Id. at 236; seealso In re Initial Pub. Offering Sec. Litig., No. 21 MC 92 (SAS), 2004 WL 60290 (S.D.N.Y. Jan. 12, 2004)(concluding Wells submissions to the SEC are not protected from discovery merely because they may containan offer of settlement and that the discovery of settlement materials is not governed by a different standard thanother documents under the Federal Rules of Civil Procedure).

The Second Circuit noted, however, that rules relating to privilege in government investigations must be craftedon a case-by-case basis, and that privilege might not be waived where the disclosing party and the governmentshare a common interest or the SEC and the disclosing party have entered into a confidentiality agreement. See

id. at 235.

Other circuits have also found such a waiver. See Westinghouse Elec. Corp. v. Republic of Philippines, 951F.2d 1414 (3d Cir. 1991) (finding party waived work product and attorney-client privilege upon voluntarydisclosure of information to SEC and Department of Justice); In re Subpoenas Duces Tecum, 738 F.2d 1367(D.C. Cir. 1984) (same); In re Initial Pub. Offering Sec. Litig., 249 F.R.D. 457 (S.D.N.Y. 2008) (rejecting theselective waiver theory and ordering defendant to turn over internal investigation documents to plaintiffs due tovoluntary disclosure of the documents to the SEC and Department of Justice, despite the existence of aconfidentiality agreement); United States v. Bergonzi, 214 F.R.D. 563 (N.D. Cal. 2003) (holding company’sdisclosure of documents to the government waives the attorney-client privilege and work product doctrine evenif a confidentiality agreement exists between the company and the government); In re Kidder Peabody Sec.Litig., 168 F.R.D. 459, 470 (S.D.N.Y. 1996) (disclosing report to SEC in litigation results in waiver of workproduct and attorney-client privilege).

The California Court of Appeals in McKesson HBOC v. Superior Court, 115 Cal. App. 4th 1229 (2004),affirmed that attorney-client and work product privileges are waived (and the relevant documents arediscoverable to plaintiffs in civil litigation) by disclosure of counsel’s investigation to government agencies,despite the claim of a common interest and the existence of a “confidentiality agreement.” The court joinedothers rejecting the “selective waiver” doctrine urged by the SEC and SIA as amici.

2) Selective Waiver Theory

In Diversified Industries v. Meredith, the Eighth Circuit sitting en banc held that the voluntary disclosure ofmaterial to the SEC does not constitute a waiver. 572 F.2d 596 (8th Cir. 1977). The disclosure was in “aseparate and nonpublic SEC investigation” and, as such, only a limited waiver applied. Id. at 611. Subsequentcourts have described the DIVERSIFIED rule as one of “selective waiver.” See Steinhardt, 9 F.3d at 235.

In Saito v. McKesson HBOC, Inc., the chancellor held that voluntary disclosure to the SEC pursuant to aconfidentiality agreement does not constitute a waiver. No. CIV. A. 18553, 2002 WL 31657622 (Del. Ch.Nov. 13, 2002). A reasonable expectation exists that such documents submitted “to the SEC under aconfidentiality agreement would not reach the hands of its other adversaries.” Id. at *7. Other courts have alsoapplied the selective waiver theory when a confidentiality agreement between the company and the regulatoryagency exists. See Permian Corp. v. United States, 665 F.2d 1214, 1218 (D.C. Cir. 1981) (upholding trialcourt’s conclusion that a confidentiality agreement was in place before disclosures were made to the SEC andthat this agreement prevented waiver of the work product privilege as to those documents).

Despite the above authorities, significant risk of a waiver occurs upon voluntary disclosure of materials toregulators, as many courts have rejected the doctrine of selective waiver. For example, in In re QwestCommunications International Inc., 450 F.3d 1179 (10th Cir. 2006), the Tenth Circuit refused to adopt the“selective waiver” or “limited waiver” approach, under which a cooperating company could produce attorney-client privileged and work-product protected documents to the DOJ or SEC without waiver of further protectionfor those materials. See also Westinghouse Elec. Corp., 951 F.2d at 1431 (finding waiver of privilege despiteconfidentiality agreement).

f. Federal Rule Of Evidence 502

A new rule addressing the issues of attorney-client privilege and work product waiver was enacted inSeptember 2008. FRE 502(a) limits subject matter waivers in instances of intentional disclosure, providing thatthe waiver extends to undisclosed privileged or protected communications on the “same subject matter” only if“they ought in fairness to be considered together.” Fed. R. Evid. 502(a) (2009). FRE 502(b) goes on to addressinadvertent disclosures and bars a waiver finding in certain instances. Fed. R. Evid. 502(b) (2009). It remains

to be seen how these and other subsections of Rule 502 will be interpreted by the courts.

g. Sarbanes-Oxley “Professional Responsibility” Dissemination

On January 23, 2003, the SEC adopted final rules to implement Section 307 of the Sarbanes-Oxley Act andthus set standards of professional conduct for attorneys appearing and practicing before the SEC in therepresentation of an issuer. These rules became effective August 5, 2003, 180 days after they were published inthe Federal Register. The rules mandate, under certain circumstances, the upward dissemination of informationwithin a company.

1) Duty To Report Evidence Of A Material Violation

If an attorney becomes aware of evidence of, or has reason to suspect, a material violation by the company orany of its directors, officers or employees, such attorney is required to notify (1) the Chief Legal Officer(“CLO”) or (2) the CLO and Chief Executive Officer (“CEO”). 17 C.F.R. § 205.3(b)(1). A material violation isdefined as “a material violation of an applicable US federal or state securities law, a material breach offiduciary duty arising under US federal or state law, or similar material violation of any US federal or statelaw.” 17 C.F.R. § 205.2(h)(i). If the attorney does not receive an “appropriate response” (as defined in 17C.F.R. § 205.2(b)) from the CLO or CEO, the attorney is required to report “up the ladder” to the auditcommittee, another committee comprising of completely independent directors, or the entire board of directorsif the company does not have a committee consisting of independent directors. 17 C.F.R. § 205.3(b)(3)(i)-(iii). Alternatively, in lieu of reporting to the CLO or CLO & CEO, the attorney may report evidence of the materialviolation to a qualified legal compliance committee (“QLCC”) – a committee comprised of independentmembers of the board of directors established primarily to handle reports of such violations. 17 C.F.R.§ 205.3(c). The SEC has confirmed that by communicating to the company’s officers or directors, the attorneyis not waiving the attorney-client privilege with regard to such information. 17 C.F.R. § 205.3(b)(1).

2) Disclosure Of Confidential Information

An attorney who fails to report a material violation may be subject to civil penalties or remedies, as well asdisciplinary action by the SEC. 17 C.F.R. § 205.(6)(a)-(b). Therefore, an attorney is allowed to use any reportof a material violation or any response thereto in connection with any investigation, proceeding, or litigation inwhich the attorney’s compliance is an issue. 17 C.F.R. § 205.3(d)(1). Furthermore, an attorney “may reveal tothe SEC, without the issuer’s consent,” confidential information related to the representation to the extent theattorney reasonably believes it necessary:

(a) to prevent the [company] from committing a material violation that is likely to cause substantial injury tothe financial interest or property of the company or investors;

(b) to prevent the [company in an SEC] investigation or administrative proceeding from committing perjury,suborning perjury, or committing any act that is likely to perpetrate a fraud upon the [SEC]; or

(c) to rectify the consequences of a material violation by the [company] that caused, or may cause,substantial injury to the financial interest of the [company] or investors in the furtherance of which theattorney’s services were used.

17 C.F.R. § 205.3(d)(2) (emphasis added). The final rules do not state whether revealing such confidentialinformation to the SEC will result in the waiver of any attorney-client privilege or work product.

5. Crime-Fraud Exception

Attorney-client communications in furtherance of criminal or fraudulent acts are not protected from disclosure. See In re Richard Roe, Inc., 68 F.3d 38, 40 (2d Cir. 1995). A communication is in furtherance of criminal orfraudulent acts when it facilitates or conceals the wrongful acts. Id. at 40. In order to gain an in camera reviewof the attorney-client communications by the court to determine the applicability of the crime-fraud exception,the party seeking discovery must make a threshold showing sufficient to support a reasonable belief that a crimeor fraud was planned or committed. United States v. Zolin, 491 U.S. 554, 563 (1989); see also In re Nat’lMortgage Equity Corp. Mortgage Pool Certificates Litig., 116 F.R.D. 297 (C.D. Cal. 1987). In addition, thecrime-fraud exception, if applicable, can also be used to abrogate attorney work-product protection. Id.

6. The Accountant-Client Privilege

a. No Federal Accountant-Client Privilege

The absence of a federal common law accountant-client privilege is well settled. See United States v. ArthurYoung & Co., 465 U.S. 805 (1984); Couch v. United States, 409 U.S. 322, 335 (1973).

b. State Statutory Privilege

Several states have an established statutory accountant-client privilege protecting confidential communicationsbetween accountant and client. See Wright & Miller, Accountant’s Privilege, 23 Fed. Prac. & Proc. Evid.§ 5427 (R 501); see, e.g., Ariz. Rev. Stat. Ann. § 32-749; Colo. Rev. Stat. Ann. § 154-1-7(7); Fla. Stat. Ann.§ 473.141; Ga. Code Ann. § 84-216; Ida. R. Ev. 515; Ill. Rev. Stat. Ch. 110 1/2, § 51; Ind. Code § 25-2.1-14-2;Iowa Code § 116.15; Ky. Rev. Stat. § 325.440; La. Rev. Stat. Ann. § 37.85; Md. Ann. Code, art. 75A, § 20;Mich. Comp. Laws § 338.523; Miss. Code § 73-33-16(2); Mo. Rev. Stat. § 326.151; Mont. Code Ann 37-50-402; Nev. Rev. Stat. §§ 49. 125-.205; N.M. Stat. Ann. § 36-6-6(c); Pa. Stat. Ann., tit. 63, § 911a; P.R. LawsAnn., tit. 20, § 790; Tenn. Code Ann. § 61-1-116; Tex. Rev. Civ. Stats., Art. 41a-1, sec. 26.

c. Federal Court – Federal Rules Of Evidence Apply

Rule 501 of the Federal Rules of Evidence provides in pertinent part:

the privilege of a witness … shall be governed by the principles of the common law as they may beinterpreted by the courts of the United States in the light of reason and experience. However, in civilactions and proceedings, with respect to an element or defense as to which State law supplies the rule ofdecision, the privilege of a witness … shall be determined in accordance with state law.

d. Federal Court – No Privilege If Both Federal And State Claims

In an action arising under federal question jurisdiction, but involving both federal and state causes of action,courts have held that a state statutory accountant-client privilege does not apply to any of the claims in thelitigation. See, e.g., F.D.I.C. v. Mercantile Nat’l Bank of Chicago, 84 F.R.D. 345 (N.D. Ill. 1979).

Counsel for accountant defendants nevertheless should consider either asserting the privilege or requesting acourt order on the privilege issue because accountants often are under a statutory duty to protect the confidentialcommunications of their clients or else risk disciplinary proceedings. See, e.g., Fla. Stat. Ann. § 473.323(providing that a breach of an accountant’s obligation to protect privileged materials could subject the

accountant to disciplinary action); Ross v. Popper, 9 B.R. 485 (S.D.N.Y. 1980) (noting that attorneys “quiteproperly” followed considerations of professional ethics by asserting attorney-client privilege in response topurported waiver by bankruptcy trustee).

e. Federal Court – Diversity Action

A state statutory accountant-client privilege may be asserted in a diversity case. See, e.g., Commercial UnionIns. Co. of Am. v. Talisman, Inc., 69 F.R.D. 490 (E.D. Mo. 1975) (noting that state-based accountant-clientprivilege could successfully be asserted by defendant-accountant in diversity action). Accordingly, in a federaldiversity or state court action, counsel for an accountant should pay close attention to choice of law issues.

7. Fifth Amendment Privilege

Due to the increased interest of the United States Attorney’s Office in securities fraud cases, one must considerinstructing a client to assert his or her Fifth Amendment privilege against self-incrimination in civil classactions. The Fifth Amendment to the U.S. Constitution provides in part that, “[n]o person … shall becompelled in any criminal case to be a witness against himself.” U.S. Const. amend. V. Of course, such astrategy may have serious ramifications in the civil proceeding. The following are a few issues to considerwhen advising a client to assert his or her Fifth Amendment privilege.

a. Corporations

The Fifth Amendment privilege against self-incrimination applies only to individuals and does not apply tocorporations, partnerships or other entities. See, e.g., United States v. Doe, 465 U.S. 605, 608 (1984); Bellis v.United States, 417 U.S. 85, 94 (1974); Hale v. Henkel, 201 U.S. 43, 69-70 (1906), overruled in part on othergrounds, Murphy v. Waterfront Comm’n of N.Y. Harbor, 378 U.S. 52 (1964).

b. Producing Documents

The privilege generally does not apply to the production of incriminatory documents. See United States v. Doe,465 U.S. 605, 610 (1984); S.E.C. v. First Jersey Sec., Inc., 843 F.2d 74, 76-77 (2d Cir. 1988). However, theprivilege may apply where the act of producing documents itself is a “testimonial act,” i.e., where by producingthe documents the party effectively admits their existence and authenticates them as its own. See Doe, 465 U.S.at 612; In re DG Acquisition Corp., 151 F.3d 75, 79-80 (2d Cir. 1998); In re Three Grand Jury SubpoenasDuces Tecum Dated January 29, 1999, 191 F.3d 173, 178 (2d Cir. 1999). The issue may turn on whether theindividual is a current or former employee. If the individual is a current employee of the corporation, theindividual holds the documents as a representative of the corporation and thus cannot assert the privilege even ifthe documents would incriminate the individual personally. See Braswell v. United States, 487 U.S. 99, 108-09(1988); In re Grand Jury Witnesses, 92 F.3d 710, 712 (8th Cir. 1996). On the other hand, if the individual is nolonger an employee, several courts have held that the individual may assert the Fifth Amendment privilegebecause the individual is no longer acting on behalf of the corporation. In re Grand Jury Proceedings, 71 F.3d723, 724 (9th Cir. 1995); Three Grand Jury Subpoenas, 191 F.3d at 183. But see In re Grand Jury SubpoenaDated November 12, 1991, 957 F.2d 807, 812 (11th Cir. 1992) (holding that a corporate custodian of recordscontinues to hold documents in a representative capacity even after his or her employment is terminated andtherefore may be compelled to produce them regardless of his or her Fifth Amendment right); In re Sealed Case(Gov’t Records), 950 F.2d 736, 740 (D.C. Cir. 1991) (same).

c. Adverse Inference

In a criminal proceeding, there can be no adverse comment on an individual’s decision to assert the FifthAmendment privilege. See, e.g., Baxter v. Palmigiano, 425 U.S. 308, 317 (1976); Griffin v. California, 380U.S. 609, 612 (1965). A defendant may also assert his or her Fifth Amendment privilege regarding any matterin a civil proceeding that may incriminate the individual criminally, but the court or jury may draw an adverseinference from the individual’s invocation of the privilege. See, e.g., Baxter, 425 U.S. at 318; Doe ex rel. Rudy-Glanzer v. Glanzer, 232 F.3d 1258, 1264 (9th Cir. 2000); S.E.C. v. Musella, 578 F. Supp. 425, 429-30(S.D.N.Y. 1984) (holding that the SEC can infer from an individual’s assertion of the Fifth Amendmentprivilege that the individual willfully violated the federal securities laws). Further, one court has even held thatan adverse inference may be drawn against a corporation from an employee’s assertion of the FifthAmendment. Brink’s, Inc. v. City of New York, 717 F.2d 700, 707-10 (2d Cir. 1983).

However, a finding of liability cannot be based solely on the adverse inference. See Curtis v. M&S Petroleum,Inc., 174 F.3d 661, 675 (5th Cir. 1999); Daniels v. Pipefitters’ Ass’n Local Union No. 597, 983 F.2d 800, 802(7th Cir. 1993); United States v. Premises Located at Route 13, 946 F.2d 749, 756 (11th Cir. 1991).

d. Preclusion Of Evidence

When an individual asserts his or her Fifth Amendment privilege against self-incrimination, a court maypreclude the individual from offering evidence on that issue at trial or allow the party to be impeached with hisor her silence on those matters. See, e.g., Harris v. City of Chicago, 266 F.3d 750, 753-54 (7th Cir. 2001); In reEdmond, 934 F.2d 1304, 1308-09 (4th Cir. 1991) (sustaining district court order striking affidavits opposingsummary judgment after parties refused to answer questions at depositions); Traficant v. C.I.R., 884 F.2d 258,265 (6th Cir. 1989) (upholding trial court’s order barring the defendant from introducing evidence on theauthenticity of his own statement and of tape recordings because he had invoked the Fifth Amendment and hadrefused to respond to discovery on those points); Gutierrez-Rodriguez v. Cartagena, 882 F.2d 553, 577 (1st Cir.1989) (“A defendant may not use the fifth amendment to shield herself from the opposition’s inquiries duringdiscovery only to impale her accusers with surprise testimony at trial.”). But see S.E.C. v. Greystone Nash, Inc.,25 F.3d 187, 192-94 (3d Cir. 1994) (holding that a party invoking the privilege is not prevented from presentingevidence to the fact-finder to support his own position).

8. Assertion Of “Work Product” Protection Over Identities Of ConfidentialWitnesses

The majority of district courts will reject a plaintiff’s effort to withhold the identities of confidential witnessesreferenced in the complaint. See Miller v. Ventro Corp., No. C01-01287SBA, 2004 WL 868202, at *2 (N.D.Cal. Apr. 21, 2004) (holding that a plaintiff must answer interrogatories seeking identity of confidentialwitnesses referred to in its complaint and thus rejecting plaintiff’s arguments that the identities of theconfidential witnesses constituted undiscoverable work product or that disclosure is unnecessary since theconfidential witnesses were presumably identified as part of its initial disclosures).

G. Motions For Summary Judgment

1. Legal Standard

Summary judgment is appropriate when “the pleadings, depositions, answers to interrogatories, and admissionson file, together with affidavits, if any, show that there is no genuine issue as to any material fact and that themoving party is entitled to a judgment as a matter of law.” Fed. R. Civ. P. 56(c); Celotex Corp. v. Catrett, 477U.S. 317, 325-26 (1986). A genuine issue is one where “the evidence is such that a reasonable jury could returna verdict for the nonmoving party.” Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986).

When ruling on a summary judgment motion, courts have refused to consider new theories and material

misstatements not previously included in a securities fraud complaint, reasoning that PSLRA’s deliberatescheme is thrown into disarray if new theories are permitted to be produced in response to a motion to dismiss. See In re St. Jude Medical, Inc., Sec. Litig., 629 F. Supp. 2d 915, 921 (D. Minn. 2009) (citing several cases).

a. Burden On Moving Party

The moving party bears the initial burden of identifying evidence that demonstrates the absence of a genuineissue of material fact. Celotex, 477 U.S. at 323; see also Devereaux v. Abbey, 263 F.3d 1070, 1076 (9th Cir.2001) (en banc) (“The Celotex ‘showing’ can be made by pointing out through argument the absence ofevidence to support plaintiff’s claim.”). Inferences that arise from direct evidence may constitute proofprovided they are “specific and substantial,” not merely speculative. See Bergene v. Salt River Project Agric.Imp. & Power Dist., 272 F.3d 1136, 1142 (9th Cir. 2001).

b. Opposing Party

Once this burden is satisfied, the opposing party must “set forth specific facts showing that there is a genuineissue of material fact in dispute.” In re Silicon Graphics Inc., Sec. Litig., 970 F. Supp. 746, 752 (N.D. Cal.1997); see also Celotex, 477 U.S. at 324. The court should view the evidence and any inferences that may bedrawn in a light most favorable to the nonmovant. See Adickes v. S.H. Kress & Co., 398 U.S. 144, 158-59(1970). Once the moving party has met that burden, the opposing party “may not rest upon the mere allegationsor denials of the adverse party’s pleading, but … must set forth specific facts showing that there is a genuineissue for trial.” Fed. R. Civ. P. 56(c); Anderson, 477 U.S. at 248. “To defeat a motion for summary judgment,the nonmoving party … must raise ‘significant probative evidence’ that would be sufficient for a jury to find forthat party.” LaChance v. Duffy’s Draft House, Inc., 146 F.3d 832, 835 (11th Cir. 1998) (quoting Anderson, 477U.S. at 249). If the evidence adduced by the nonmovant is “merely colorable” or “not significantly probative,”summary judgment is appropriate. Anderson, 477 U.S. at 249-50.

Defendants typically move for summary judgment in Section 10(b) and Rule 10b-5 cases on the basis that nogenuine issue of material fact exists with regard to: (1) scienter; (2) false or misleading statements oromissions; (3) the materiality of defendants’ alleged misrepresentations or omissions; (4) reliance; and/or(5) loss causation.

2. Scienter

Defendants often move for summary judgment on the grounds that there is insufficient evidence that defendantsacted with scienter. See, e.g., Geffon v. Micrion Corp., 249 F.3d 29, 36 (1st Cir. 2001) (affirming grant ofsummary judgment on ground that plaintiffs introduced insufficient evidence of scienter); Newton v. Merrill,Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 274-75 (3d Cir. 1998) (finding factual dispute wheredefendant broker-dealers represented that they would execute the plaintiffs’ orders to maximize plaintiffs’economic gain while “[knowing] that they intended to execute the plaintiffs’ orders at [one] price even if betterprices were reasonably available”); RMED Int’l, Inc. v. Sloan’s Supermarkets, Inc., 185 F. Supp. 2d 389,403-04 (S.D.N.Y. 2002) (genuine issue existed as to scienter because plaintiffs offered evidence of defendants’motive and opportunity to commit fraud and knowledge of undisclosed antitrust investigation); Freedman v.Value Health, Inc., 135 F. Supp. 2d 317 (D. Conn. 2001) (granting defendants’ motion for summary judgmentbecause, among other things, no genuine issue of material fact regarding defendants’ intent to deceive existed),aff’d, 34 F. App’x 408 (2d Cir. 2002); Tse v. Ventana Med. Sys., Inc., 123 F. Supp. 2d 213, 225 (D. Del. 2000)(granting defendants’ motion for summary judgment because incentive compensation is insufficient evidence ofscienter), aff’d, 297 F.3d 210 (3d Cir. 2002); Marucci v. Overland Data, Inc., No. 97 CV 0833-TW (JFS), 1999WL 1027053, at *8 (S.D. Cal. Aug. 2, 1999) (genuine issue existed as to whether “[d]efendants acted with atleast deliberate recklessness in failing to properly disclose” company’s supply problems); Carlson v. XeroxCorp., 392 F. Supp. 2d 267 (D. Conn. 2005) (finding false exculpatory statements and a failure to comply with

an SEC investigation are both evidence of fraudulent intent). “On a motion for summary judgment … the issueis whether the evidence, taken as a whole, could support a finding by a reasonable juror that defendants actedwith the intent to deceive, manipulate or defraud investors.” In re N. Telecom Ltd. Sec. Litig., 116 F. Supp. 2d446, 462-63 (S.D.N.Y. 2000) (finding no genuine issue as to scienter where facts did not show that company’saccounting practices were “inherently fraudulent or deceptive”).

The following issues relating to scienter frequently arise in motions for summary judgment:

a. Insider Trading

Courts often grant motions for summary judgment where there is an absence of insider trading during the classperiod. Schuster v. Symmetricon, Inc., No. C94 20024 RMW, 2000 WL 33115909, at *8 (N.D. Cal. Aug. 1,2000) (granting defendants’ summary judgment motion on the issue of scienter where defendants who hadmade allegedly false or misleading statements had not made insider sales during the period and evidencedemonstrated that they believed their optimistic statements and acted in good faith); N. Telecom, 116 F. Supp.2d at 462-63 (finding insufficient evidence to enable reasonable juror to conclude that defendants acted withscienter where insiders sold no stock and derived no other concrete benefit from the alleged fraud); In re OracleCorp., 867 A.2d 904, 906 (Del. Ch. 2004) (“[N]o rational trier of fact could find that … Ellison or Henleypossessed material, nonpublic financial information as of the time of their trades.”), aff’d, 872 A.2d 960 (Del.2005). By contrast, suspicious trading during the class period may preclude summary judgment. See Provenzv. Miller, 102 F.3d 1478, 1491 (9th Cir. 1996); Marksman Partners, L.P. v. Chantal Pharms. Corp., 46 F. Supp.2d 1042 (C.D. Cal. 1999) (finding genuine issue of material fact existed regarding scienter when defendantengaged in insider sales), aff’d, 234 F.3d 1277 (9th Cir. 2000).

b. Inconsistencies Between Internal Documents And Public Statements

Conflicts between internal documents and public statements often lead courts to conclude that there is a genuineissue of material fact regarding scienter. See In re Reliance Sec. Litig., 135 F. Supp. 2d 480, 508 (D. Del. 2001)(finding genuine issue of material fact existed where outside directors signed allegedly fraudulent SEC filingsafter receiving reports of company’s deteriorating financial condition); Kaufman v. Motorola, Inc., No. 95 CV1069, 1999 WL 688780, at *11, *13 (N.D. Ill. Apr. 16, 1999) (finding adverse undisclosed information ininternal documents, combined with evidence of company’s extensive internal reporting system, created genuineissue as to whether the defendants “knew or recklessly disregarded the high levels of inventory excess”);Marucci v. Overland Data, Inc., No. 97 CV 0833-TW (JFS), 1999 WL 1027053, at *8 (S.D. Cal. Aug. 2, 1999)(finding issue regarding scienter existed where internal reports indicated that defendants had knowledge ofsupply problems that they failed to disclose in prospectus).

Courts such as the First Circuit have further found that the absence of inconsistencies between internaldocuments and public statements can rebut claims of scienter. Geffon v. Micrion Corp., 249 F.3d 29, 36-37 (1stCir. 2001) (affirming grant of summary judgment on ground that plaintiffs introduced insufficient evidence ofscienter where they offered no internal documents or other evidence to support their assertion that internalcompany documents defined terms differently than how the terms were used in public statements); see also N.Telecom, 116 F. Supp. 2d at 462-63 (finding no genuine issue regarding scienter where company’s publicstatements accurately reflected its internal forecasts); Freedman v. Value Health, Inc., 135 F. Supp. 2d 317, 342(D. Conn. 2001) (finding no genuine issue of material fact regarding defendant’s scienter because, among otherthings, his statement was “consistent with reasonably available data”), aff’d, 34 F. App’x 408 (2d Cir. 2002).

c. Liability Of Outside Directors

An outside director’s awareness of potential fraud and failure to investigate it may constitute sufficient evidence

of scienter to preclude summary judgment. See, e.g., Stat-Tech Liquidating Trust v. Fenster, 981 F. Supp.1325, 1342 (D. Colo. 1997) (finding genuine issue of material fact regarding scienter existed where “evidencesupport[ed] an inference that [director] was on notice concerning problems in the company’s SEC compliance,its accounting department, and its auditors, and … did not undertake any investigation or analysis of thesematters because his sole interest was in disposing of his stock at a substantial profit”). If plaintiffs fail todemonstrate that an outside director was aware of possible improprieties, the outside director may prevail on asummary judgment motion based on the absence of scienter. Kaufman, 1999 WL 688780, at *11, *13 (findingno genuine issue regarding scienter of outside director where plaintiffs failed to show that he was put on “noticeof a possible material failure of disclosure” that he should have investigated).

d. Liability Of Auditors

Auditors may prevail on a summary judgment motion with regard to scienter if plaintiffs fail to put forthevidence demonstrating that the auditors acted in bad faith or recklessly. For example, in In re Ikon OfficeSolutions, Inc., 277 F.3d 658, 668 (3d Cir. 2002), the Third Circuit affirmed summary judgment where notriable issue of fact existed as to whether auditors acted with scienter in performing an audit. The court foundthat the auditors “took appropriate steps to determine whether allegations [of accounting fraud against thecompany] had any merit,” and nothing in the record showed that the auditors’ “judgment – at the momentexercised – was sufficiently egregious such that a reasonable accountant reviewing the facts and figures shouldhave concluded that Ikon financial statements were misstated and that as a result the public was likely to bemisled.” Id. at 673. The court also noted “[t]he mere fact that [the auditors] did not conduct [their] own fraudinvestigation or alert [their] field auditors to the allegations of fraud [was] not probative, as the relevant inquiryis bad faith, not bad judgment.” Id. at 670. Thus, the plaintiffs could not make the minimal showing of highlyunreasonable conduct, involving an extreme departure from the standards of ordinary care that presents adanger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor musthave been aware of it. Id. at 667; see also Marksman Partners, L.P. v. Chantal Pharm. Corp., 46 F. Supp. 2d1042, 1046-50 (C.D. Cal. 1999) (granting defendant auditor’s motion for summary judgment because plaintiffsfailed to raise a genuine issue that the auditor’s accounting decisions and auditing procedures were so deficientthat the audit amounted to no audit at all, or that the accounting judgments that were made were such that noreasonable accountant would have made them if confronted with the same facts). But see In re Reliance Sec.Litig., 135 F. Supp. 2d 480, 510 (D. Del. 2001) (finding genuine issue of material fact existed regarding scienterof independent auditors because a reasonable juror could determine that, given the information available tothem, the “auditors did not believe that the [company’s] loan loss reserves were adequate”); In re Worldcom,Inc. Sec. Litig., 352 F. Supp. 2d 472 (S.D.N.Y. 2005) (finding that principles of collective knowledge and intentcould apply to establish scienter in securities fraud action against an accounting firm, and plaintiffs were notrequired to show that at least one employee of the firm acted with scienter).

3. False Or Misleading Statement Of Material Fact

a. False Or Misleading Statement

Defendants’ motions for summary judgment often contend that the statements alleged in the complaint were notfalse or misleading. Courts have usually denied summary judgment, though, where adverse internal documentsand other evidence raise a dispute as to the falsity of the statements. Newton v. Merrill, Lynch, Pierce, Fenner& Smith, Inc., 135 F.3d 266, 273 (3d Cir. 1998) (reversing summary judgment where genuine issue of materialfact existed over defendant broker-dealers’ implied misrepresentation that they would execute plaintiffs’ ordersin manner calculated to maximize plaintiffs’ gain); Marucci v. Overland Data, Inc., No. 97 CV 0833-TW (JFS),1999 WL 1027053, at *8 (S.D. Cal. Aug. 2, 1999) (denying defendants’ motion for summary judgment becauseinternal reports and deposition testimony demonstrated that genuine issue existed as to whether company’sprospectus contained false or misleading statements); Miller v. NTN Commc’ns, Inc., No. 97-CV-1116 TWJAH, 1999 WL 817217, at *8 (S.D. Cal. May 21, 1999) (denying defendants’ motion for summary judgment

where undisclosed agreements demonstrated that triable issue existed concerning false or misleading nature ofstatements); Kaufman v. Motorola, Inc., No. 95 CV 1069, 1999 WL 688780, at *11, 13 (N.D. Ill. Apr. 16,1999) (internal documents demonstrated genuine issue as to whether defendants made false or misleadingstatements or omissions of material fact regarding inventory levels).

Courts grant summary judgment when there is no evidence that the statements lacked a reasonable basis or werefalse when made. In re Sybase, Inc. Sec. Litig., 48 F. Supp. 2d 958, 963 (N.D. Cal. 1999) (granting defendants’motion for summary judgment and concluding no reasonable jury could find a false or misleading statementwhere plaintiff failed to demonstrate that defendants’ “budget forecasts and general statements of optimismlacked a reasonable basis”); see also Binder v. Gillespie, 184 F.3d 1059, 1067 (9th Cir. 1999) (affirmingsummary judgment for auditor when there was insufficient evidence that auditor participated in preparation ofallegedly false or misleading financial statements marked “unaudited”).

b. Adopting Statements In Analyst Reports

Defendants may also move for summary judgment on the basis that there is no genuine issue of fact as towhether defendants adopted the statements of analyst reports. In re Stratosphere Corp. Sec. Litig., 66 F. Supp.2d 1182, 1200 (D. Nev. 1999) (finding defendants did not adopt statements in analyst reports because theypresented sufficient evidence that they “never commented upon submitted draft reports, except to correctmatters of public record” and rarely distributed analyst reports to investors); Schuster v. Symmetricon, Inc.,No. C 94 20024 RMW, 2000 WL 33115909, at *2-3 (N.D. Cal. Aug. 1, 2000) (finding defendants were notliable for statements in analyst reports because plaintiff “failed to adduce any admissible evidence linkingspecific comments by defendants with specific statements in analysts’ reports”).

c. Materiality

A statement is material if there is a “substantial likelihood that the disclosure of the omitted fact would havebeen viewed by the reasonable investor as having significantly altered the ‘total mix’ of information madeavailable.” Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988). “Like scienter, materiality is [a] fact-specificelement of a Rule 10b-5 claim which should normally be left to the trier of fact . . . . However, when norational trier of fact can find that an alleged misrepresentation or omission was material, summary judgmentmay nevertheless be justified in appropriate cases.” Miller v. NTN Commc’ns, Inc., No. 97-CV-1116 TW(JAH), 1999 WL 817217, at *8-9 (S.D. Cal. May 21, 1999) (citations omitted) (finding genuine issue of factexisted as to whether alleged misrepresentations and omissions were material); S.E.C. v. Autocorp Equities,Inc., 292 F. Supp. 2d 1310, 1320 (D. Utah 2003) (holding that although materiality is a question of fact,summary judgment is proper where authenticity of an asset’s value is so obviously important to an investor). Interestingly, in Miller v. Thane International, Inc., 508 F.3d 910, 922 (9th Cir. 2007), the Ninth Circuit held“[t]he district court erred when it considered the movement in share price of a stock that did not trade on anefficient market to determine materiality,” even though the evidence showed “the shares had the ability toincorporate the obvious” misstatement. Id. at 919 (holding that a false promise to list shares on the NASDAQNMS is material because “a reasonable . . . .shareholder would have wanted to know where [] new . . . .shareswould be trading and would have viewed the fact of [the] nonlisting ‘as having significantly altered the totalmix of information.’”). The Ninth Circuit in Thane remanded the action to the district court for a determinationon loss causation, which that court found to be absent because even an inefficient market will impound materialinformation, and the company’s stock price did not drop for 19 days after the failure to list on NMS. In ThaneII, the Ninth Circuit affirmed the judgment for defendants, noting that while materiality and loss causation arerelated inquiries, they are nonetheless distinct because materiality is an ex ante inquiry into whether areasonable investor would consider a particular misstatement important, whereas loss causation is an ex postinquiry into whether the misstatement actually caused a loss. Miller v. Thane Int’l., Inc., 615 F.3d 1095 (9thCir. 2010).

Courts have found summary judgment appropriate when plaintiffs fail to raise a triable issue of fact regardingthe materiality of an alleged misrepresentation or omission. In re Int’l Bus. Mach. Corp. Sec. Litig., 163 F.3d102, 109 (2d Cir. 1998) (affirming summary judgment where statements regarding company’s dividend werenot material); In re Corning, Inc. Sec. Litig., 349 F. Supp. 2d 698, 720-22 (S.D.N.Y. 2004) (granting summaryjudgment for the defendants because the failure to disclose breast implant litigation over a ten-year period untila major verdict led to bankruptcy was immaterial, given that during the non-disclosure period, the facts aboutbreast implant suits and claims were highly favorable to the companies); In re N. Telecom Ltd. Sec. Litig., 116F. Supp. 2d 446, 462-63 (S.D.N.Y. 2000); In re Stratosphere Corp. Sec. Litig., 66 F. Supp. 2d 1182, 1200 (D.Nev. 1999) (dismissing claims relating to statements of general optimism or “vaguely positive statements thatcould not be relied upon by [the] reasonable investor”). But see Media Gen., Inc. v. Tomlin, 387 F.3d 865 (D.C.Cir. 2004) (reversing grant of summary judgment because there was a genuine issue of material fact whether alawsuit brought by a former employee of the acquired company was a material contingency at the time ofmerger negotiations, even though it was immaterial for purposes of acquiring company’s post-merger Form 8-Kfiling); RMED Int’l, Inc. v. Sloan’s Supermarkets, Inc., 185 F. Supp. 2d 389, 401-02 (S.D.N.Y. 2002) (findingnon-disclosure of FTC investigation threatening completion of acquisitions was material); Ostler v. CodmanResearch Group, Inc., No. 98-356-JD, 1999 WL 813889 (D.N.H. Aug. 12, 1999) (denying defendants’ motionfor summary judgment because defendants failed to show that plaintiff, who let his stock options expire,allegedly as a result of defendants’ incomplete picture of the company’s financial status, would not be able toprove that the omitted information was material); Marucci v. Overland Data, Inc., No. 97 CV 0833-TW (JFS),1999 WL 1027053, at *8 (S.D. Cal. Aug. 2, 1999) (finding “swift and severe drop in the share price” followingdisclosure of company’s supply problems supported materiality of defendants’ allegedly false or misleadingstatements regarding supply problems in prospectus).

When statements are accompanied by appropriate cautionary language, courts may deem them immaterial. Gasner v. Bd. of Supervisors, 103 F.3d 351, 359 (4th Cir. 1996) (finding challenged misrepresentations andomissions were immaterial as a matter of law under the bespeaks caution doctrine, because they wereaccompanied by appropriate cautionary language); N. Telecom, 116 F. Supp. 2d at 462-63 (finding plaintiffsfailed to establish defendants made material misrepresentations because the challenged statements “[w]henviewed in their surrounding context … are either immaterial, cautionary, or have a reasonable basis in fact”). But see In re Reliance Sec. Litig., 135 F. Supp. 2d 480, 510 (D. Del. 2001) (holding genuine issue of materialfact existed as to whether defendants’ statements were actionable because reserve estimates were not forward-looking statements and thus were not rendered immaterial under the bespeaks caution doctrine or protected bythe Safe Harbor provisions of the Reform Act); Stratosphere, 66 F. Supp. 2d at 1192-96 (finding, based oninternal memoranda, triable issue of fact existed as to whether defendants had actual knowledge that statementswere false, and thus as to whether the statements were protected by the Safe Harbor for forward-lookingstatements). In the Ninth Circuit, “[s]ummary judgment based on the ‘bespeaks caution’ doctrine is onlyappropriate when reasonable minds could not disagree as to whether the mix of information in the document ismisleading.” Provenz v. Miller, 102 F.3d 1478, 1491 (9th Cir. 1996) (reversing summary judgment on basis ofmateriality where cautionary language was too general to render the challenged statements immaterial).Summary judgment is clearly appropriate where the allegedly actionable statements fall within the ReformAct’s safe harbor for forward looking statements. See Employers Teamsters Local Nos. 175 and 505 v. CloroxCo., 353 F.3d 1125, 1131 (9th Cir. 2004).

4. Reliance

In a motion for summary judgment, defendants may also challenge plaintiffs’ claim of reliance by arguing thatthe evidence fails to show: (1) that plaintiffs relied on the alleged misrepresentations or omissions, (2) that thefraud on the market presumption of reliance applies, or (3) that plaintiffs’ reliance was reasonable. Poth v.Russey, 281 F. Supp. 2d 814, 821 (E.D. Va. 2003), aff’d, No. 03-1308, 2004 WL 614623 (4th Cir. Mar. 30,2004) (granting summary judgment where plaintiffs unreasonably relied on unsubstantiated oral statements thatcontradicted written documentation plaintiff had already signed) (citing Foremost Guar. Corp. v. Meritor Sav.Bank, 910 F.2d 118, 123-24 (4th Cir. 1990) (providing eight factor test to determine if reliance is reasonable));RMED Int’l, Inc. v. Sloan’s Supermarkets, Inc., 185 F. Supp. 2d 389, 405 (S.D.N.Y. 2002) (rejecting

defendants’ argument that the fraud on the market presumption was inapplicable where (1) the company’s stockwas traded on AMEX, and (2) there was a plausible, market-based explanation for the decline in the stockprices); Gabriel Capital, L.P. v. NatWest Fin., Inc., 177 F. Supp. 2d 169 (S.D.N.Y. 2001) (denying summaryjudgment where genuine issue existed as to whether “the timely receipt of the [company’s] OfferingMemorandum defeats plaintiff’s claim of reliance on material presented at the road show”); Steed Fin. LDC v.Nomura Sec. Int’l Inc., No. 00 CIV. 8058 (NRB), 2004 WL 2072536, at *8 (S.D.N.Y. Sept. 14, 2004) (grantingsummary judgment because reliance on the alleged misrepresentation was unreasonable where plaintiff hadample opportunity to investigate the many red flags contained in defendants’ disclosures), aff’d, 148 F. App’x66 (2d Cir. 2005); Amendolia v. Rothman, No. CIV. A. 02-8065, 2003 WL 23162389 (E.D. Pa. Dec. 8, 2003)(holding plaintiff could not show reliance because she admittedly had no intention of changing financialadvisors regardless of defendants’ alleged false statements).

5. Loss Causation

Plaintiffs’ failure to prove loss causation is often raised at the summary judgment stage, though defendants mustmeet a “heavy burden of proof” to succeed in obtaining summary judgment. Provenz v. Miller, 102 F.3d 1478,1491 (9th Cir. 1996). In the Ninth Circuit, “the defendants must prove, as a matter of law, that the depreciationof the value [of the investment] resulted from factors other than the alleged false and misleading statements.” Id. In contrast, “[t]o establish loss causation, plaintiffs must “simply alleg[e] that the false and misleadingstatements ‘touch[ed] upon the reasons for the investment’s decline in value.” Id. at 1492 (internal quotationmarks omitted). Other courts similarly require plaintiffs to demonstrate that “[a] direct or proximaterelationship between the loss and the [alleged] misrepresentation.” Gasner v. Bd. of Supervisors, 103 F.3d 351,359 (4th Cir. 1996); Castellano v. Young & Rubicam, Inc., 257 F.3d 171, 186 (2d Cir. 2001) (same).

In Provenz, the Ninth Circuit affirmed the trial court’s rejection of defendants’ loss causation defense becauseplaintiffs offered evidence that the company’s revenue recognition practices “touched upon” the allegedlyinflated stock price and that the company’s public disclosure of previously undisclosed information “touchedupon” the decline in the stock price. 102 F.3d at 1491; see also Castellano, 257 F.3d at 186 (finding triableissue existed as to loss causation because “a jury could find that foreseeability link[ed] the omitted informationand the [plaintiff’s] ultimate injury”); In re Reliance Sec. Litig., 135 F. Supp. 2d 480, 510 (D. Del. 2001)(disputed issue remained as to whether plaintiffs who purchased shares after director resigned from board reliedon his alleged misrepresentations because “[director’s] resignation is not enough to break the chain ofcausation”); Miller v. NTN Commc’ns, Inc., No. 97-CV-1116-TW JAH, 1999 WL 817217, at *8 (S.D. Cal.May 21, 1999) (finding summary judgment was inappropriate where evidence that “honest representationsregarding . . . .transactions would have shown that [the company’s] shares were over-inflated and wouldpossibly have persuaded plaintiffs to refrain from investing in the company”). Nonetheless, courts have foundthat defendants are able to demonstrate the absence of loss causation and grant summary judgment on thatbasis. Heliotrope Gen., Inc. v. Ford Motor Co., 189 F.3d 971, 978 (9th Cir. 1999) (affirming grant of summaryjudgment where information undisclosed in prospectus had entered the market before plaintiff purchased itsshares and thus could not have caused plaintiff’s loss); In re N. Telecom Ltd. Sec. Litig., 116 F. Supp. 2d 446,462-63 (S.D.N.Y. 2000) (granting summary judgment where plaintiffs failed to raise a disputed issue as towhether defendants’ alleged accounting fraud and misrepresentations caused an inflation of the company’sstock price); Tse v. Ventana Med. Sys., Inc., 123 F. Supp. 2d 213, 223-25 (D. Del. 2000), aff’d, 297 F.3d 210(3d Cir. 2002) (plaintiffs could not establish loss causation because their alleged loss of possible profits was“wholly speculative”); Shanahan v. Vallat, No. 03 Civ. 3496(PAC), 2008 WL 4525452, at *5 (S.D.N.Y. Oct. 3,2008) (granting summary judgment for defendants where plaintiff’s loss was caused by “industry-widephenomena” causing comparable losses to other investors and not by fraudulent misstatements or omissions); Inre Retek Inc. Sec. Litig., 621 F. Supp. 2d 690 (D. Minn. 2009) (granting summary judgment because plaintiffsfailed to establish that market became aware of corporation’s misrepresentations as to its true financialcondition via corrective press release as required to establish loss causation); Alaska Elec. Pension Fund v.Flowserve Corp., 572 F.3d 221, 233-34 (5th Cir. 2009) (reversing grant of summary judgment because genuineof issue of material fact existed regarding whether company’s statement regarding prior projected earningscaused some portion of investors’ loss after the relevant truth began to leak out).

H. Trial Of Securities Class Actions

While securities class action trials have been rare in the past, cases do go to trial. “[I]ncreasingly aggressivesettlement postures now being taken by plaintiffs are decreasing the defendants’ relative risks of going to trialin many cases, and defendants are less likely to settle when they believe they have a defensible case.” MichaelTu, Trial’s Rewards Starting To Outweigh Its Risks, The National Law Journal, Oct. 10, 2005. Since 1996,only 22 securities class actions have gone to trial. RiskMetrics Group, Securities Class Action Trials in thePost-PSLRA Era (Jan. 2010), available at blog.riskmetrics.com/slw/SCAS%20Trials.pdf. Two recent securitiesclass action trials include IN RE JDS UNIPHASE CORP. SECURITIES LITIGATION, No. CV 02-1486CW (N.D. Cal. 2007) and IN RE APOLLO GROUP INC. SECURITIES LITIGATION, No. CV 04-2147-PHX-JAT (D. Ariz. 2007). The IN RE JDS UNIPHASE trial involved allegations by investors that JDSUniphase misrepresented the company’s financial health and resulted in a defense verdict after four weeks oftrial. In IN RE APOLLO GROUP, shareholders alleged that the University of Phoenix committed securitiesfraud by failing to disclose that it paid the Department of Education $9.8 million to settle allegations that itsrecruiter’s compensation program violated the False Claims Act. The trial lasted two months and resulted in a$280 million jury verdict for the plaintiffs.

The possibility of a securities class action going to trial requires counsel to prepare trial strategies from themoment the case is accepted. A comprehensive outline of essential trial tactics and strategies has beencompiled by counsel in the Everex Securities Litigation, Howard v. Hui, No. C-92-3742 (N.D. Cal. 1992), afterachieving a favorable directed verdict at trial. [1] See Robert P. Varian, et al., Winning Securities Class Actionsat Trial: Lessons Learned, Securities Litigation: Planning and Strategies, SD79 ALI-ABA 295 (1999). Themost salient points of the article are summarized below.

1. Jury Education

While defense counsel in securities actions are aware of the particular role that plaintiffs’ firms play in thesecurities arena, jurors are not. Jurors imagine angry investors gelling to form a class, finding an attorney toaccept the case, and hiring experts to aid them in pursuing their rights in the court system. This perception mayfoster the belief that even completely baseless suits have merit. Because most jurors will view the evidencethrough this filter, erasing this belief at the onset of the presentation of the case is paramount. An openingstatement, which points out that the action was filed by one individual, rather than by a class of investors, and isbeing driven by the plaintiffs’ firms, rather than by the investors themselves, may aid this process.

2. Simple Strategy

Complex securities arguments, appropriate in legal briefs, do not resonate well with jurors. Therefore, it isimportant to simplify the defense case and utilize timelines, graphics, and other visual aids to assimilatecomplex information and help jurors remember important facts and themes. Defense counsel must rise abovethe minutia of SEC filings, stock price movements, and accounting forecasts in order to focus the suit on thedefendants and the fraud accusations they face. Accusing an individual of committing an intentional wrong ismore troubling to jurors than claims brought against a faceless corporation. Counsel should therefore argue thatthe reputations of hard-working individuals are on the line, and not merely the losses incurred by investorswhile “playing” in the stock market.

3. Plaintiff Witnesses

As plaintiff investors take the stand, defense counsel must respond with tempered and balanced questioning orotherwise risk alienating jurors. Often it appears that the only reason such witnesses are put on the stand is togarner jury sympathy by describing how they have been affected by the alleged misconduct. The impulsereaction to engage in blistering cross-examination must be controlled. Instead, defense counsel should use this

opportunity to inquire as to the amount of pre-purchase investigation the plaintiff investor conducted. Counselmust not appear to the jurors to be berating the witness for making a bad investment. Similarly, defensecounsel should use tact when inquiring further about the witness’s participation in other class actions, lack ofcontact with other class members, plaintiff’s counsel or experts before filing the suit, and continued stockpurchases in the face of price declines.

4. Pre-Trial Elimination Of Claims

By narrowing the claims before trial, defense counsel reduces the risk that the jury will pick up on extraneousinformation. The more information the plaintiffs put into play, the less probable a favorable outcome. Thisincreased risk disrupts any contemporaneous settlement discussions and may dismantle the simple format putforward by defense counsel. Therefore, while drafting pre-trial briefs such as motions to dismiss and requestsfor summary judgment, defense counsel should keep the possibility of trial in mind and aim to reduce theamount of claims, relevant facts, and issues. Early issue-elimination can later support trial motions, such as amotion in limine excluding harmful evidence.

5. Damages

Plaintiff-style damage analysis has drawn academic criticism, prompting many defenders to pursue extendedexperts’ testimony dissecting the damage requests in great detail. To be successful in this endeavor, the defenseshould control its witness and avoid diluting points that might otherwise have a major impact. Importantly, thedefense should also use this opportunity to underscore important trial themes, focus on major flaws in theanalysis, and provide the jury with a defensible alternative damage number in the event liability is found.

Defendants may request that damages be determined in one of two ways: (1) per-share, or (2) in gross. Relyingon per-share basis limits the jury’s discretion but may not allow the jury to understand the magnitude of theultimate award. The gross analysis is preferable in cases where the defense believes the jury is not inclined tomake a large award. See Robert P. Varian, et al., Winning Securities Class Actions at Trial: Lessons Learned,22 Bank and Corporate Governance Law Reporter 321-331 (1999).

I. Settlement Considerations

Settlement is strongly favored, particularly in complex class actions, to minimize potential litigation costs andreduce the strain on judicial resources. See, e.g., In re Gen. Motors Corp. Pick-Up Truck Fuel Tank Prods.Liab. Litig., 55 F.3d 768, 786 (3d Cir. 1995).

1. The Court’s Role In The Settlement Process

a. Court Approval Or Disapproval

Federal Rule of Civil Procedure 23(e) provides that “[t]he claims, issues, or defenses of a certified class may besettled, voluntarily dismissed, or compromised only with the court’s approval.” The court must thereforepreliminarily approve or disapprove any settlement. See In re Warner Commc’ns Sec. Litig., 798 F.2d 35 (2dCir. 1986) (stating that it is not the function of the court to modify the terms of settlement as proposed by theparties); In re United Energy Corp. Solar Power Modules Tax Shelter Inv. Sec. Litig., No. CV 87-3962KN(GX), 1989 WL 73211, at *3 (C.D. Cal. Mar. 9, 1989) (noting that the court will not substitute its businessjudgment for that of the parties but will determine whether the proposed settlement is within a range ofreasonableness); In re BankAmerica Corp. Sec. Litig., 350 F.3d 747, 752 (8th Cir. 2003) (holding that theReform Act does not expressly divest the district court of its Rule 23 authority or discretion by explicitlygranting veto power to lead plaintiffs; Congress did not intend to usurp the district court’s traditional

responsibility to guard the interests of absent class members). After examining the proposed settlement andreaching a decision, the court will pursue one of two courses:

If the court disapproves the settlement, the court is required to notify the parties of the provisions to which itobjects and instruct the parties on what must be done in order to gain court approval of the settlement. SeeMartens v. Thomann, 273 F.3d 159 (2d Cir. 2001) (reversing district court’s decision for failing to state reasonsfor denial of settlement agreement); In re Cal. Micro Devices Sec. Litig., 168 F.R.D. 257 (N.D. Cal. 1996).

If the court preliminarily approves the settlement, the court will require that notice of the settlement be given toall class members pursuant to Federal Rules of Civil Procedure 23(e)(1).

b. Notice

1) General

Under Federal Rules of Civil Procedure 23(e)(1), if the court permits a Rule 23(b)(3) class action settlement tobe maintained, “[t]he court must direct notice in a reasonable manner to all class members who would be boundby the proposal.”

Rule 23(e)(4) provides that “[i]f the class action was previously certified under Rule 23(b)(3), the court mayrefuse to approve a settlement unless it affords a new opportunity to request exclusion to individual classmembers who had an earlier opportunity to request exclusion but did not do so.” Thus, a court may givemembers of a certified class a second opportunity to opt-out as part of the settlement process.

The notice must inform the members (i) of their right to opt-out, (ii) that they will be bound by any judgment orsettlement if they do not opt-out, and (iii) if they do not request to opt-out, they may enter an appearancethrough counsel. A class action settlement is binding on all members of the class, even absent class memberswho do not receive individual notice, if the notice is procedurally adequate. See Presidential Life Ins. Co. v.Milken, 946 F. Supp. 267 (S.D.N.Y. 1996). Thus, where class members choose to opt-out, the res judicataeffect of settlement is impaired because they will not be bound by the settlement.

The possibility of opt-outs can be an issue in any agreement to settle because, prior to executing a settlementagreement, knowing with certainty whether or how many class members may choose to opt-out is difficult. Butsee Biben v. Card, 789 F. Supp. 1001, 1004 (W.D. Mo. 1992) (noting its broad discretionary powers under Rule23(d), court ordered early submission of proof-of-claims to assist in determination of damages and thus, interalia, facilitate settlement); Robinson v. Union Carbide Corp., 544 F.2d 1258, 1263 (5th Cir. 1977) (Wisdom, J.,concurring) (finding that “early identification” of damage information would “encourage accurate settlementdiscussions”); In re Storage Tech. Corp. Sec. Litig., No. 92-K-750, 1994 WL 1718450, at *1 (D. Colo. May 16,1994) (requiring that a questionnaire accompany initial class notice, the court noted that a “questionnaire[would] assist the parties in determining damages and [might] facilitate settlement”). One way that this can beaddressed in settlements is to give the defendant a negotiated right to terminate the settlement if there is morethan an agreed upon level of opt outs.

2) Reform Act’s Settlement Notice Requirements

Section 101 of the Reform Act amended both the Securities Act and the Exchange Act by adding newrequirements for the contents of any settlement notice. 15 U.S.C. § 77z-1(a)(7); 15 U.S.C. § 78u-4(a)(7). These new sections require that any proposed or final settlement notice to the class contain the following:

A “statement of plaintiff recovery,” including both the global and the per share amount of the settlement;

A “statement of potential outcome of case.” Two alternatives under this provision are available: (1) if theparties agree on the average amount of damages per share that would be recoverable if plaintiff prevailed,then this amount must be disclosed; (2) if the parties do not agree, then “a statement from each settlingparty concerning the issue or issues on which the parties disagree” is required. Notably, these statements“shall not be admissible in any Federal or State judicial action or administrative proceeding, other than anaction or proceeding arising out of such statements;”

A “statement of attorneys’ fees or costs sought” from any fund established as part of the settlement. Thestatement should indicate which parties or counsel intend to seek such fees or costs, the aggregate and pershare amount, “and a brief explanation supporting the fees and costs sought;”

An “identification of representatives of lawyers” for the plaintiff class “who will be reasonably available toanswer questions from class members,” including their names, telephone numbers and addresses;

“A brief statement explaining the reasons why the parties are proposing settlement;” and

“Such other information as may be required by the court.”

These statements must be summarized on the cover page of the notice. However, at least one district court hasheld that minor deviations from compliance with PSLRA requirements does not render the notice invalid. In reIndep. Energy Holdings PLC Sec. Litig., 302 F. Supp. 2d 180 (S.D.N.Y. 2003) (finding that if cover page ofsettlement does not have all the required information, it is not fatal, as long as the required information isreadily ascertainable and understandable).

3) Case Law On Notice

Abundant case authority describes the type of notice and service of notice necessary to satisfy statutory andconstitutional requirements. In brief, the notice should include (a) the rights of the class members, including themanner in which objections could be lodged and the right to opt-out could be exercised; (b) the nature, history,and progress of the litigation; (c) the proposed settlement; (d) the method of allocating the proposed settlement;(e) the judgment to be entered; (f) the time and place of the fairness hearing before the court; and (g) themanner in which class members could gain access to court papers. Krangel v. Golden Rule Res., Ltd., 194F.R.D. 501, 504-05 (E.D. Pa. 2000). The Ninth Circuit also requires that the “average recovery per share” isbased on all of the shares in the class, as opposed to the estimated fraction of class members likely to file aclaim. In re Veritas Software Corp. Sec. Litig., 496 F.3d 962, 971 (9th Cir. 2007). Although the representativeplaintiffs are not required to exhaust every conceivable method of identifying potential class members,individual notice generally must be sent to all class members who can be identified with reasonable effort. SeeIn re HPL Techs., Inc. Sec. Litig., No. C-02-3510 VRW (N.D. Cal. Nov. 5, 2004) (“[P]lain and full notice to thein-and-outs that [the] settlement extinguishes their claims for no consideration whatsoever is essential to afinding that the settlement is fair.”); Burns v. Elrod, 757 F.2d 151 (7th Cir. 1985); Eisen v. Carlisle &Jacquelin, 417 U.S. 156, 177 (1974).

Special notice problems may arise when no class has been certified at the time the settlement is proposed. SeeIn re Gen. Motors Corp. Pick-Up Truck Fuel Tank Prods. Liab. Litig., 55 F.3d 768, 800 (3d Cir. 1995)(warning that approval of settlement without certifying class would preclude res judicata effect with regard toabsent class members); Woodall v. Drake Hotel, Inc., 913 F.2d 447, 451 (7th Cir. 1990) (holding, in an agediscrimination class action, inadequate notice is prejudicial even though absent class members are not bound bythe settlement because settlement “adversely affected [absent members’] ability to achieve redress”); Simer v.Rios, 661 F.2d 655 (7th Cir. 1981) (approval of a settlement prior to class certification and without notice toputative class members violated due process rights of absent class members). Clearly, notice to absent class

members is required where the settlement will have a preclusive effect on claims later asserted by them.

c. Fairness Hearing

Federal Rule of Civil Procedure 23(e) provides that “notice of the proposed dismissal or compromise shall begiven to all members of the class in such manner as the court directs.” The court holds a “fairness hearing” toconsider whether the proposed settlement is fair, reasonable, and adequate to all members of the class prior toapproval of the settlement. See Neuberger v. Shapiro, 110 F. Supp. 2d 373, 377 (E.D. Pa. 2000) (“[I]napproving a settlement, the court acts as a fiduciary for absent class members.”); Moore v. Halliburton Co., No.3:02-CV-1152-M, 2004 WL 2092019 at *3 (N.D. Tex. Sept. 9, 2004) (“The Court must protect the interests ofthe absent class members who would be bound by a settlement ... ‘As such, the Court owes a fiduciary duty tothe class to ensure that the interests of every member of the class are adequately represented.’”) (quoting In reQuintus Sec. Litig., 148 F. Supp. 2d 967, 970 (N.D. Cal. 2001)). The most significant aspect of this provision isthat once a settlement is approved, it serves as res judicata for all parties to all claims covered by theagreement. See Devlin v. Scardelletti, 536 U.S. 1, 10 (2002) (“[N]onnamed class members are parties to theproceedings in the sense of being bound by the settlement.”).

1) Burden Of Proof

At the fairness hearing, the proponent of the settlement has the burden of “demonstrating 1) the settlement isnot collusive but was reached after arm’s length negotiations; 2) the proponents are counsel experienced insimilar cases; 3) there has been sufficient discovery to enable counsel to act intelligently; and 4) the number ofobjectors or their relative interests is small.” Schwartz v. Novo Industri A/S, 119 F.R.D. 359, 362 (S.D.N.Y.1988); see also Neuberger, 110 F. Supp. at 377 (noting proponent has the burden of establishing the settlementis fair).

2) Objections

Members of the proposed settlement class who object to the terms of the settlement are entitled to appear at thesettlement hearing and submit their objections to the court without first intervening. See Devlin, 536 U.S. at14. If no one in the class objects, the court may streamline the hearing. However, if objectors exist, they havethe right to present evidence and argument at the hearing. The court may also permit them to conduct discoveryon relevant issues if reasonable and requested in a timely manner. Girsh v. Jepson, 521 F.2d 153 (reversingapproval of settlement agreement where district court denied objector the right to conduct discovery); Bell Atl.Corp. v. Bolger, 2 F.3d 1304, 1314-15. Objectors also have the right to bring an appeal if the court approvesthe settlement. See Devlin, 536 U.S. at 14.

3) Fairness Factors

In In re Sterling Foster & Co., Inc. Sec. Litig., 238 F. Supp. 2d 480 (E.D.N.Y. 2002), the court identifiedseveral factors governing the fairness and adequacy of a proposed class action settlement, including the: (a) complexity, expense, and likely duration of the litigation; (b) reaction of the class to the settlement; (c) stageof the proceedings and the amount of discovery completed; (d) risks of establishing liability; (e) risks ofestablishing damages; (f) risks of maintaining the class action through the trial; (g) ability of the defendants towithstand a greater judgment; (h) range of reasonableness of the settlement fund in light of the best possiblerecovery; and (i) range of reasonableness of the settlement fund to a possible recovery in light of all theattendant risks of litigation. Id. at 484 (citing City of Detroit v. Grinnell Corp., 495 F.2d 448, 463 (2d Cir.1974)); see also Hanlon v. Chrysler Corp., 150 F.3d 1011 (9th Cir. 1998); In re Gen. Motors Corp. Pick-Up

Truck Fuel Tank Prods. Liab. Litig., 55 F.3d 768, 805 (3d Cir. 1995); Newby v. Enron Corp., 394 F.3d 296, 301(5th Cir. 2004) (applying a six-factor test, including examination of whether the settlement was obtained byfraud or collusion).

At the hearing, the court cannot conduct a “mini trial” into the merits of the claims but may only examine thefactors of fairness. Gen. Motors, 55 F.3d at 796. Whether the court is required to, or even allowed to, considerthe fairness to parties other than members of the class is unclear. See, e.g., Eichenholtz v. Brennan, 52 F.3d478, 481 (3d Cir. 1995).

2. Settlement Prior To Certification Of A Class

a. Hesitancy

Courts may be reluctant to approve a class action settlement before the class is certified because of uncertaintyas to who represents the class and the possibility that defendants’ counsel will attempt to deal with the mosteasily swayed plaintiffs’ counsel. See Weinberger v. Kendrick, 698 F.2d 61, 72 (2d Cir. 1982) (voicing concernwith the practice of bypassing formal class certification by sending notice of proposed settlement to prospectiveclass members); In re Beef Indus. Antitrust Litig., 607 F.2d 167, 173 (5th Cir. 1979) (finding the practicecontroversial); Ace Heating & Plumbing Co. v. Crane Co., 453 F.2d 30 (3d Cir. 1971); see also Raymond A.Fylstra, Settlement of Class Action Cases Prior to Class Certification, 69 Ill. B.J. 24 (Sept. 1980). But seePresidential Life Ins. Co. v. Milken, 946 F. Supp. 267, 279 (S.D.N.Y. 1996) (“The fact that a suit is settled priorto class certification does not, in and of itself, demonstrate the existence of collusion.”).

b. Court Approval

Settlements that take place prior to formal class certification require a higher standard of fairness. See In reMego Fin. Corp. Sec. Litig., 213 F.3d 454, 458 (9th Cir. 2000); In re Chiron Corp. Sec. Litig., 2007 WL4249902 (N.D. Cal. 2007) (“Where approval for settlement and certification are sought simultaneously …district courts must be even more scrupulous than usual in examining the fairness of the proposed settlement.”)(citations omitted). Courts have routinely approved pre-certification settlements. See, e.g., Carlough v.Amchem Prods, Inc., 5 F.3d 707 (3d Cir. 1993) (approving settlement negotiated between certain plaintiffs andcertain defendants for all claims that might be asserted in the future prior to certification); Brucker v. Thyssen-Bornemisza Europe, N.V., 424 F. Supp. 679 (S.D.N.Y. 1976), aff’d sub nom. Brucker v. Indian Head, Inc., 559F.2d 1202 (2d Cir. 1977) (approved after considerable litigation “where there were not different counsel vyingto be class representatives before the settlement agreement was reached and publicized”); Plummer v. ChemicalBank, 91 F.R.D. 434, 440 (S.D.N.Y. 1981), aff’d, 668 F.2d 654 (2d Cir. 1982) (stating that pre-certificationsettlement is appropriate in certain cases but inappropriate in this case where settlement was substantiallyformulated prior to commencement of the action); Weinberger v. Kendrick, 698 F.2d 61, 73 (2d Cir. 1982)(approving settlement because it met a clear showing of fairness and substantial discovery had been conducted);Polar Int’l Brokerage Corp. v. Reeve, 187 F.R.D. 108, 113 (S.D.N.Y. 1999) (“[W]hen a settlement class iscertified after the terms of settlement have been reached, courts must require a ‘clearer showing of asettlement’s fairness, reasonableness and adequacy and the propriety of the negotiations leading to it.’”)(citations omitted).

c. Temporary Class

Courts often certify a temporary class for settlement purposes in cases where settlement is reached beforeregular class certification. In re Gen. Motors Corp. Pick-Up Truck Fuel Tank Prods. Liab. Litig., 55 F.3d 768,786-97 (3d Cir. 1995) (holding that settlement classes are cognizable under Rule 23, and discussing the prosand cons of such classes); In re Joint E. & S. Dist. Asbestos Litig., 132 F.R.D. 332, 333 (E.D.N.Y. 1990)

(“[C]ourt has power to act prior to addressing the merits of the class certification motion [and] may appointcounsel to represent the proposed class.”); Harden v. Raffensperger Hughes & Co., Inc., 933 F. Supp. 763 (S.D.Ind. 1996) (noting that “it is not unusual for a court to recognize tentative classes or subclasses for purposes ofsettlement,” and such recognition usually occurs before certification of litigation class); In re Dennis GreenmanSec. Litig., 829 F.2d 1539 (11th Cir. 1987) (allowing certification solely for settlement purposes); In re BeefIndus. Antitrust Litig., 607 F.2d 167, 177-78 (5th Cir. 1979) (“[T]emporary settlement classes have proved to bequite useful in resolving major class actions disputes.”); see also H. Newberg, Newberg on Class Actions,§§ 11.27, 22.78 (2d ed. 1985).

However, even if the court finds the settlement to be fair, it still may not approve the proposed settlement ifclass certification is improper. See Amchem Prods., Inc. v. Windsor, 521 U.S. 591, 593-594 (1997) (“Federalcourts, in any case, lack authority to substitute for Rule 23’s certification criteria a standard neveradopted ... that if a settlement is ‘fair,’ then certification is proper.”).

3. Settlement Prior To Appointment Of Lead Counsel

Attempts to settle prior to the appointment of class counsel may be problematic. For example, in In reCalifornia Micro Devices Securities Litigation, No. C-94-2817-VRW, 1995 WL 476625 (N.D. Cal. Aug. 4,1995), the court ordered that class counsel be selected by a competitive bidding process described in In reOracle Securities Litigation, 131 F.R.D. 688, modified, 132 F.R.D. 538 (N.D. Cal. 1990), and In re Wells FargoSecurities Litigation, 156 F.R.D. 223 (N.D. Cal. 1994). The court stated that such a bidding process, “or onethat emulates the results of such a process” was necessary to ensure that the class representatives would fairlyand adequately protect the interests of the class in accordance with Federal Rules of Civil Procedure 23(a)(4). In re Cal. Micro Devices, 1995 WL 476625, at *4. However, well before this process could be initiated, asettlement was negotiated between defense counsel and two of the three law firms that had been first to fileactions. The court found that these negotiations undermined the competitive bidding process and, on that basis,denied motions both for preliminary approval of the settlement and the lead firm’s appointment as classcounsel. In re Cal. Micro Devices, 168 F.R.D. 257 (N.D. Cal. 1996).

4. Settlement With Individual Class Members

Once the plaintiff class is certified and the opt-out deadline has passed, an individual settlement with the namedplaintiffs who are part of the certified class will not be permitted. See In re Painewebber Ltd. P’ship Litig., 147F.3d 132 (2d Cir. 1998); H. Newberg, Newberg on Class Actions, § 11.75 (2d ed. 1985). Defendants are free,without court approval, to negotiate settlements – side settlements – with absent class members who opt out. See Duhaime v. John Hancock Mut. Life Ins. Co., 183 F.3d 1, 4 (1st Cir. 1999).

Where the court has denied class certification, defendants are free to negotiate individual settlements withplaintiffs without court intervention. Fed. R. Civ. P. 41(a)(1); Painewebber, 147 F.3d at 138 (court approvalnot required for compromises with those outside of class). Furthermore, settlement does not bar the settlingplaintiffs from appealing the denial of class certification. In re DES Litig., 7 F.3d 20, 25 n.5 (2d Cir. 1993)(recognizing Supreme Court’s holding in Deposit Guar. Nat’l Bank, Jackson, Miss. v. Roper, 445 U.S. 326(1980), that denial of class certification may be appealed notwithstanding entry of judgment in plaintiffs’favor); Montgomery Ward & Co. v. Warehouse, Mail Order, Office, Tech. and Prof’l Employees Union,911 F. Supp. 1094, 1103 n.7 (N.D. Ill. 1995) (same).

5. Rule 23 And The “Opt-out”

In Phillips Petroleum Co. v. Shutts, the Supreme Court held that in class suits “which seek to bind known[plaintiff class members] concerning claims wholly or predominantly for money judgments, … due processrequires at a minimum that an absent plaintiff be provided with an opportunity to remove himself from the classby executing and returning an ‘opt-out’ or ‘request for exclusion’ form to the court.” 472 U.S. 797, 811-12

(1985).

Opt-out settlements appear to be growing in significance. For instance, California’s teacher pension fund optedout of a $400 million class settlement with Qwest Communications and reached a $46.5 million settlement inDecember 2006 in its separate case against Qwest Communications, its accountants and investment banks, andcertain former directors and officers. Similarly, the State of Alaska in December 2006 entered into a $50million opt-out settlement disposing of its claims against AOL Time Warner, which had settled with the classfor $300 million. In the same vein, five New York City public pension funds opted out of the 2005 $6.1 billionWorldCom class-action settlement and settled their own lawsuits for a total of $78.9 million. Such opt-outsettlements may allow the opt out plaintiff to benefit from state blue sky laws and, if successful, may allow for amuch larger recovery of claimed damages.

The type of class action can impact the settlement process and the ability of absent class members to opt-out. Fed. R. Civ. P. 23(b) provides three sets of circumstances which may justify maintenance of a suit as a classaction: (1) prosecution of separate actions creating the risk of inconsistent judgments or, as a practical matter,disposing of the interests of non-parties; (2) a party acting or refusing to act with respect to the class andinjunctive or declaratory relief is sought; or (3) common questions of law or fact predominating and class actionprosecution would be superior to other available methods for adjudicating the controversy.

Generally speaking, (b)(1) and (b)(2) class actions are not “wholly or predominantly for money judgments,”and, therefore, providing absent members with an opportunity to opt-out is not necessary. See, e.g., In re JointE. & S. Dist. Asbestos Litig., 78 F.3d 764, 777-78 (2d Cir. 1996) (denying class members’ motion to opt-out notan abuse of discretion); 1 Newberg on Class Actions § 1.18 (3d ed. 1992). The overwhelming majority ofsecurities class actions are (b)(3) class actions, and therefore the opt-out is usually available.

If a dispute arises about whether a class member has followed the appropriate opt-out procedures, the burden ison the class member to establish that he or she made a sufficient effort to communicate an intent to opt outthrough the appropriate channels. See, e.g., In re Worldcom, Inc. Sec. Litig., No. 02 CIV. 5288 (DLC), 2005WL 1048073 (S.D.N.Y. May 5, 2005) (holding testimony alone, absent documentation, that individual mailedin class opt out form is insufficient to carry evidentiary burden).

6. Practical Considerations With Settlements

Defense counsel should consider the following matters, among others, when structuring a settlement.

a. Timing

No clear-cut rule prescribes when the time is right to settle a case. The advantages of early settlement mayinclude: (a) smaller settlement contribution; (b) reduction in litigation expenses; (c) avoidance of disruption toa company’s business or interference with its customers or clients; (d) early distribution to the class ofsettlement funds; (e) possible termination of the litigation before full liability is exposed; and (f) minimizationof adverse publicity. See Schlusselberg v. Colonial Mgmt. Assocs., Inc., 389 F. Supp. 733 (D. Mass. 1974).

However, the disadvantages of early settlement include: (a) lacking sufficient factual knowledge to make anaccurate assessment of the case; (b) foregoing the opportunity to “win” the case; and (c) facing the uncertaintyof final judgment for non-settling defendants, if only a partial settlement is reached.

b. Parties

Where possible, all parties to the case should be included in the settlement agreement; if one or more partiesrefuse to settle, steps should be taken to cut off by court order any and all claims that non-participating parties

might bring.

c. Publicity

Defendants, especially professionals, must consider the impact of adverse publicity from the settlement on theirreputation and standing with peers, employees, and the community. Counsel may wish to negotiate anappropriate confidentiality requirement in the settlement agreement. The Reform Act makes suchconfidentiality agreements more difficult to effectuate as it prohibits the sealing of settlements, except wheredisclosure would cause direct and substantial harm to a party. 15 U.S.C. § 77z-l(a)(5); 15 U.S.C. § 78u-4(a)(5).

d. Admissions

The agreement should provide that no defendant admits any allegations of wrongdoing in the complaint (or, ifapplicable, any cross-complaints or cross-claims).

e. Releases

Defense counsel should ensure that the releases cover all claims raised or that could have been raised by theallegations in the complaint. Consider the degree to which claims that have not been asserted or that are as yetunknown may be compromised on behalf of a class. Releases of at least equal scope should be obtained fromall co-defendants and third-party defendants participating in the settlement. The agreement should also providea mechanism for obtaining releases from non-settling defendants who subsequently elect to settle.

f. Scope Of The Class

Consider the degree to which class members may be bound by the settlement. Unlike litigating a class actionand seeking to narrow or defeat the plaintiff class, when settling a class action, defendants want to broaden theclass as much as possible. Broadening the class also broadens the release of claims. Thus, to the extentpossible, the class should be broadened by time period, type of securities (including options), and type ofclaim. If defendants have previously succeeded in limiting the class, counsel should consider stipulating to abroader class, e.g., the class described in the complaint, for purposes of settlement. If a class has not yet beencertified, counsel should request that the court’s order approving the settlement contain a certification of thebroadest class possible.

g. Consideration

Cash, of course, is always acceptable. Inasmuch as cash may not always be available, particularly for smallerstart-up companies, parties may resort to other forms of consideration or injunctive relief to fashion a settlementadvantageous to all concerned. See, e.g., In re Cal. Micro Devices Sec. Litig., 965 F. Supp. 1327, 1330 (N.D.Cal. 1997) (approving a settlement consisting of cash and non-cash consideration); In re MicroStrategy, Inc.Sec. Litig., 148 F. Supp. 2d 654 (E.D. Va. 2001) (approving a completely non-cash settlement). These cashsubstitutes are often in the form of:

1) Stock

The defendant may offer its own stock in settlement of the case. See MicroStrategy, 148 F. Supp. 2d at 659(offering Class A common stock as part of settlement); In re Am. Bank Note Holographics, Inc., 127 F. Supp.2d 418 (S.D.N.Y. 2001) (offering cash, stock and warrants); Greenfield v. Villager Indus., Inc., 483 F.2d 824,827 (3d Cir. 1973) (offering unregistered shares of defendants’ stock).

2) Warrants

A warrant is a certificate entitling the owner to purchase stock at a specified price, usually only for a specifiedtime. A warrant differs from a stock option because a warrant is granted to shareholders, not employees. See Inre MicroStrategy, 148 F. Supp. 2d at 659 (offering warrants as part of settlement); In re Am. Bank NoteHolographics, Inc., 127 F. Supp. 2d 418 (S.D.N.Y. 2001) (same); In re Milken & Assocs. Sec. Litig., 150F.R.D. 46, 50 (S.D.N.Y. 1993) (same). Class action settlements where the sole value exchanged is warrantshave been approved even over the objections of class members. In re Brown Co. Sec. Litig., 355 F. Supp. 574(S.D.N.Y. 1973) (approving shareholder class action settlement consisting of warrants worth $1.6 million). Interestingly, the Eleventh Circuit affirmed a dismissal of a complaint by the shareholders who initially settledtheir action for warrants and later alleged that misrepresentations by the company caused them to agree toaccept the warrants in the settlement. Hall v. Coram Healthcare Corp., 157 F.3d 1286 (11th Cir. 1998).

3) Contingent Value Rights

Frequently, stock or warrants are offered as consideration with a guarantee that the instrument will have aspecific value. These guarantees are sometimes called Contingent Value Rights or CVR’s. See In re CendantCorp. Prides Litig., 51 F. Supp. 2d 537, 541 (D.N.J. 1999), vacated in part, 243 F.3d 722 (3d Cir. 2001)(approving non-cash settlement consideration of convertible stock rights).

4) Waiver Of Rights As Consideration

Relinquishing one party’s rights under collateral agreements has been used as consideration to settle cases. SeeIn re Brown Co. Sec. Litig., 355 F. Supp. at 589-90 (involving waivers of claims for indemnity); White v.Auerbach, 363 F. Supp. 366 (S.D.N.Y. 1973), rev’d on other grounds, 500 F.2d 822 (2d Cir. 1974) (affirmingsurrender of rights under executive compensation agreement).

5) Corporate Restructuring

In one case, the settlement consisted of a plan to realign corporate stock to alter control of the corporation. Cannon v. Tex. Gulf Sulphur Co., 55 F.R.D. 308, 325 (S.D.N.Y. 1972). In another case, the terms of aproposed merger were revised to increase the benefits distributed to minority shareholders. Oppenlander v.Standard Oil Co., 64 F.R.D. 597 (D. Colo. 1974). The parties can also agree to plans of divestiture of stockheld by the corporation. See Wellman v. Dickinson, 497 F. Supp. 824, 828-29 (S.D.N.Y. 1980), aff’d, 647 F.2d163 (2d Cir. 1981). Injunctions or agreements requiring the corporation to undertake certain reforms, or torefrain from certain actions, may also serve as effective settlement tools.

6) Corporate Governance Changes

Sometimes changes in corporate governance procedures, e.g., narrowing the trading window during which

employees can buy and sell the corporation’s stock or changing accounting procedures, may serve asconsideration. In re Caterpillar, Inc., 51 S.E.C. Docket 147 (Mar. 31, 1992) (reporting Caterpillar settled byagreeing to cease and desist from future violations of Exchange Act § 13(a) and to “implement and maintainprocedures designed to ensure compliance with Item 303 of Regulation S-K.…”). This is especially common insettlement of derivative suits.

h. Future Litigation Costs

In rare instances, defense counsel may wish to negotiate for a separate fund from settlement proceeds providingindemnification for defense costs incurred in actions brought by opting-out class members, as well asindemnification for any breach by settling plaintiffs. The need for such an arrangement depends on theinsurance coverage of the defendant.

i. Effect On Other Litigation

Special problems may arise where parties attempt to settle class and derivative actions simultaneously. “Thisstems in large measure from the inherent conflict between the interests supposedly protected by the class actionand those benefitted by the derivative action.” In re Oracle Sec. Litig., 829 F. Supp. 1176, 1183 (N.D. Cal.1993). Although both groups are largely made up of shareholders, they do not necessarily include the sameshareholders. Thus, a favorable result in the class action may tend to transfer wealth from the plaintiffs in thederivative action to the plaintiffs in the class action and vice versa. Moreover, while the corporation will likelybe named a defendant in the class action, it will be the party on whose behalf plaintiff is suing in the derivativeaction. The Oracle court denied approval of the settlement, finding that the settlement committee ofindependent board members relied on “inherently biased advice” and therefore, “their approval of thesettlement [was] worthless for purposes of analyzing whether the settlement reasonably protect[ed] the interestsof the corporation and its shareholders.” Id. at 1189.

j. Appeal And Collateral Attack

The settlement agreement should provide an express waiver of any right by plaintiff to appeal or attackcollaterally a judgment of dismissal entered pursuant to the settlement. As is self-evident from the incessantfluctuations of the open market, the value of settlements involving stock or warrants as consideration canmaterially change after the settlement agreement concludes. A decline in the value of the stock-based portionof the settlement may present plaintiffs with an incentive to seek opportunities to renegotiate the considerationfor the agreement. The Eleventh Circuit rejected such an attempt, shrouded in the guise of a motion to enforcethe terms of the settlement agreement. In re T2 Med., Inc., 130 F.3d 990 (11th Cir. 1997). Plaintiffs brought a“motion to enforce stipulation of settlement” claiming fraud, mutual mistake, and breach of contract. Id. at993. The district court rejected plaintiffs’ motion as beyond its jurisdiction, and the Eleventh Circuit agreed. Id. at 994-95. Plaintiffs’ motion to “enforce” the settlement agreement in reality was an attempt to renegotiatethe agreement on grounds (subsequent events) that expressly had been waived in the stipulation of settlement. Id. at 993.

7. Partial Settlements

a. Global Settlements Not Always Possible

Global settlement of securities litigation is often desirable for both plaintiffs and defendants. From thedefendant’s perspective, a global settlement terminates the litigation, permits the client to put the litigationbehind it, and resolves questions of indemnity, contribution, and cross-actions. However, in large cases

involving multiple defendants, sub-classes or alleged wrongdoing over a long period of time, a consensusamong defendants to settle may not be possible. Some defendants accordingly may enter into a partialsettlement with the plaintiffs. Partial settlements present several legal and practical issues.

b. Indemnity

Arguably, indemnity is not available under the federal securities laws. See In re Cont’l Airlines, 203 F.3d 203,215-16 (3d Cir. 2000); Baker, Watts & Co. v. Miles & Stockbridge, 876 F.2d 1101 (4th Cir. 1989); King v.Gibbs, 876 F.2d 1275, 1281 (7th Cir. 1989); Stowell v. Ted S. Finkel Inv. Servs. Inc., 641 F.2d 323, 325 (5thCir. 1981); Laventhol, Krekstein, Horwath & Horwath v. Horwitch, 637 F.2d 672 (9th Cir. 1980); Globus v.Law Research Serv., Inc., 418 F.2d 1276 (2d Cir. 1969); South Carolina Nat’l Bank v. Stone, 749 F. Supp.1419, 1429 (D.S.C. 1990) (finding it well settled that “one tortfeasor may not seek indemnification fromanother under Rule l0b-5”).

The minority view disallows indemnification where scienter is involved, but allows it where one tortfeasor isguilty of negligence only, e.g., a Section 11 tortfeasor seeking indemnification from a Rule l0b-5 tortfeasor. See Adalman v. Baker, Watts & Co., 599 F. Supp. 752, 759 (D. Md. 1984); Muth v. Dechert, Price & Rhoads,391 F. Supp. 935 (E.D. Pa. 1975). State law governs the availability of indemnity in respect of state law claims. See Lucas v. Hackett Assocs., Inc., 18 F. Supp. 2d 531, 535-36 (E.D. Pa. 1998) (holding that indemnity is notavailable for federal securities claims or for state law claims that seek “damages for what are essentiallyviolations of the federal securities laws” but allowing indemnity for state claims that are not “de facto federalsecurities claims” to be determined by the state court). California Corporations Code Sections 25505 and25510 limit the availability of indemnity to a corporation against its principal executive officers, directors, andcontrolling persons whose willful violations gave rise to corporate liability. The theory of indemnity – whethercontractual, federal common law or implied right – will not change the result. See In re Olympia Brewing Co.Sec. Litig., 674 F. Supp. 597 (N.D. Ill. 1987).

c. Contribution

1) General

Congress has expressly conferred a right to contribution for actions brought under Sections 9 and 18 of theExchange Act, 15 U.S.C. §§ 78i(e), 78r(b), as well as Section 11 of the Securities Act, 15 U.S.C. § 77k(f). Fornearly a quarter century, an implied right to contribution has existed under Section 10(b). See Employers Ins. ofWausau v. Musick, Peeler & Garrett, 954 F.2d 575 (9th Cir. 1992), aff’d, 508 U.S. 286 (1993). Congress didnot provide for an express right to contribution for Section 12 of the Securities Act, 15 U.S.C. § 771 (see BakerWatts & Co. v. Miles & Stockbridge, 876 F.2d 1101(4th Cir. 1989)), Section 15 of the Securities Act, 15 U.S.C.§ 77o (see Premier Capital Mgmt., LLC v. Cohen, No. 02C5368, 2005 WL 1564926 (N.D. Ill. July 1, 2005)),Section 16 of the Exchange Act, 15 U.S.C. § 78p, or Section 20A of the Exchange Act, 15 U.S.C. § 78t-1. Contribution is available under the law of most states. See, e.g., N.Y.C.P.C.R. § 1401; Cal. Corp. Code§ 25505; Am. Motorcycle Ass’n v. Superior Court, 20 Cal. 3d 578, 591-98 (1978). A right to contribution existsonly among joint tortfeasors. See Laventhol, Krekstein, Horwath & Horwath v. Horwitch, 637 F.2d 672 (9thCir. 1980); Am. Motorcycle, 20 Cal. 3d at 600; Steed Fin. LDC v. Laser Advisers, Inc., 258 F. Supp. 2d 272,281-82 (S.D.N.Y. 2003) (holding that “joint tortfeasors” are only those who jointly participate in fraud, and thattherefore independent, though concurrent, tortfeasors lack a right to contribution); Restatement (Second) ofTorts, §§ 886A-886(B) (1979); Cal. Corp. Code § 25505; 15 U.S.C. § 77k (contribution under the SecuritiesAct limited to “any person who, if sued separately, would have been liable to make the same payment”). Themodern trend is toward equitable contribution based on relative culpability, rather than the pro-rata approach.

2) The Reform Act

The Reform Act limits joint and several liability. One of the key purposes of the Reform Act was to discourage“the targeting of deep pocket defendants, including accountants, underwriters, and individuals who may becovered by insurance without regard to their actual culpability.” See Joint Explanatory Statement of theCommittee on Conference on the Private Securities Reform Act of 1995, 27 Sec. Reg. & L. Rep. (BNA) 1890-91 (Dec. 1, 1995).

Prior to the Reform Act, the existing “system of joint and several liability create[d] coercive pressure forentirely innocent parties to settle meritless claims rather than risk exposing themselves to liability for a grosslydisproportionate share of the damages in the case.” H.R. Conf. Rep. 104-369, 1995 U.S.C.C.A.N. 730, 736-37(Nov. 28, 1995).

Subject to limited exceptions, the Reform Act abolishes joint and several liability for non-knowing violations ofthe securities laws. Thus, absent knowing violation of the securities laws, a defendant is typically liable onlyfor the percentage of damages for which he is determined to be responsible. See Exchange Act Section 21D(f).

3) Settlement Bar Statutes

(a) General

A plaintiff class will often be able to reach an accord with some, but not all, of the defendants. A defendant thatis otherwise willing to settle may be faced with the threat of contribution claims by non-settling defendants. Asa result, the defendant is unlikely to enter into a partial settlement. Several states have responded to thisinhibiting effect on settlements by passing settlement bar statutes. These statutes bar non-settling defendantsfrom seeking contribution from settling defendants in certain circumstances. See Nelson v. Bennett,662 F. Supp. 1324, 1329 n.7 (E.D. Cal. 1987) (citing 19 different state statutes); S.C. Nat’l Bank v. Stone,749 F. Supp. 1419, 1430 (D.S.C. 1990). Under most settlement bar statutes, if a judgment is later enteredagainst the non-settling defendants, the non-settling defendants are entitled to an offset against the judgment inan amount proportionate to the amount of the settlement. See 2 H. Newberg, Newberg on Class Actions§ l2.42A at 87 (Supp. 1988). The statutes require that the settlements be made in good faith. See In re NucorpEnergy Sec. Litig., 661 F. Supp. 1403, 1411-12 (S.D. Cal.1987).

(b) The Reform Act Settlement Bar

The Reform Act provides for settlement bars for claims pursuant to the Exchange Act. The Exchange Actspecifically provides that upon entry of a settlement by the court, the court shall issue an order barring anyclaims for contribution by or against the settling party. 15 U.S.C. § 78u-4(f)(7). Additionally, the final verdictor judgment shall be reduced by the percentage liability of the settling party or the amount of settlement,whichever is greater. Id.; see also In re Sterling Foster & Co. Sec. Litig., 238 F. Supp. 2d 480 (E.D.N.Y.2002). This bar also applies to outside directors in Section 11 actions. See Lucas v. Hackett Assocs., Inc., 18 F.Supp. 2d 531, 534 (E.D. Pa. 1998) (applying 15 U.S.C. § 78u-4(f)(7) of the Reform Act contribution bar infavor of settling defendants, but holding that “the settling defendants will be estopped from contending in thefuture that viatical settlements are not securities”).

However, the PSLRA settlement bar allows a settling defendant to seek contribution from a third party, if the

settlement agreement extinguishes that third party’s liability. 15 U.S.C. § 78u-4(f)(7)(A). See In re CendantCorp. Sec. Litig., No. 98-CV-1664, 2007 WL 2164241, at *6 (D.N.J. July 25, 2007) (holding PSLRA settlementbar did not prevent settling defendant from seeking contribution against Ernst & Young because the settlementagreement, between plaintiff and settling defendant released Ernst & Young from liability to the plaintiff).

(c) Examples of State Good Faith Settlement Statutes

California Code of Civil Procedure Section 877.6 provides, in pertinent part, that:

[a]ny party to an action in which it is alleged that two or more parties are joint tortfeasors or joint co-obligorson a contract debt shall be entitled to a hearing on the issue of the good faith of a settlement entered into by theplaintiff or other claimant and one or more alleged tortfeasors …, [¶] (c) A determination by the court that thesettlement was made in good faith shall bar any other joint tortfeasor or co-obligor from any further claimsagainst the settling tortfeasor or co-obligor for equitable comparative contribution, or partial or comparativeindemnity, based on comparative negligence or comparative fault.

N.Y. Gen. Oblig. L. § 15-108 (b) provides that:

A release given in good faith by the injured person to one tortfeasor are … relieves him from liability to anyother person for contribution….

4) Judicial Approval Is Required

Judicial approval of the fairness and adequacy of the settlement is required in some jurisdictions before thecourt will bar claims against settling defendants. See Nelson, 662 F. Supp. at 1338. Among the factors to beconsidered in determining whether the settlement is “fundamentally fair and equitable” are “the possibleuncollectability of any larger judgment which might be entered against the settling defendants, the adequacy ofthe settlement amount in light of the comparative culpability of the settling defendants and the uncertainties ofestablishing such liability and the participation of a magistrate or judge in the settlement negotiations.” Nelson,622 F. Supp. at 1338; see Tech-Bilt. Inc. v. Woodward-Clyde & Assoc., 38 Cal. 3d 488, 499-500 (1985)(discussing factors to be taken into account in determining if settlement is made in good faith); Harden v.Raffensperger, Hughes & Co., 933 F. Supp. 763 (S.D. Ind. 1996) (addressing court’s power to order acontribution bar); TBG, Inc. v. Bendis, 36 F.3d 916 (10th Cir. 1994).

5) Application Of Settlement Bars By Federal Courts

Traditionally, a determination that a settlement by some defendants was entered into in good faith did not bar aright to contribution by non-settling defendants for federal securities claims. See Laventhol, Krekstein,Horwath & Horwath v. Horwitch, 637 F.2d 672 (9th Cir. 1980) (finding claims not cut off, but settlingdefendants did not pay “proper” or “fair” share, and suggesting in dictum that result might be different ifdefendants had done so); Harrison v. Sheats, 608 F. Supp. 502, 505-07 (E.D. Cal. 1985) (holding despitefinding of good faith settlement under Section 877.6, non-settling defendant entitled to contribution on federalsecurities claims); Altman v. Liberty Equities Corp., 54 F.R.D. 620 (S.D.N.Y. 1972). However, even before theReform Act, the trend was to cut off claims if a “fair” share is paid by a settling defendant. See Nelson v.Bennett, 662 F. Supp. 1324 (E.D. Cal. 1987) (implied rights of contribution in federal securities actions shouldbe subject to implied settlement bar rule under federal common law); In re Nucorp Energy Sec. Litig.,661 F. Supp. 1403 (S.D. Cal. 1987) (rejecting argument that “fair” share can only be determined after trial);

Smith v. Mulvaney, No. 85-0688, 1985 WL 29953, at *4 (S.D. Cal. June 5, 1985) (holding non-settlingdefendant not entitled to contribution in case where court made finding of good faith settlement underSection 877.6); see also First Fed. Sav. & Loan Ass’n of Pittsburgh v. Oppenheim, Appel, Dixon & Co.,631 F. Supp. 1029, 1036 (S.D.N.Y. 1986) (holding “good faith” settlement under New York law barredcontribution to non-settling defendant on federal securities claims and rejecting “fairness” approach).;Employers Ins. of Wausau v. Musick, Peeler & Garrett, 954 F.2d 575 (9th Cir. 1992), aff’d, 580 U.S. 286(1993) (explaining contribution may be sought through a third party action).

Furthermore, courts have held that nothing in the Reform Act divests a court of its power to fashion a bar orderthat is broader than that contemplated in the Reform Act. See Wisc. Inv. Bd. v. Ruttenberg, 300 F. Supp. 2d1210 (N.D. Ala. 2004); In re Healthsouth Corp. Sec. Litig., 572 F.3d. 854 (11th Cir. 2009) (holding thatPSLRA is not grounds for forbidding a district court from barring claims other than contribution claims). Inother words, the Reform Act does not necessarily strip district courts of the power to enter settlement bar ordersin securities fraud litigation that extinguish non-contribution claims in related cases. See id.

However, other recent court decisions dealing with settlement bars have expressly refused to approvestipulations of settlement that contain proposed bar orders that deviate from the scope of §21D(f)(7)(B) of the1934 Act. See In re Heritage Bond Litig., 546 F.3d 667, 671 (9th Cir. 2008) (holding that a district court’sapproval of the securities class action settlement may bar only claims for contribution or indemnity “ordisguised claims for such relief,” not independent claims against settling defendants); In re Global CrossingSec. & ERISA Litig., 225 F.R.D. 436, 447 (S.D.N.Y. 2004) (approving settlement for D&O defendants onlyafter settling defendants and plaintiffs agreed to adopt the non-settling defendants’ proposal for an alternate barorder, more limited than the original proposal); In re Worldcom, Inc. Sec. Litig., No. 02 CIV. 3288, 2005 WL335201 (S.D.N.Y. Feb. 14, 2005) (refusing to approve partial settlement stipulation that contained bar orderwith judgment reduction provision that could reduce settling defendants’ contribution below that of §21D(f)(7)(B) of the 1934 Act); In re IPO Sec. Litig., 226 F.R.D. 186 (S.D.N.Y. 2005) (conditioning preliminary approvalof settlement on revision of overly broad bar order that left final limitations to the trial court to a bar order“limited to the express wording of §78u-4(f)(7)(A)”). But see Denney v. Jenkins & Gilchrist, No. 03 CIV. 5460(SAS), 2005 WL 388562 (S.D.N.Y. Feb. 18, 2005) (preliminarily approving bar order that left calculation ofjudgment credit to the jurisdictions in which a class member may bring a claim in case with multiple actions inmultiple jurisdictions), vacated in part on other grounds, Denney v. Deutsche Bank AG, 443 F.3d 253 (2d Cir.2006).

Plaintiffs have argued that the Reform Act’s bar order provisions (reducing a verdict or judgment by the greaterof (i) an amount that corresponds to the percentage of responsibility of that covered person; or (ii) the amountpaid to the plaintiff by that covered person) act as a serious deterrent to partial settlement in cases with deeppocket non-settling defendants and potentially enormous exposure. Judge Cote in Worldcom even agreed, butruled that “because the statutory language is clear, the remedy must be legislative.” See In re Worldcom, 2005WL 335201 at *15.

If the outside directors remain in an action where this imbalance of wealth is present, the plaintiff willbe able to collect the entirety of judgment from other [] violators regardless of what percentage ofresponsibility the jury assigns to the outside directors. This is because the plaintiff can collect theentire judgment from a wealthy jointly and severally liable defendant (who will in turn be able torecover only what the outside director co-defendants are actually able to pay, up to the percentage ofthe final judgment for which the jury has deemed them responsible). On the other hand, if the outsidedirectors settle, under the [Reform Act] formula, the outside directors’ assessed proportion of liabilitywill be subtracted from the final judgment amount if it is greater than the actual settlement amount,reducing the plaintiff’s overall recovery by the difference between the proportion of liability and thesettlement amount. As explained above, if the stakes in the case are high, even a relatively smallpercentage of outside-director liability can translate into a vast sum of money to which the plaintiffwill have denied itself access by choosing to settle with the outside directors. As a result, if the “deeppockets” refuse to settle, it is likely that the plaintiff will refuse to settle with outside directors onterms they are able to meet.

Id.

Apart from the Reform Act, some federal courts have refused to apply the forum state’s statute and haveattempted instead to fashion a federal common law. See Nelson v. Bennett, 662 F. Supp. 1324, 1388 (E.D. Cal.1987) (refusing to apply California’s settlement bar statute and instead fashioning a federal common law rulewhich arguably applied the same factors required under the California statute); Eichenholtz v. Brennan, 52 F.3d478 (3d Cir. 1995); Franklin v. Kaypro Corp., 884 F.2d 1222 (9th Cir. 1989); In re Sunrise Sec. Litig.,698 F. Supp. 1256 (E.D. Pa. 1988). But see Langford v. Fox, No. 84 CIV. 5308 (LBS), 1988 WL 70351(S.D.N.Y. Sept. 28, 1988) (“A ‘no-bar’ policy, then, would leave little incentive for one party in a multi-partylitigation to settle, and public policy has long favored settlement, particularly in the case of complex securitiesactions.”).

6) Calculating Set-off Amounts For Non-Settling Defendants

An issue in the federal settlement bar doctrine is the amount of setoff to which the non-settling defendants areentitled by virtue of the plaintiffs’ recovery from the settling defendants. When a settlement extinguishes thecontribution rights of non-settling defendants, those non-settling defendants are entitled to a set-off against thejudgment. See Franklin v. Kaypro Corp., 884 F.2d 1222, 1231 (9th Cir. 1989); In re Masters Mates & PilotsPension Plan, 957 F.2d 1020, 1031 (2d Cir. 1992). Before the enactment of the Reform Act, courts weredivided among three methods for calculating set-off amounts:

(a) The Pro Tanto Method

Any judgment against the non-settling defendants is reduced by the amount paid in settlement. See, e.g.,Harden v. Raffensperger, Hughes & Co., 933 F. Supp. 763 (S.D. Ind. 1996) (adopting pro tanto method forsecurities class action); Singer v. Olympia Brewing Co., 878 F.2d 596, 600 (2d Cir. 1989) (noting pro tantomethod also called “one satisfaction rule”); In re Jiffy Lube Sec. Litig., 772 F. Supp. 890 (D. Md. 1991) (callingthe pro tanto method the most equitable method to all parties).

(b) The Pro Rata Method

Liability is divided into equal slices represented by the aggregate judgment; one slice is allocated to eachdefendant. See Herzfeld v. Laventhol, Krekstein, Horwath & Horwath, 540 F.2d 27, 38 (2d Cir. 1976);

(c) The Proportional Method

The jury determines the relative culpability of each defendant, and the non-settling defendants are liable fortheir share of the judgment based on culpability; Franklin, 884 F.2d at 1231. The claims against non-settlingdefendants will be discounted by the amount that corresponds to that settling defendant’s percentage ofresponsibility.

7) The Reform Act Approach To Set-offs

The PSLRA incorporates aspects of the “proportionate share” approach employed by the Ninth Circuit inFranklin v. Kaypro prior to passage of the PSLRA, and the pro tanto approach favored by other circuits, suchas the Second Circuit. See, e.g., Singer v. Olympia Brewing Co., 878 F.2d 596, 600 (2d Cir. 1989). According tothe PSLRA:

If a covered person enters into a settlement with the plaintiff prior to final verdict or judgment, theverdict or judgment shall be reduced by the greater of (i) an amount that corresponds to the percentageof responsibility of that covered person; or (ii) the amount paid to the plaintiff by that covered person.

15 U.S.C. § 78u-4(f)(7)(B).

Thus, the proportionate method, or option (i), most likely will apply where a settlement is reached with adefendant facing potential liability for all or most of the damages, while the pro tanto method, or option (ii),most likely will apply where a settlement is reached with a defendant that pays more than its proportionateshare of liability. See In re Worldcom, Inc. Sec. Litig., No. 02 Civ. 3288, 2005 U.S. Dist. LEXIS 1805(S.D.N.Y. Feb. 10, 2005) (analyzing proportionate method); In re Initial Pub. Offering Sec. Litig., 226 F.R.D.186, 192 (S.D.N.Y. 2005) (rejecting argument that plaintiffs must know the exact size of the pro tanto creditbased on amount that would ultimately be received before a settlement could be approved); see also Gerber v.MTC Elec. Tech. Co., 329 F.3d 297, 304-305 (2d Cir. 2003) (discussing the difficulty in calculatingproportionate damages in cases before the outcome of a trial on claims that are not common, such as section10(b) and section 14 claims), cert. denied, 540 U.S. 966 (2003).

8) Parties Not In Suit

Settlement agreements cannot bar contribution actions by settling defendants against individuals who were notparties to the original suit. See Employers Ins. of Wausau v. Musick, Peeler & Garrett, 954 F.2d 575, 579 (9thCir. 1992), aff’d, 508 U.S. 286 (1993). The Ninth Circuit determined that the district court erred in failing torecognize that the “fair share” paid by the settling party depends “on the context in which it is used since theconcept of fairness is inherently relational.” Id. at 579. The court noted that “an action for contribution isconcerned with the [fair share] of the individual tortfeasor relative to all others jointly liable for the injury,” asopposed to the “fair share” of the settlement which is relative only to the other defendants. Id. The courtconcluded that “it is axiomatic that a defendant may pay her fair share relative to other parties in the suit and yetpay more than her fair share relative to the universe of all tortfeasors.” Id. This rule appears to remain in effectafter the passage of the PSLRA, in light of the statute’s limitation of the contribution bar to settling defendants,the requirement that allocation of proportional liability determinations include non-parties, and § 21D(f)(8). However, no court has yet squarely addressed the issue.

d. Cross-Actions

Partial settlements present problems concerning cross-actions among co-defendants for primary wrongdoing,indemnity or contribution. Co-defendants may be under pressure to file a cross-action at the time of answeringthe complaint; any subsequent cross-action requires leave of court. Defense counsel must consider whether tofile a cross-action early in the litigation and risk creating an adversarial relationship with both plaintiff and co-defendants or wait until there is substantial exposure in the event of a partial settlement by some defendants, atwhich time a court may be unwilling to grant leave to file a late cross-action absent newly discovered facts. The Reform Act’s bar on contribution claims by or against a settling defendant greatly simplifies this analysis.

e. Severance Of Claims

In the event of a completed or proposed partial settlement, a plaintiff may elect to sever pendent state claims

from any remaining federal causes of action against the non-settling defendants. In California practice, if aplaintiff obtains a good faith determination pursuant to Section 877.6, a non-settling defendant faces increasedpressure to settle because (a) a pendent claim for negligent misrepresentation will yield the same recovery as aRule 10b-5 action but does not require proof of scienter, and (b) the non-settling defendant found liable underthe pendent claim may not obtain contribution under Section 877.6.

8. Collateral Attack Of Settlement

a. Potential Derivative Suits

Counsel should attempt to protect settlements from derivative complaints challenging the terms of thesettlement or alleging the same facts contained in the class action itself. Defendants in a federal securities classaction who enter into a comprehensive settlement with class plaintiffs can be sued derivatively in state court bynon-class member shareholders making virtually identical allegations and challenging the allocation of thesettlement in the federal action as between the company’s officers and its insurer. Therefore, counsel may wishto negotiate releases not just between plaintiffs and defendants but between co-defendants as well – particularlyas between the company and its management.

b. Issue Preclusion Of Federal Claims

A “global” settlement approved in a state court action may release related federal claims. In Epstein v. MCA,Inc., defendants opposed plaintiffs’ federal class certification motion on the grounds that the motion was barredby a Delaware state court action which purported to settle and release both pending state and federal lawclaims. 50 F.3d 644 (9th Cir. 1995). Plaintiffs filed a class action suit against Matsushita in the DelawareCourt of Chancery after Matsushita acquired a Delaware corporation, MCA, Inc. While the Delaware action(which alleged only state law claims) was pending, the “Epstein” plaintiffs filed another class action in federaldistrict court in California alleging violations of certain Exchange Act rules that are within the exclusivejurisdiction of the federal courts. The district court declined to certify the class, entered summary judgment forMatsushita, and dismissed the action. With the federal case on appeal, a settlement was negotiated in the statecourt action and entered as an order of the Delaware Court. This settlement included a global release of allclaims arising out of the Matsushita-MCA acquisition. Matsushita then invoked the settlement to bar furtherprosecution of the federal court action under the Full Faith and Credit Act, 23 U.S.C. § 1738.

The Ninth Circuit found that the state court plaintiffs could not release federal claims of absent class membersin a state court action when the state court did not have jurisdiction to dispose of those federal claims. Id. at665-66. The court therefore declined to give full faith and credit to the Delaware judgment because it purportedto release federal claims based upon different underlying facts from those at issue in the state court action, eventhough the claims in both the federal and state action arose from the same transaction, namely, the merger. Id.at 668.

The Supreme Court reversed the Ninth Circuit in Matsushita Electric Industrial Co. v. Epstein, 516 U.S. 367(1996). The Full Faith and Credit Act, 28 U.S.C. § 1738, requires federal courts to give the judgments of statecourts “the same full faith and credit … as they have by law or usage in the courts of such State … from whichthey are taken.” Nothing in the Act or the securities laws, the Supreme Court ruled, indicated that the Act didnot apply to state court judgments voluntarily releasing exclusively federal claims. 516 U.S. at 381-84. Insteadof judging the validity of the global settlement by the law of Delaware, however, as the Full Faith and CreditAct requires, the Ninth Circuit had fashioned its own test, under which the preclusive effect of the state courtsettlement judgment would be limited to claims that could have been extinguished by adjudication of the stateclaims. Id. at 372 (citing Epstein, 50 F.3d at 665). The Supreme Court then remanded the case to the NinthCircuit.

On remand, the Ninth Circuit initially refused to find that the Epstein plaintiffs’ claims were barred by theDelaware judgment approving the settlement. The court denied full faith and credit to the Delaware judgmenton the grounds that the decision had denied the absent members of the plaintiff class the due process rights toadequate representation. See Epstein v. MCA, Inc., 126 F.3d 1235 (9th Cir. 1997). A petition for rehearing waslater granted and a reconstituted Ninth Circuit panel withdrew its initial decision and came to the oppositeresult. See Epstein v. MCA, Inc., 179 F.3d 641, 648 (9th Cir. 1999). The full court held that adequacy ofrepresentation as determined by the state court was not subject to broad collateral review. As long asprocedural safeguards were employed, absent class members’ due process rights to adequate representationwere protected by the certifying court and, if necessary, remedied on appeal within the forum state’s judicialsystem and by direct review in the United States Supreme Court. Id.

9. Insurance Issues

a. Allocations Are Made From Time Of Settlement

An insurer is responsible for covering costs incurred after settlement so long as potential liability exists basedon facts known to the insured. See Luria Bros. & Co. v. Alliance Assurance Co. Inc., 780 F.2d 1082, 1091 (2dCir. 1986). Courts will not permit insurers to re-litigate the underlying action in order to avoid theirobligations. See Nodaway Valley Bank v. Cont’l Cas. Co., 715 F. Supp. 1458, 1465 (W.D. Mo. 1989), aff’d,916 F.2d 1362 (8th Cir. 1990); Nordstrom, Inc. v. Chubb & Son, Inc., 820 F. Supp. 530 (W.D. Wash. 1992),aff’d, 54 F.3d 1424 (9th Cir. 1995). Instead, a court will allocate defense costs based on the court’sdetermination of what “reasonable allocations should have been made, considering uncertainties in both factand law known at the time of the settlement.” Nodaway Valley Bank, 715 F. Supp. at 1465.

b. An Insurer’s Ability To Allocate

Generally, Director & Officer (“D&O”) Insurance coverage will not cover claims against uninsured individualsor entities. See PepsiCo, Inc. v. Cont’l Cas. Co., 640 F. Supp. 656 (S.D.N.Y. 1986); Fed. Realty Inv. Trust v.Pac. Ins. Co., 760 F. Supp. 533 (D. Md. 1991). However, unless the policy is exceptionally clear, allocatingbetween insured and uninsured defendants and claims may be a major source of negotiation between the carrierand the insured. The question that typically arises is how to allocate when a case includes both covered anduncovered claims, individuals, or entities. See Level 3 Commc’n v. Fed. Ins. Co., 168 F.3d 956 (7th Cir. 1999)(applying “insured vs. insured” exclusion but requiring allocation as between “covered and uncovered” loss).

An insurer providing D&O insurance may allocate defense costs according to covered and uncovered claims. See Okada v. MGIC Indem. Corp., 823 F.2d 276, 282 (9th Cir. 1986); Gon v. First State Ins. Co., 871 F.2d 863,868-69 (9th Cir. 1989). However, no right of allocation exists if “there is no reasonable means of prorating.” Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424, n.5 (9th Cir. 1995) (en banc) (citations omitted); see alsoFed. Realty Inv. Trust, 760 F. Supp. at 536-37. In Okada, the underlying complaint was found to govern theallocation allowance. 823 F.2d at 282. The insurer had to advance defense costs for all covered and potentiallycovered claims although the insurer could reserve its rights as to those claims that fell within the policy’sexceptions to coverage. Id. In Gon, the allocation between covered and uncovered claims could not be easilydistinguished. 871 F.2d at 868-69. The insurer, however, was responsible for all legal expenses as incurred,subject to apportionment and reimbursement for defense of uncovered claims after settlement or judgment. Id.at 869.

Theories of Allocation. The circuit courts currently disagree concerning the appropriate allocation theory toapply when considering an issuer’s responsibility for the reimbursement of defense costs and settlementpayments. The Second Circuit looks at “the relative exposure of the respective parties.” PepsiCo, 640 F. Supp.at 662. The Seventh and Ninth Circuits apply the “larger settlement rule,” allocating as uncovered only thosecosts of litigation or settlement that were greater due to the inclusion of uninsured parties (or claims).

Caterpillar, Inc. v. Great Am. Ins. Co., 62 F.3d 955 (7th Cir. 1995); Harbor Ins. Co. v. Cont’l Bank Corp., 922F.2d 357 (7th Cir. 1990); Nordstrom, Inc., 54 F.3d 1424; Safeway Stores, Inc. v. Nat’l Union Fire Ins. Co., 64F.3d 1282 (9th Cir. 1995).

Bankruptcy Preference. Where the insurer contributes to the settlement under a D&O policy and thecorporation files for bankruptcy shortly thereafter, an issue can arise as to whether the funds contributed by thecarrier may be withdrawn from the settlement as a voidable preference under Section 547 of the BankruptcyCode, 11 U.S.C. § 547. This question was addressed in In re Imperial Corp. of America, 144 B.R. 115 (S.D.Cal. 1992). After securities class actions and derivative suits were filed against it, Imperial Corporation ofAmerica (“ICA”) negotiated a $13 million settlement with plaintiff shareholders. ICA’s insurer, AmericanCasualty, transferred $12.5 million to the settlement fund pursuant to the terms of the D&O policy AmericanCasualty had issued to ICA. Approximately one month later, ICA filed for Chapter 11 bankruptcy protection. Id. at 117.

American Casualty instituted an action to recover the $12.5 million on the theory that the amount constituted avoidable transfer from ICA’s estate under Section 547. However, examining carefully the terms of the D&Opolicy, the court concluded that the policy provided for payment to ICA only for indemnification of its officersand directors. Because ICA could receive payment under the policy only on behalf of its employees, ICA couldhave no interest of its own in the proceeds. Therefore, since “the indemnification proceeds paid to theSettlement Fund … were not a transfer of an interest of the debtor in property,” American Casualty’scontribution to the settlement was not within the terms of Section 547, and American Casualty could notrecover the $12.5 million on this basis. Id. at 120.

10. Attorneys’ Fees After Settlement

When granting fee awards, district courts have broad discretion in determining what is reasonable under thecircumstances. See Luciano v. Olsten Corp., 109 F.3d 111, 115 (2d Cir. 1997); In re Indep. Energy HoldingsSec. Litig., 302 F. Supp. 2d 180, 182 (S.D.N.Y. 2003).

a. Lead Counsel

Under the PSLRA, a fee agreement negotiated between a lead plaintiff and lead counsel as part of a retaineragreement enjoys a presumption of reasonableness. In re Lucent Techs. Inc., Sec. Litig., 327 F. Supp. 2d 426,433 (D.N.J. 2004). Courts must determine whether this presumption is rebutted by a “prima facie showing thatthe retained agreement fee is clearly excessive.” Id. (quoting In re Cendant Corp. Litig., 264 F.3d 201, 283 (3dCir. 2001)); see also, In re HPL Tech., Inc. Sec. Litig., 366 F. Supp. 2d 912, 917 (N.D. Cal. 2005) (noting whilelead plaintiff’s negotiated fee arrangement with lead counsel is owed deference, the fees and expenses must stillbe objectively reasonable.)

The Ninth Circuit held in In re Mercury Interactive Corp. Sec. Litig., 618 F.3d 988 (9th Cir. 2010) that, underthe plain language of Rule 23(h), it was error for the district court to schedule the fee proceedings in such amanner that objections to the fee award had to be made prior to the filing of counsel’s fee petition andsupporting papers.

b. Reasonable Fee

Circuit courts have enumerated different tests to evaluate the reasonableness of a fee award. For example,courts in the Second Circuit examine: (1) time and labor expended by counsel; (2) magnitude and complexity ofthe litigation; (3) litigation risks; (4) quality of the representation; (5) requested fee in relation to the settlement;and (6) public policy. Goldberger v. Integrated Res., Inc., 209 F.3d 43, 50 (2nd Cir. 2000). The Second Circuitpermits both the lodestar and percentage-of-recovery methods for calculating reasonable attorney fees but

disfavors the lodestar method because the “lodestar creates an unanticipated disincentive to early settlements,tempts lawyers to run up their hours and compels district courts to engage in a gimlet-eyed review of line-itemfee audits.” In re Merrill Lynch & Co., Inc. Research Reports Sec. Litig., No. 02 MDL 1484(JFK), 2007 WL313474, at *12 (S.D.N.Y. Feb. 1, 2007) (employing the Goldberger factors to reduce lead counsel’s fee from28% (lodestar multiplier of 2.43) to 22.5% (lodestar multiplier of 1.95)); see also In re Nortel Networks Corp.Sec. Litig., 539 F.3d 129 (2d Cir. 2008) (upholding district court’s reduction of a negotiated fee award from8.5% to 3%, but noting 3% was at the lower-end of what was considered reasonable and that courts should give“serious consideration” to agreements between parties); In re NTL Inc. Sec. Litig., No. 02 Civ. 3013(LAK),2007 WL 1294377, at *4 (S.D.N.Y. May 2, 2007) (applying the Goldberger factors and lode-star “cross-check”to find a 15% fee (negative lodestar multiplier of 0.42) reasonable because it provided sufficient incentive whileavoiding a windfall to counsel at the expense of the plaintiff class); In re Merrill Lynch & Co., Inc. ResearchReports Sec. Litig., 246 F.R.D 156 (S.D.N.Y. 2007) (applying Goldberger factors and lodestar method todetermine that attorneys’ fees of 24% of a $125 million settlement fund were reasonable).

In the Third Circuit, courts apply the factors established in Gunter v. Ridgewood Energy Corp.: (1) complexityand duration of litigation; (2) presence or absence of substantial objections; (3) skill and efficiency of counsel;(4) size of fund and number of persons benefited; (5) risk of nonpayment; (6) amount of time that counseldevoted to the case; and (7) awards in similar cases. 223 F.3d 190 (3d Cir. 2000). The Third Circuit alsorecognizes use of the lodestar method as a check on the percentage-of-recovery calculation. In re Rite AidCorp. Securities Litigation, 396 F.3d 294, 300 (3d Cir. 2005). When performing the lodestar cross check,district courts should apply blended billing rates that approximate the fee structure of all attorneys who workedon the matter. Id. at 306 (holding failure to apply blended rate of partner and associate required vacating theaward and remanding for further consideration); In re HPL Tech., Inc. Sec. Litig., 366 F. Supp. 2d at 918(holding application of lodestar cross check which considered only percentage-based fees and failed to take intoaccount the nature and amount of work put into case is insufficient to ensure a reasonable fee).

The Sixth Circuit applies the factors set forth in Ramey v. Cincinnati Enquirer, Inc., 508 F.2d 1188, 1196 (6thCir. 1974) to determine the reasonableness of fee awards. These relevant factors are: “(1) the value of thebenefit rendered to the corporation to its stockholders, (2) society’s stake in rewarding attorneys who producesuch benefits in order to maintain an incentive to others, (3) whether the services were undertaken on acontingent fee basis, (4) the value of the services on an hourly basis, (5) the complexity of the litigation, and (6)the professional skill and standing of the counsel involved on both sides.” Id.; see also In re Cardinal HealthInc. Sec. Litig., 528 F. Supp. 2d 752 (S.D. Ohio 2007) (discussing the weight afforded to each of the Rameyfactors, including the lodestar cross-check).

In the Seventh Circuit, attorneys’ fees are assessed by “estimating what the parties would have agreed to hadnegotiations occurred at the outset.” Sutton v. Bernard, 504 F.3d 688, 693 (7th Cir. 2007). The district courtshould apply a market-based approach and consider the risk of no recovery. Id. The court should not apply a“degree of success” calculation to determine a fee percentage rate in common fund cases. Id.

c. Non-Lead Counsel

Non-lead counsel are entitled to some compensation when they have conferred a benefit upon the class. Indep.Energy Holdings, 302 F. Supp. 2d at 182 (holding that fees incurred by non-lead counsel after the appointmentof lead counsel are non-compensable); Gottlieb v. Barry, 43 F.3d 474, 490 (10th Cir. 1994) (“[W]e fail to seewhy the work of counsel later designated as class counsel should be fully compensated, while the work ofcounsel who were not later designated class counsel ... should be wholly uncompensated.”); In re CendantCorp. Sec. Litig., 404 F.3d 173, 197 (3d Cir. 2005) (determining fees for the work of non-lead counselpreformed before the appointment of the lead plaintiff will rest in the first instance with the district court,whereas after a lead plaintiff has been appointed, the primary responsibility for compensation shifts to the leadplaintiff, subject to ultimate court approval).


A. Section 10(b) Of The 1934 Act And Rule 10b-5

Section 10(b) of the 1934 Act, 15 U.S.C. § 78j, provides:

a. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality ofinterstate commerce or of the mails, or of any facility of any national securities exchange –

b. To use or employ, in connection with the purchase or sale of any security registered on a nationalsecurities exchange or any security not so registered, any manipulative or deceptive device orcontrivance in contravention of such rules and regulations as the Commission may prescribe as necessaryor appropriate in the public interest or for the protection of investors.

Rule 10b-5, 17 C.F.R. § 240.10b-5, provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality ofinterstate commerce, or of the mails or of any facility of any national securities exchange,

a. to employ any device, scheme or artifice to defraud,

b. to make any untrue statement of a material fact or to omit to state a material fact necessary in order tomake the statements made in light of the circumstances under which they were made, not misleading,

or

c. to engage in any act, practice, or course of business which operates or would operate as a fraud or deceitupon any person, in connection with the purchase or sale of any security.

1. Definition Of Security

In order to fall under the 1934 Act, the thing purchased or sold must be a “security” within the meaning of 15U.S.C. § 78c(a)(10). The term “security” has been broadly defined to include “virtually any instrument thatmight be sold as an investment.” See, e.g., Reves v. Ernst & Young, 494 U.S. 56, 60 (1990), aff’d, 507 U.S. 170(1993). “Stock” is “always an investment if it has the economic characteristics traditionally associated withstock.” Id. at 62 (citing Landreth Timber Co. v. Landreth, 471 U.S. 681, 687, 693 (1985)). Notes are presumedto be securities, a presumption that may be rebutted only by showing that the instrument falls into an exemptedcategory or else bears a “family resemblance” to notes in those exempted categories. Id. at 64-65. Otherinstruments, such as partnership interests and time deposits, have been found to be securities based on the“economic realities” of the transaction. See S.E.C. v. W.J. Howey Co., 328 U.S. 293, 301 (1946).

Under Howey, a security involves (i) an investment of money, (ii) in a common enterprise, (iii) with expectationof profits (iv) to come solely from efforts of others. Id. Significantly, the Supreme Court has stated “thatCongress, in enacting the securities laws, did not intend to provide a broad federal remedy for all fraud.” Marine Bank v. Weaver, 455 U.S. 551, 556 (1982). Particularly where an alternative federal scheme exists to


protect individuals, the Court is more reluctant to find that an instrument is a security. Id. at 558-59 (holdingcertificate of deposit not a security because federal banking laws ensure that individuals are already“abundantly protected”); see also Int’l Bhd. of Teamsters, Chauffeurs, Warehouseman & Helpers of Am. v.Daniel, 439 U.S. 551 (1979) (“If any further evidence were needed to demonstrate that pension plans of thetype involved are not subject to the Securities Acts, the enactment of ERISA in 1974 … would put the matter torest.”).

An investment contract will not be deemed a “security” absent an investment of money. Noncontributorypension plans, for example, are not securities because the plans do not require the employees to give upspecific consideration in return for a separable financial interest with characteristics of a security. See Fishoff v.Coty Inc., No. 09 Civ. 628(SAS), 2009 WL 1585769 (S.D.N.Y. June 8, 2009) (finding that a corporation’s non-contributory incentive plan was not an investment contract and thereby could not be deemed to be a security). However, in S.E.C. v. Edwards, the Supreme Court held that a contributory investment scheme is always asecurity subject to federal securities laws, because regardless of whether an investor expects fixed returns orvariable returns, “[i]n both cases, the investing public is attracted by representations of investment income.” 124 S. Ct. 892, 894 (2004). In regard to the “solely from the efforts of others” prong of Howey, the Court inS.E.C. v. Mutual Benefits Corp., 408 F.3d 737 (11th Cir. 2005), found that a distinction should not be made“between a promoter’s activities prior to his having use of an investor’s money and his activities thereafter.” Id.at 743; Wuliger v. Mann, No. 3:03 CV 1531, 2005 WL 1566751, at *12-13 (N.D. Ohio July 1, 2005) (findingthat viatical settlements were securities, the court noted in regard to such pre/post-purchase distinctions,“economic realities dictate against a narrow approach since there will always be opportunistic entrepreneurswho attempt to evade liability based on those distinctions”). The Second Circuit has emphasized that courts, inevaluating the Howey factors, may look beyond the formal relationship and to the reality of the parties’positions to determine whether the transaction is a “security.” U.S. v. Leonard, 529 F.3d 83, 85-88 (2d Cir.2008) (holding that interests in film companies constitute securities because the investors’ role was passive).

The Ninth Circuit has applied a “risk capital” subtext to determine whether an instrument satisfies Howey’sdefinition of an investment contract. See, e.g., Danner v. Himmelfarb, 858 F.2d 515, 519 (9th Cir. 1988) (underthe risk capital standard the ultimate question is whether the funding party contributed risk capital subject to theentrepreneurial or managerial efforts of others). The “risk capital” test, however, was rejected by the SupremeCourt as a means for determining whether an investment is a “note” under the Securities Acts. S.E.C. v. R.G.Reynolds Enters. Inc., 952 F.2d 1125, 1131 n.6 (9th Cir. 1991). Additionally, while adopted by some statecourts in interpreting state “Blue Sky” legislation, the “risk capital” analysis is of limited use today in federalcourts.

2. Private Right Of Action

Section 10(b) does not expressly create a private right of action; however, the existence of an “implied remedyis simply beyond peradventure.” Herman & MacLean v. Huddleston, 459 U.S. 375, 380 (1983). And of coursethe Reform Act’s requirements for private securities litigation have now in effect given express Congressionalapproval to the private right of action.

3. Overview Of The Elements Of Rule 10b-5

In order to state a cause of action under Rule 10b-5, a private plaintiff must allege each of the followingelements: (a) plaintiff is a purchaser or seller of a security; (b) defendant made a material misstatement oromission; (c) the misrepresentation or omission was “in connection with” the purchase or sale of the security;(d) defendant’s misrepresentation or omission caused plaintiff’s loss; (e) the plaintiff relied on defendant’smisrepresentation or omission; (f) defendant acted with the requisite scienter; and (g) plaintiff suffered damagesfrom the harm. [2] Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005). These elements are discussedbelow.

A plaintiff must allege the elements of a primary violation of 10b-5 with respect to each defendant. Central

Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994) (“Any person or entity,including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement(or omission) on which a purchaser or seller of securities relies may be liable as a primary violator underRule 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met.”); see alsoSimpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006), vacated by Simpson v. Homestore.com, Inc.,519 F.3d 1041 (9th Cir. Mar 26, 2008) (containing extensive discussion of what constitutes a primary violation(cited below)); In re Enron Corp. Sec., Derivative & ERISA Litig., 439 F. Supp. 2d 692, 707 (S.D. Tex. 2006)(noting that all 10(b)-5 elements must be satisfied as to each defendant).

4. Purchaser/Seller Requirement

Plaintiff must be either an actual purchaser or an actual seller of securities, or must possess a contractual right topurchase or sell a security. Being a potential purchaser or seller is not enough. Thus, standing is absent wherean individual (who lacks a contractual right to buy or sell) declines to buy or sell a security because of analleged misstatement or omission. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).

The Supreme Court grounded its decision in the language of section 10(b) of the Securities Exchange Act andRule 10b-5, requiring that any alleged fraud be “in connection with the purchase or sale” of securities. See id.at 733-34, 755-60; see also Davidson v. Belcor, Inc., 933 F.2d 603, 606 (7th Cir. 1991) (holding ex-wife ofpurchaser who had beneficial interest in proceeds of stock sale or exchange had no standing under Section 10(b)or Rule 10b-5); Fraser v. Fiduciary Trust Co., 417 F. Supp. 2d 310 (S.D.N.Y. 2006) (finding officer ofinvestment management company lacked standing to bring securities fraud suit against the company becausethe shares of the company earned as part of compensation did not satisfy the purchaser-seller requirement);Seippel v. Sidley, Austin, Brown & Wood, LLP, 399 F. Supp. 2d 283, 296 (S.D.N.Y. 2005) (denying motion todismiss, court stated that wife may have standing to sue under 10b-5 ‘in connection with’ the exercise and saleof options granted to her husband by her former employer, as well as in the issuance of stock to her husband bythe company he created); Griggs v. Pace Am. Group, Inc., 170 F.3d 877 (9th Cir. 1999) (holding plaintiff whoreceived only a contingent contractual right to receive stock had standing as a “purchaser” under Section 10(b)and Rule 10b-5); In re Cendant Corp. Sec. Litig., 81 F. Supp. 2d 550, 557-58 (D.N.J. 2000) (holding absentsome individual investment decision, employees who receive options or modifications to options under anEmployee Option Stock Plan (“ESOP”) have no standing as purchasers or sellers of securities under Section10(b) or Rule 10b-5); Kinsey v. Cendant Corp., No. 04 CIV. 0582 (RWS), 2004 WL 2591946, at *7 (S.D.N.Y.Nov. 16, 2004) (holding conversion of previously granted options of a target company into the right to buyshares of an acquiring company is not a “purchase” for purposes of federal securities laws); In re AdelphiaCommc’ns Corp. Sec. & Derivative Litig., 398 F. Supp. 2d 244 (S.D.N.Y. 2005) (holding plaintiffs whoreceived stock as a dividend did not engage in purchase within the scope of 10(b)); Ontario Pub. Serv.Employees Union Pension Trust Fund v. Nortel Networks Corp., 369 F.3d 27, 32 (2d Cir. 2004), cert. denied,125 S. Ct. 919 (2005) (clarifying that to have standing, plaintiff must be a purchaser or seller of a security of theentity that made the alleged misrepresentation, not merely a purchaser or seller of a security of any companyaffected by the misrepresentation); Jayhawk Capital Mgmt., LLC v. LSB Indus., Inc., No. 08-2561-EFM, 2009WL 3766371 at *8-9 (D. Kan. Nov. 10, 2009) (finding that plaintiffs had standing because “[l]ooking at thetransaction realistically and as a whole, [the purchase and conversion of securities] involved the sale ofsecurities” thereby rejecting defendant’s technical argument that the transaction was two separate transactionsin which plaintiffs merely held securities and were unable to sell); Abbey v. 3F Therapeutics, Inc., No. 06 CV409(KMW), 2009 WL 4333819 at *6-8 (S.D.N.Y. Dec. 2, 2009) (finding that plaintiff-investor in a shellholding company had standing under Blue Chip Stamps when that “holding company is created for the solepurpose of facilitating an individual’s investment in a single company”). Further, because the plaintiff must bean actual purchaser or seller of securities, a securities claim is not automatically assignable. Dobyns v. Trauter,552 F. Supp. 2d 1150 (W.D. Wash. 2008) (dismissing 10b-5 claim brought by purported assignee due tosuspicious timing and evidentiary problems).

5. The Materiality Requirement

A material misstatement is a misrepresentation of a material fact or an omission of a material fact necessary inorder to make statements made, in light of the circumstances under which they were made, not misleading. 17C.F.R. § 240.10b-5.

Preliminarily, note that only subsection (b) of Rule 10b-5 makes reference to a material misstatement. Whilecompliance with disclosure obligations may be sufficient to dismiss a claim based on Rule 10b-5(b), suchcompliance will not necessarily dispose of claims based upon Rules 10b-5(a) and (c) because violations of thosesections are not limited to an untrue statement of material fact or an omission to state a material fact, and thusthe materiality analysis may differ from that under Rule 10(b)-5(b). Benzon v. Morgan Stanley Distrib., Inc.,420 F.3d 598, 610 (6th Cir. 2005) (citing Affiliated Ute Citizens v. United States, 406 U.S. 128, 152-53 (1972)).

a. Definition

The basic definition of materiality is well-established. “An omitted fact is material if there is a substantiallikelihood that a reasonable shareholder would consider it important” in making an investment decision.” TSCIndus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). “[T]o fulfill the materiality requirement there must bea substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonableinvestor as having significantly altered the ‘total mix’ of information made available.” Basic Inc. v. Levinson,485 U.S. 224, 231-32 (1988) (citations omitted) (adopting TSC Industries materiality standard for Rule 10b-5cases); Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824 (8th Cir. 2003) (materiality should be judged fromperspective of reasonable investor at the time of misrepresentation, not from perspective of investor lookingback); Acito v. IMCERA Group, Inc., 47 F.3d 47, 52 (2d Cir. 1995) (failure to report negative FDA inspectionsof manufacturing plant held immaterial where plant was only one of thirty and FDA took no materially adverseaction against company); In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357, 369 (3d Cir. 1993) (findingoptimistic statement couched amid numerous warnings in prospectus not material); Greenhouse v. MCGCapital Corp., 392 F.3d 650, 658 (4th Cir. 2004) (finding misrepresentation of an executive’s educationalcredentials in public filings immaterial where it serves as plaintiffs’ one and only allegation of fraud); Atlas v.Accredited Home Lenders Holding Co., et al., 556 F. Supp. 2d 1142 (S.D. Cal. 2008) (finding that publicstatements by defendant, a subprime mortgage lender, regarding underwriting standards were material toinvestors, as illustrated by the frequency with which defendants emphasized the standards in press releases andother public statements); Lapin v. Goldman Sachs Group, Inc., 506 F. Supp. 2d 221 (S.D.N.Y. 2006) (rejectingdefendant’s “truth on the market” defense to materiality, finding that public reports of conflicts of interest werecounteracted by contemporaneous statements by the defendant analyst firm that its research was objective);Davis v. SPSS, Inc., 431 F. Supp. 2d 823 (N.D. Ill. 2006) (dismissing complaint with prejudice because theallegations insufficiently alleged the amount, and hence the materiality, of the improper revenue recognition);In re Corning, Inc. Sec. Litig., 349 F. Supp. 2d 698, 720-22 (S.D.N.Y. 2004) (finding immaterial defendants’failure to disclose breast implant litigation over a ten-year period until a major verdict led to bankruptcy, giventhat during the non-disclosure period, claims were relatively few, settlement amounts were a fraction of onepercent of Dow Corning’s net income, and the company won most cases).

b. Mixed Question Of Law And Fact

Materiality is “a mixed question of law and fact, involving as it does the application of a legal standard to aparticular set of facts.” TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). The materiality of anomission is a fact-specific determination that is often properly left to the jury. Fecht v. Price Co., 70 F.3d 1078,1080-81 (9th Cir. 1995). Only in two situations should the court resolve this question as a matter of law: (1) ifthe immateriality of the statement or allegedly omitted fact is so obvious that reasonable minds could not differ(Id.; see also TSC Indus., 426 U.S. at 445, (quoting John Hopkins Univ. v. Hutton, 422 F.2d 1124, 1129 (4thCir. 1970))); or, (2) “if the information is trivial or is ‘so basic that any investor could be expected to know it.’” Ganino v. Citizens Util. Co., 228 F.3d 154, 162 (2d Cir. 2000) (citation omitted); see also No. 84 Employer-Teamster Joint Council Pension Trust Fund v. Am. W. Holding Corp., 320 F.3d 920 (9th Cir. 2003) (rejecting

bright-line rule for materiality that would require an immediate market reaction in favor of fact-specificinquiry).

c. Materiality Of Small Accounting Misstatements

In accounting cases, courts will sometimes view materiality in terms of the percentage of a given misstatementmeasured against a given denominator, with amounts in the range of 2% being presumptively immaterial. See,e.g., Parnes v. Gateway 2000, Inc., 122 F.3d 539, 546 (8th Cir. 1997) (finding immaterial defendants’ allegedoverstatement of assets by $6.8 million as a matter of law where this amount represented only 2% of thecompany’s total assets). But see S.E.C. v. Cohen, No. 4:05 CV 371 (DJS), 2006 WL 2225410, at *2 (E.D. Mo.Aug. 2, 2006) (citing SEC Staff Accounting Bulletin No. 99 and rejecting 2% litmus test because it failed toaddress the cumulative effect of several misstatements)

d. Materiality Of Statements Concerning Medical Devices

In Siracusano v. Matrixx Initiatives, Inc., the Ninth Circuit examined whether appellees’ failure to discloseinformation regarding the possible link between the medicine, Zicam, and anosmia constituted an omission of amaterial fact. 585 F.3d 1167, 1178-79 (9th Cir. 2009). Relying on the Second Circuit’s “statisticalsignificance” standard of materialty, the lower court found the omission to be immaterial because the number ofcomplaints that appellees were aware of were not “statistically significant.” The Ninth Circuit rejected thisreasoning, ruling that the question of whether an event occurs frequently enough to be statistically significant isa question of fact, not of law.

In contrast, a district court in Indiana granted defendant’s motion to dismiss because plaintiffs failed toadequately allege that defendants possessed material information regarding product recalls, the adverse actionresulting from an FDA inspection, and the halt in production of certain medical devices at the time the allegedmisstatements occurred. Plumbers and Pipefitters Local Union 719 Pension Fund v. Zimmer Holdings, Inc.,No. 1:08-cv-1041-SEB-DML, 2009 WL 428940 (S.D. Ind. Dec. 1, 2009).

e. Materiality Of Proposed Mergers

Difficult materiality issues arise in connection with information regarding mergers, which is often speculative,yet which can have obvious significance to investors. In Basic Inc. v. Levinson, 485 U.S. 224 (1988), theSupreme Court held that public companies and their officials are liable for issuing misleading denials orincomplete statements regarding preliminary merger negotiations when that information is “material.” In Basic,the company was sued by former shareholders who alleged that it made misleading statements when it deniedthat it had been engaged in merger talks for more than a year. When the merger talks led to the takeover of theCompany, the shareholders contended that they had suffered damages by selling their shares prior to thetakeover at prices artificially depressed by Basic’s misstatements. Though the Court adopted the “reasonableinvestor” standard of materiality set forth in TSC Industries with regard to Section 10(b) and Rule 10b-5, itdeclined to adopt a bright-line rule regarding materiality. Instead, the Court noted the difficulty of assessingmateriality with respect to contingent or speculative events and adopted the case-by-case approach set forth inS.E.C. v. Tex. Gulf Sulphur Co., 401 F.2d 833, 849 (2d Cir. 1968) (en banc). Basic, 485 U.S. at 238-40(holding “fact-specific inquiry” must be applied when judging the materiality of “contingent or speculative”information or events).

Thus, “materiality [of forward-looking information] ‘will depend at any given time upon a balancing of both theindicated probability that the event will occur and the anticipated magnitude of the event in light of the totalityof the company activity.’” Basic, 485 U.S. at 238. The Court noted that companies did not necessarily have ablanket duty to disclose the existence of negotiations. Instead, they could choose to remain silent or adopt a “no

comment” posture provided they did not make inaccurate, incomplete or misleading statements in suchcircumstances.

The Basic Court also rejected the Sixth Circuit’s rule that once a company denies the existence of mergerdiscussions, even discussions that might not have been material are thereby rendered material. The SixthCircuit’s approach, according to the Court, failed to recognize that to prevail on a Rule 10b-5 claim, “[a]plaintiff must show that the statements were misleading as to a material fact. It is not enough that a statementis false or incomplete, if the misrepresented fact is otherwise insignificant.” Id.; see also Weiner v. QuakerOats Co., 129 F.3d 310 (3d Cir. 1997) (holding in light of potential acquisition, purchasers successfully statedsecurities fraud claim based on corporation’s failure to update information about its total debt-to-totalcapitalization ratio guideline). Taylor v. First Union Corp. of S.C., 857 F.2d 240 (4th Cir. 1988) (holdingmerger discussions were preliminary, contingent, and speculative, thus no duty to disclose existed); Grossmanv. Novell, Inc., 909 F. Supp. 845 (D. Utah 1995), aff’d, 120 F.3d 1112 (10th Cir. 1997) (finding that companystatements concerning merger were no more than vague declarations of corporate optimism and thereforeimmaterial); Panfil v. ACC Corp., 768 F. Supp. 54, 58 (W.D.N.Y.), aff’d, 952 F.2d 394 (2d Cir. 1991) (“Themere ‘intention’ to pursue a possible merger at some time in the future, without more, is simply not a materialfact under rule 10b-5.”).

f. The Level Of Detail

The Court in Basic emphasized that the Exchange Act’s purpose is not “simply to bury the shareholders in anavalanche of trivial information – a result that is hardly conducive to informed decision making.” Basic, 485U.S. at 231 (citing TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 448-49 (1976)); see also Ganino v.Citizens Util. Co., 228 F.3d 154, 161-62 (2d Cir. 2000) (“It is not sufficient to allege that the investor mighthave considered the misrepresentation or omission important. On the other hand, it is not necessary to assertthat the investor would have acted differently if an accurate disclosure was made.”); In re VeriFone Sec. Litig.,784 F. Supp. 1471, 1480 (N.D. Cal. 1992), aff’d, 11 F.3d 865 (9th Cir. 1993) (finding no duty to disclose factthat customers listed in prospectus were not currently ordering from company because prospectus did notcontain any representations about current or future orders from those customers); Gallagher v. Abbott Labs.,269 F.3d 806, 808 (7th Cir. 2001) (holding that companies do not have absolute duty to disclose all informationmaterial to stock prices as soon as news comes into their possession; “[w]e do not have a system of continuousdisclosure. Instead firms are entitled to keep silent (about good news as well as bad news) unless positive lawcreates a duty to disclose”).

g. Information Of Which The Market Is Already Aware

Courts have ruled that it is not a material omission to fail to point out information of which the public is alreadyaware. Baron v. Smith, 380 F.3d 49, 57 (1st Cir. 2004) (citing In re Donald Trump Casino Sec. Litig., 7 F.3d357, 377 (3d Cir. 1993)) (no violation where investors were not informed of the weakened economic conditionsin particular geographic areas); Iron Workers Loc. 16 Pens. v. Hilb Rogal & Hobbs, 432 F. Supp 2d. 571, 580(E.D. Va. 2006) (explaining where information about a company was made available in any analyst report, orby newspaper articles, any withholding of information by the company is immaterial and any omissions by thecompany are cured).

6. Actionable Misstatements

a. Accurate Statements Of Historical Fact

Statements of historical fact that are accurate when made are not actionable. In re Ford Motor Co. Sec. Litig.,381 F.3d 563, 570 (6th Cir. 2004) (holding that the disclosure of accurate earnings data does not become

misleading even if the company might predict less favorable results in the future); In re Convergent Techs. Sec.Litig., 948 F.2d 507, 514 (9th Cir. 1991) (rejecting plaintiff’s contention that financial statements showing pastgrowth misled investors by implying that the company expected its upward trend to continue); Rintel v. Wathen,806 F. Supp. 1467, 1470 (C.D. Cal. 1992) (“[P]laintiffs must allege facts other than the disclosure of accuratehistorical data along with general statements of optimism … in order to state a cause of action.”); Anderson v.Abbott Labs., 140 F. Supp. 2d 894, 909 (N.D. Ill. 2001), aff’d, 269 F.3d 806 (7th Cir. 2001) (“Accuratestatements of historical fact, such as past financial results, are not actionable.”).

Furthermore, “it is well-established that the accurate reporting of historic successes does not give rise to a dutyto further disclose contingencies that might alter the revenue picture in the future.” McDonald v. Kinder-Morgan, Inc., 287 F.3d 992, 998 (10th Cir. 2002) (citing In re Advanta Corp. Sec. Litig, 180 F.3d 525, 538 (3dCir. 1999)).

b. General Statements Of Optimism And Puffery

Generalized statements of optimism (e.g., “we expect this to be a fine year for us”) and puffery are notactionable. See, e.g., In re Ford Motor, 381 F.3d at 570 (determining that statements regarding company’scommitment to safety and quality were immaterial because a reasonable investor would not view them as“significantly changing the general gist of available information”); Grossman v. Novell, Inc., 120 F.3d 1112,1121 (10th Cir. 1997) (statements made by corporation regarding merger, that corporation had experienced“substantial success” in integrating sales forces, that merger was moving “faster than we thought,” and thatmerger presented “compelling set of opportunities” were immaterial statements of corporate optimism andwould not support securities fraud claim); Parnes v. Gateway 2000, Inc., 122 F.3d 539, 547 (8th Cir. 1997)(“[S]oft, puffing statements generally lack materiality because the market price of a share is not inflated byvague statements predicting growth.”) (citation omitted); San Leandro Emergency Med. Group Profit SharingPlan v. Philip Morris Cos., 75 F.3d 801, 811 (2d Cir. 1996) (holding no securities fraud where company madegenerally optimistic statements regarding its prospects and, a few months later, announced a price reduction incompany’s premium brand of cigarette); Raab v. Gen. Physics Corp., 4 F.3d 286, 289 (4th Cir. 1993) (holdingthat statements in Annual Report lacked materiality “because the market price of a share is not inflated byvague statements of growth”); In re Cerner Corp. Sec. Litig., 425 F.3d 1079, 1083-84 (8th Cir. 2005) (holdingthat favorable statements regarding company’s growth, product demand, and future earnings were notmaterially false and misleading due to the company’s failure to disclose that it was losing deals due to increasedcompetition, dissatisfied customers and an economic downturn, where no actual impact was shown.); In reAetna Inc. Sec. Litig., 34 F. Supp. 2d 935, 945 (E.D. Pa. 1999) (“[V]ague expressions of corporate optimismand expectations about a company’s prospects are not actionable because reasonable investors do not rely onsuch statements in making investment decisions.”) (citing Lasker v. New York State Elec. & Gas Corp., 85 F.3d55, 57-58 (2d Cir. 1996)); Jakobe v. Rawlings Sporting Goods Co., 943 F. Supp. 1143, 1157 (E.D. Mo. 1996)(holding CEO’s statement that “I’m confident that this business is sound and poised for growth” was a soft,puffing statement and immaterial as a matter of law); In re Foundry Networks, Inc. Sec. Litig., No. C 00-4823,2003 WL 22077729 (N.D. Cal. Aug. 29, 2003) (company officials’ public statement that business “remains ontrack” was a statement of general optimism, and thus not sufficient to support a securities fraud claim); In reClearly Canadian Sec. Litig., 875 F. Supp. 1410, 1419 (N.D. Cal. 1995) (statements that company “is well-positioned for the future or that it will be a $1 billion dollar company … or … that the company’s distributionagreements are steps towards becoming a global leader” are not actionable as a matter of law); In re VertexPharm., Inc. Sec. Litig., 357 F. Supp. 2d 343, 351 (D. Mass. 2005) (general statements about company’ssuccess not false or misleading where problems with specific product did not have “extensive company-wideeffects”).

Under certain circumstances, however, optimistic statements may be actionable where plaintiff makessufficiently particularized allegations of falsity. See Warshaw v. Xoma Corp., 74 F.3d 955, 959 (9th Cir. 1996)(“even optimistic statements, when taken in context, might constitute a basis for a claim under Section 10(b)and Rule 10b-5”); Fecht v. Price Co., 70 F.3d 1078, 1083 (9th Cir. 1995) (holding allegations of specific

problems undermining defendants’ optimistic claims were sufficient to explain how they are false); In reInterMune, Inc. Sec. Litig., No. C 03-2954 SI, 2004 WL 1737264 (N.D. Cal. July 30, 2004) (finding plaintiffsmade sufficiently detailed allegation of falsity regarding defendants’ statements regarding a marketed drug and,hence, statements were not mere “puffery”).

c. Qualitative Statements Of Opinion

The Supreme Court in Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991), held that knowingly falsestatements of opinion or belief contained in a proxy statement could be actionable, at the least to support a Rule14a-9 claim. The proxy statement in Virginia Bankshares set forth the board’s recommendation thatshareholders approve a merger because minority shareholders would receive a “high” value for their stock. Theplaintiff shareholder alleged that the directors did not believe the price was high or the terms of the merger werefair but recommended the merger only because they wanted to remain on the board.

In finding that knowingly false statements of reasons, opinions, or beliefs could be actionable even thoughconclusory in form, the Court stated that “a statement of belief by corporate directors about a recommendedcourse of action, or an explanation of their reasons for recommending it,” may be material because “there is asubstantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.” Id. at1090-91. As to the term “high” value, the Court found “that such conclusory terms in a commercial context arereasonably understood to rest on a factual basis that justifies them as accurate, the absence of which rendersthem misleading.” Id. at 1093. The Court did say, however, that “proof of mere disbelief or belief undisclosedshould not suffice for liability.” Id. at 1095-96; see also In re Stac Elecs. Sec. Litig., 89 F.3d 1399, 1409 (9thCir. 1996) (finding that plaintiffs’ complaint failed to make any showing that any of the implied assertionsarising from statements in Stac’s prospectus were inaccurate); In re Wells Fargo Sec. Litig., 12 F.3d 922, 930(9th Cir. 1993) (determining that statements which imply factual assertions are actionable if one of threeimplied assertions is inaccurate: that the statement is genuinely believed, that there is a reasonable basis for thatbelief, and that the speaker is not aware of any undisclosed facts tending to seriously undermine the accuracy ofthe statement); Mayer v. Mylod, 988 F.2d 635, 639 (6th Cir. 1993) (“Material statements which contain thespeaker’s opinion are actionable under Section 10(b) . . . if the speaker does not believe the opinion and theopinion is not factually well-grounded.”).

The First Circuit in In re Credit Suisse First Boston, LLC, 431 F.3d 36 (1st Cir. 2005), affirmed the dismissal ofsecurities fraud claims based on alleged false “buy” recommendations made by CSFB’s analysts with respect toa company’s stock. The Court reiterated that a plaintiff can challenge a statement of opinion by pleading factssufficient to indicate that the speaker did not actually hold the opinion expressed, but to do this plaintiff must“point to provable facts that strongly suggest knowing falsity” and may not rely on “conclusory allegationsregarding an analyst’s hidden beliefs.” Id. at 49 (emphasis added). Regarding this heightened “subjectivefalsity” standard, the Court reasoned that “[i]n cases premised on misstatements of opinion, [] the falsityelement, at a minimum, entails an inquiry into whether the statement was subjectively false.... Accordingly, thesubjective aspect of the falsity requirement and the scienter requirement essentially merge.” Id. at 48; accord Inre Salomon Analyst Level 3 Litig., 350 F. Supp. 2d 477, 490 (S.D.N.Y. 2004). Thus, “if a plaintiff adequatelypleads that a statement of opinion was subjectively false when made, the complaint will, ex proprio vigure,satisfy the pleading requirements of the PSLRA relative to scienter.” Credit Suisse First Boston, 431 F.3d at48.

Cases relating to the collapse of the subprime mortgage market have frequently focused on statements ofopinion, particularly in a 1933 Act context. See, e.g., In re IndyMac Mortgage-Backed Sec. Litig., 2010 U.S.Dist. LEXIS 61458 (S.D.N.Y. June 21, 2010) (appraisals and credit ratings were non-actionable matters ofopinion).

d. Statements Rendered False Due To GAAP Violations

A statement made in violation of GAAP may be found to be misleading or inaccurate under the federalsecurities laws. See In re Daou Sys., Inc., 411 F.3d 1006 (9th Cir. 2005); S.E.C. v. Caserta, 75 F. Supp. 2d 79,90 (E.D.N.Y. 1999); In re Physician Corp. of Am. Sec. Litig., 50 F. Supp. 2d 1304, 1317, n.17 (S.D. Fla. 1999)(“[B]ased on the particularities of the facts and circumstances alleged, facts demonstrating overstatement ofrevenues and income in violation of GAAP may constitute the false and misleading statements of material factnecessary for alleging a violation of Rule 10b-5.”); S.E.C. v. Reyes, 491 F. Supp. 2d 906, 913 (N.D. Cal. 2007)(finding GAAP violation even though defendants claimed that misstatements under APB 25’s treatment ofcompensation expenses were immaterial because defendant’s annual report footnotes adequately disclosed anddocumented expenses under FAS 123); In re Levi Strauss & Co. Sec. Litig., 527 F. Supp. 2d 965, 991 (N.D.Cal. 2007) (“[C]hanges in valuation allowances are to be recorded in the period in which the available facts andevidence indicate that it is more likely than not that the associated deferred tax assets will not be realized infuture periods.”). But see In re Nat’l Century Fin. Enters., No. 2:03-MD-1565, 2007 WL 2331929, at *8 (S.D.Ohio Aug. 13, 2007) (dismissing complaint because allegations that auditors misapplied GAAS whileconducting the audit and caused and made misstatements were not misleading public statements).

The premise is simple: if a company’s accounting was improper under GAAP, then figures in reported financialstatements arguably are misleading. In certain cases, however, plaintiffs may attempt to couch misleadingbusiness practices as accounting fraud. For example, in In re Marsh & Mclennan Cos., Inc. SecuritiesLitigation, 501 F. Supp. 2d 452 (S.D.N.Y. 2006), the court rejected plaintiff’s attempt to allege GAAPviolations, noting that the complaint simply recouched the allegations of misleading business practices asaccounting fraud. The complaint failed to cite specific instances of fraudulent accounting practices and failedto cite to any GAAP provisions prohibiting the company’s accounting practices. Even though the court foundthat the complaint did allege misleading statements regarding the company’s business practices, it did not allegefacts showing that the financial statements misstated the company’s financial condition.

e. Statements Regarding Legal Compliance

As a general matter, general statements regarding legal compliance are not actionable because companies haveno duty to opine about the legality of their own actions. See, e.g., Ind. State Dist. Council of Laborers & HodCarriers Pension & Welfare Fund v. Omnicare, Inc., 583 F.3d 935, 945 (6th Cir. 2009). Such information isconsidered “soft” and, therefore, disclosure is not required. Id. However, general statements regarding legalcompliance are actionable if plaintiffs plead sufficient facts to establish that defendants actually knew they werefalse when made. Id. at 945-46; accord Kushner v. Beverly Enters., Inc., 317 F.3d 820, 831 (8th Cir. 2003)(holding that company’s general assertion that it complied with Medicare regulations was not actionable eventhough company was later embroiled in large Medicare fraud investigation, because complaint did notadequately allege defendants knew the statements were untruthful).

f. Forward-Looking Statements And The Reform Act’s Safe Harbor

The Reform Act carved out a “safe harbor” for certain forward-looking statements. 15 U.S.C. § 77z-2; 15U.S.C. § 78u-5. The purpose of the Safe Harbor provision is to encourage disclosure of forward-lookinginformation. H.R. Conf. Rep. No. 104-369, 104th Cong. 1st Sess. at 53 (1995). Specifically, Congress sought“to loosen the ‘muzzling effect’ of potential liability for forward-looking statements, which often kept investorsin the dark about what management foresaw for the company.” Harris v. Ivax Corp., 182 F.3d 799, 806 (11thCir. 1999) (citing H.R. Conf. Rep. 104-369, at 42), reh’g denied, 209 F.3d 1275 (11th Cir. 2000).

1) Covered Forward-Looking Statements

A forward-looking statement is defined as a statement containing a projection of revenue, income or earnings

per share, management’s plans or objectives for future operations, and a prediction of future economicperformance. 15 U.S.C. § 77z-2; 15 U.S.C. § 78u-5(I)(1)(A)-(C). Any statement of “the assumptionsunderlying or relating to” such forward-looking statements also qualifies as a forward-looking statement. 15U.S.C. § 78u-5(I)(1)(D). Moreover, a present-tense statement may fall within the meaning of a forward-looking statement if the truth or falsity of the statement cannot be discerned until some point after the statementis made. Harris, 182 F.3d at 805; Winick v. Pac. Gateway Exchange, Inc., 73 F. App’x 250, 252-53 (9th Cir.2003); In re Splash Tech. Holdings, Inc. Sec. Litig., 160 F. Supp. 2d 1059, 1067-68 (N.D. Cal. 2001).

However, the Reform Act’s safe harbor does not immunize an allegedly fraudulent statement of present orhistorical fact merely because a forward-looking statement is made along with it. Makor Issues & Rights, Ltd.v. Tellabs Inc., 513 F.3d 702, 705 (7th Cir. 2008) (“[A] mixed present/future statement is not entitled to the safeharbor with respect to the part of the statement that refers to the present.”); accord In re Stone & Webster, Inc.Sec. Litig., 414 F.3d 187, 213 (1st Cir. 2005) (“The mere fact that a statement contains some reference to aprojection of future events cannot sensibly bring the statement within the safe harbor if the allegation offalsehood relates to non-forward-looking aspects of the statement.”); see also In re Nortel Networks Corp. Sec.Litig., 238 F. Supp. 2d 613, 629 (S.D.N.Y. 2003) (stating that “even when an allegedly false statement has botha forward-looking aspect and an aspect that encompasses a representation of present fact, the safe harborprovision of the PSLRA does not apply”) (internal quotations omitted). Nonetheless, even statements ofpresent fact will be protected if they “are too vague” and, “when read in context, cannot meaningfully bedistinguished from the future projection of which they are a part.” Institutional Investors Group v. Avaya, Inc.,564 F.3d 242, 255 (3rd Cir. 2009); cf. Ind. State Dist. Council of Laborers & Hod Carriers & Welfare Fund v.Omnicare, Inc., 583 F.3d 935, 943 (6th Cir. 2009) (CEO’s statement that “revenue and earnings growth outlookremains positive” fell within safe harbor because it included the predictive term “growth outlook”; the term“remains” was not enough of a “present circumstance” to take it out of the safe harbor).

2) Definition Of The Safe Harbor

Under the Reform Act Safe Harbor, a forward-looking statement cannot as a matter of law be the basis forSection 10(b) liability IF EITHER:

(a) the forward-looking statement is—identified as a forward-looking statement, and is accompanied by meaningful cautionary statementsidentifying important factors that could cause actual results to differ materially from those in theforward-looking statement;or

(b) the plaintiff fails to prove that the forward-looking statement –(i) if made by a natural person, was made with actual knowledge that the statement was false or

misleading, or

(ii) if made by a business entity, was made or approved by [an executive officer] with actualknowledge by that officer that the statement was false or misleading.

15 U.S.C. § 78u-5(c)(1) (emphasis added); Baron v. Smith, 380 F.3d 49, 53-54 (1st Cir. 2004); see also In reSplash Tech. Holdings, Inc. Sec. Litig., 160 F. Supp. 2d 1059, 1068 (N.D. Cal. 2001).

In other words, “the statute provides that a forward-looking statement cannot be the basis for [section] 10bliability if either the forward-looking statement is accompanied by meaningful cautionary language, or theplaintiff fails to prove that the person making the statement made it with actual knowledge that the statementwas false and misleading.” In re Boeing Sec. Litig., 40 F. Supp. 2d 1160, 1167 (W.D. Wash. 1998). In thisway, the Reform Act not only codified but also expanded upon the “bespeaks caution” doctrine, see supra PartII.C.3.d, by precluding liability if plaintiff fails to prove “actual knowledge” that the forward-looking statement

was false or misleading. See In re Advanta Corp. Sec. Litig., 180 F.3d 525, 536 (3d Cir. 1999).

Several courts hold that even forward-looking statements made with actual knowledge of their falsity areprotected by the safe harbor so long as they are identified as forward-looking and accompanied by meaningfulcautionary language. See, e.g., Harris v. Ivax Corp., 182 F.3d 799, 803 (11th Cir. 1999) (noting that “if astatement is accompanied by meaningful cautionary language, the defendants’ state of mind is irrelevant.”)(internal quotations omitted); In re Gilat Satellite Networks, Ltd., No. CV-02-1510 (CPS), 2005 WL 2277476,at *11-12 (E.D.N.Y. Sep. 19, 2005) (“[T]he first prong of the PSLRA safe harbor places a limit on materiality. Once a court determines that a forward-looking statement is accompanied by cautionary language sufficientlymeaningful as to render it incapable of being reasonably relied upon, it is immaterial as a matter of law and thecourt need not consider the defendants’ state of mind. The second prong, subsection B, imposes a heightenedscienter requirement for forward-looking statements not accompanied by cautionary language. Those falsestatements are immunized so long as they were not knowingly false.”). The Fifth Circuit has reached a contraryconclusion, holding that “the safe harbor provision is inapplicable to all alleged misrepresentations” where “thedefendants actually knew that their statements were misleading at the time they were made.” Lormand v. U.S.Unwired, Inc., 565 F.3d 228, 244 (5th Cir. 2009).

3) The Safe Harbor Applies To Oral Statements

The Safe Harbor also applies to oral statements if accompanied by (1) a statement identifying the projection as aforward-looking statement that cautions that actual results could differ materially; and (2) a reference topublicly available written materials which describe the necessary risk factors. See 15 U.S.C. § 77z-2(c)(1)(B)(2); 15 U.S.C. § 78u-5(c)(1)(B)(2); see also Constr. Laborers Pension Trust of Greater St. Louis v. NeurocrineBiosciences, Inc., 2008 WL 2053733, at *10-11 (S.D. Cal. May 13, 2008) (statements made during conferencecalls referring listeners to risk factors contained in SEC filings were sufficient to incorporate the risk factors byreference).

4) No Duty To Update Forward-Looking Statements

Furthermore, the Safe Harbor provisions in both the Securities Act and the Exchange Act specifically providethat neither provision imposes a duty to update a forward-looking statement. See 15 U.S.C. § 77z-2(d); 15U.S.C. § 78u-5(d).

5) Defining “Meaningful Cautionary Language”

In determining whether forward-looking statements are accompanied by sufficient “meaningful cautionarylanguage,” several courts have looked at what it means to identify “important factors that could cause actualresults to differ materially.” Citing the language of the Reform Act, courts have held that defendants mustidentify such important factors but need not identify all such factors. Harris v. Ivax Corp., 182 F.3d 799, 807(11th Cir. 1999) (“[F]ailure to include the particular factor that ultimately causes the forward-looking statementnot to come true will not mean that the statement is not protected by the safe harbor.”) (quoting from the H.R.Conf. Rep. 104-369 at 44); see also Ehlert v. Singer, 85 F. Supp. 2d 1269, 1273 (M.D. Fla. 1999), aff’d andremanded, 245 F.3d 1313 (11th Cir. 2001) (explaining the Reform Act “does not require that the prospectus listall factors that might influence the company’s financial future”); Rasheedi v. Cree Research, Inc., No. 1:96 CV00890, 1997 WL 785720, at *1 (M.D.N.C. Oct. 17, 1997) (quoting H.R. Conf. Rep. 104-369). Thus,defendants do not have to “caution against every conceivable factor that may cause results to differ.” Rasheedi,1997 WL 785720, at *2; see also Wenger v. Lumisys, Inc., 2 F. Supp. 2d 1231, 1242 (N.D. Cal. 1998) (rejectingplaintiff’s argument that every oral forward-looking statement must be accompanied by a separate cautionary

statement to receive Safe Harbor protection).

Courts will, however, evaluate the content of the cautionary language to make sure it is “meaningful.” See In reCompuware Sec. Litig., 301 F. Supp. 2d 672 (E.D. Mich. 2004) (determining that defendant’s warning ofpossible competition was not meaningful because it implied that competition was only a possibility, whendefendant was aware that a competing business was a significant threat); In re Duane Reade Inc. Sec. Litig., No.02- CIV. 6478, 2003 WL 22801416 (S.D.N.Y. Nov. 25, 2003), aff’d, 107 F. App’x 250 (2d Cir. 2004) (holdingthat cautionary language that is “too prominent and specific to be disregarded” will protect a company fromliability for its forward-looking information) (citations omitted); Selbst v. McDonald’s Corp., No. 04C2422,2005 WL 2319936, at *18 (N.D. Ill. Sept. 21, 2005) (holding vague and boilerplate cautionary language is notsufficient to bring projections within first prong of the safe harbor rule) (citing Asher v. Baxter Int’l Inc., 377F.3d 727 (7th Cir. 2004)).

6) Some Forward-looking Statements Ineligible For The Safe Harbor

The Reform Act’s Safe Harbor is subject to limitations and does not protect certain types of forward-lookingstatements, including statements: (1) included in financial statements prepared in accordance with GAAP,particularly those that purport to be forward-looking but fail to disclose existing material information (see, e.g.,In re Home Health Corp. of Am. Sec. Litig., No. CIV. A. 98-834, 1999 WL 79057, at *10 (E.D. Pa. Jan. 29,1999)); (2) contained in an IPO registration statement; (3) made in connection with a tender offer; (4) made inconnection with a partnership, LLC or direct participation program offering; or (5) made in beneficialownership disclosure statements filed with the SEC under Section 13(d) of the 1934 Act. See 15 U.S.C. §77z-2(b)(2); 15 U.S.C. § 78u-5(b)(2); H.R. Conf. Rep. 104-369 at 46.

Moreover, the Safe Harbor does not extend to an issuer who: (a) during the three year period preceding the dateon which the statement was first made, has been convicted of a felony or misdemeanor under § 15(b)(4)(I)-(iv)or is the subject of a decree or order involving a violation of the securities laws; or (b) makes the statement inconnection with a “blank check” securities offering, “rollup transaction,” or “going private” transaction; or (c)issues penny stock. See 15 U.S.C. § 77z-2(b)(1); 15 U.S.C. § 78u-5(b)(1); H.R. Conf. Rep. 104-369 at 46.

g. Statements That “Bespeak Caution”

Even if forward-looking statements fall outside the Reform Act’s Safe Harbor, the statements may still fallunder the traditional “bespeaks caution” doctrine. Most circuit and district courts have declined to imposeliability on the basis of forward-looking statements that “bespeak caution.” As explained by the Ninth Circuit: “[T]he ‘bespeaks caution’ doctrine has developed to address situations in which optimistic projections arecoupled with cautionary language … affecting the reasonableness of reliance on and the materiality of thoseprojections. To put it another way, the ‘bespeaks caution’ doctrine reflects the unremarkable proposition thatstatements must be analyzed in context.” In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1414 (9th Cir.1994) (citation omitted). The doctrine holds that economic projections, estimates of future performance, andsimilar optimistic statements in a prospectus or other written document are not actionable when precisecautionary language elsewhere in the document adequately discloses the risks involved. Even if the optimisticstatements are later found to have been based on erroneous or inaccurate assumptions when made, liability willnot be imposed so long as the risk disclosure was conspicuous, specific, and adequately disclosed theassumptions upon which the optimistic language was based. Id. at 1413. But see In re NVE Corp. Sec. Litig.,551 F. Supp. 2d 871, 893 (D. Minn. 2007) (“Meaningful cautionary language need not explicitly mention therealized risk, as long as it warned of risks of similar significance ….”), aff’d, 527 F.3d 749 (8th Cir. 2008).

The Safe Harbor provisions of the Reform Act largely adopt the “bespeaks caution” doctrine, but the ReformAct also protects statements without meaningful cautionary language where plaintiffs fail to show actualknowledge that the forward-looking statement was false or misleading. The Joint Explanatory Statement of the

Committee of Conference on the Private Securities Litigation Reform Act of 1995, 27 Sec. Reg. & L. Rep.(BNA) 1894 (Dec. 1, 1995), specifically provides that the Safe Harbor provisions are not intended to replace thebespeaks caution” doctrine or further judicial development of the doctrine. Id. at 1895; see also Little Gem LifeSciences LLC v. Orphan Medical, Inc., No. CIV. 06-1377 ADM/AJB, 2007 WL 541677 (D. Minn. Feb. 16,2007) (noting bespeaks caution doctrine applies to “going private” mergers, though the Reform Act’s “SafeHarbor” provision does not, and finding the Reform Act has no preemptive effect on the bespeaks cautiondoctrine).

1) Evolution Of The “Bespeaks Caution” Doctrine And Its Application

The “bespeaks caution” doctrine was first formulated in Polin v. Conductron Corp., 552 F.2d 797, 806 (8th Cir.1977) (holding that economic projections are not actionable if they bespeak caution) and has been subsequentlyadopted by every circuit. The “bespeaks caution” doctrine allows courts to rule that a defendant’s forward-looking representations contain enough cautionary language or risk disclosures to render the representationimmaterial, and thereby protect against claims for securities fraud. See, e.g., San Leandro Emergency Med.Group Profit Sharing Plan v. Philip Morris Cos., Inc., 75 F.3d 801, 811 (2d Cir. 1996); In re Donald J. TrumpCasino Sec. Litig., 7 F.3d 357, 364, 371-73 (3d Cir. 1993); Gasner v. Bd. of Supervisors, 103 F.3d 351, 358 (4thCir. 1996); Rubinstein v. Collins, 20 F.3d 160, 166-68 (5th Cir. 1994); Sinay v. Lamson & Sessions Co., 948F.2d 1037, 1040-41 (6th Cir. 1991); Harden v. Raffensperger, Hughes & Co., Inc., 65 F.3d 1392, 1404-06 (7thCir. 1995) (noting that “bespeaks caution” is consistent with language of Virginia Bankshares); Moorhead v.Merrill Lynch, Pierce, Fenner & Smith, Inc., 949 F.2d 243, 245 (8th Cir. 1991); In re Worlds of Wonder Sec.Litig., 35 F.3d 1407, 1413 (9th Cir. 1994) (noting, however, that by definition, the “bespeaks caution” doctrineapplies only to affirmative, forward-looking statements); Grossman v. Novell, Inc., 120 F.3d 1112, 1120 (10thCir. 1997); Saltzberg v. TM Sterling/Austin Assoc., Ltd., 45 F.3d 399, 400 (11th Cir. 1995) (per curiam); In reBaan Co. Sec. Litig., 103 F. Supp. 2d 1, 15 (D.D.C. 2000).

In In re Stac Electronics Securities Litigation, 89 F.3d 1399, 1406 (9th Cir. 1996), the complaint alleged,among other things, that Stac went public knowing, but without disclosing, that Microsoft was about to releasea competitive product. The Court found, however, that the company’s prospectus made detailed disclosuresconcerning the risks of competition, specifically stating that one developer had already licensed a competitivedata compression product and that “[t]here can be no assurance that Microsoft … will not incorporate acompetitive data compression technology in their products.” As the Court stated, the Stac prospectus “neitherstints on warnings nor fails to disclose Stac’s practices, but ‘fairly overflows’ with specific and detailedcautionary language.” Id. The Court accordingly held that the district court properly dismissed plaintiffs’prospectus-based claims. Id.; see also In re Syntex Corp. Sec. Litig., 95 F.3d 922, 929 (9th Cir. 1996) (findingno liability where annual report expressly acknowledged that the precise effect of a consent decree could not beknown, and that the company was merely stating its opinion that the consent decree would not have any“material adverse effect”); Saltzberg, 45 F.3d at 400 (affirming summary judgment where cautionary languagewas not “boilerplate and was not buried among too many other things, but was explicit, repetitive and linked tothe projections about which plaintiffs complain”); Barrios v. Paco Pharm. Servs., Inc., 816 F. Supp. 243, 250(S.D.N.Y. 1993) (“[E]conomic projections were cloaked in express warnings that they were entirelyspeculative; they are not actionable because they bespeak caution in precise language and specifically disclosethe nature and extent of the risks involved.”). But see Fecht v. Price Co., 70 F.3d 1078, 1082 (9th Cir. 1995)(reversing dismissal because cautionary language was inadequate; “[a] motion to dismiss for failure to state aclaim will succeed only when the documents containing defendants’ challenged statements include ‘enoughcautionary language or risk disclosure,’ that ‘reasonable minds’ could not disagree that the challengedstatements were not misleading”).

Where offering documents expressly warn investors not to rely on certain projections, reliance on thoseprojections clearly is not justified. Friedman v. Ariz. World Nurseries Ltd. P’ship, 730 F. Supp. 521, 536-41(S.D.N.Y. 1990), aff’d, 927 F.2d 594 (2d Cir. 1991); Brown v. E.F. Hutton Group, 735 F. Supp. 1196(S.D.N.Y. 1990) (granting summary judgment to defendants on Section 10(b) claims because prospectus

included extensive discussion of risk factors of investment), aff’d, 991 F.2d 1020 (2d Cir. 1993).

2) Cautionary Language Need Not Necessarily Be In Same Document

The “bespeaks caution” doctrine does not require the cautionary language to be contained in the same documentas the purported false statements. See, e.g., Asher v. Baxter Int’l Inc., 377 F. 3d 727, 731 (7th Cir. 2004)(holding that cautionary language contained in the company’s Form 10-K brought allegedly misleading pressreleases and executives’ oral statements within the safe harbor, even though language in the 10-K did notaccompany the press release or oral statements); In re AMDOCS Ltd. Sec. Litig., 390 F.3d 542, 548 (8th Cir.2004) (finding cautionary statements regarding market erosion and softening customer demand sufficient tomake prior statements hyping customer demand immaterial); EP Medsystems, Inc. v. EchoCath, Inc., 235 F.3d865, 874 (3d Cir. 2000) (explaining cautionary language must be directly related to the allegedmisrepresentations or omissions but does not need to actually accompany it); Grossman v. Novell, Inc., 120F.3d 1112, 1122 (10th Cir. 1997); San Leandro Emergency Med. Group Profit Sharing Plan v. Philip MorrisCos., 75 F.3d 801 (2d Cir. 1996) (holding cautionary language in Annual Report “bespeaks caution” withregard to optimistic statements in press releases and newspaper articles); Raab v. Gen. Physics Corp., 4 F.3d286 (4th Cir. 1993) (holding cautionary language in press release bespeaks caution with regard to optimisticstatement in contemporaneous Annual Report). But see In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1413(9th Cir. 1994) (stating in dicta that the “bespeaks caution” doctrine applies only when “precise cautionarylanguage elsewhere in the document adequately discloses the risks involved”).

3) Limitations On The “Bespeaks Caution” Doctrine

There are several significant limitations on the “bespeaks caution” doctrine. First, cautionary language cited tojustify application of the doctrine must precisely address the substance of the specific statement or omission thatis challenged. In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357 (3d Cir. 1993). Second, cautionarylanguage does not protect material misrepresentations or omissions when defendants knew they were falsewhen made. U.S. v. Carter, 355 F. 3d 920 (6th Cir. 2004) (“It would be perverse indeed if an offer or couldknowingly misrepresent historical facts but at the same time disclaim those misrepresented facts withcautionary language.”); In re Westinghouse Sec. Litig., 90 F.3d 696, 705-10 (3d Cir. 1996) (finding thatcautionary language did not sufficiently counter the alleged misrepresentations, i.e., that the defendantsknowingly or recklessly misrepresented the adequacy of loan loss reserves and compliance with GAAP);Provenz v. Miller, 102 F.3d 1478 (9th Cir. 1996) (finding that the alleged cautionary statements were toogeneral to trigger the “bespeaks caution” doctrine; defendant’s disclosure that it was having sourcing and costproblems with certain product line held insufficient where evidence suggested that the line was plagued withdelays and performance problems so severe that the company was losing orders and constantly cutting salesforecasts); see also Harden v. Raffensperger, Hughes & Co., 65 F.3d 1392, 1404 (7th Cir. 1995) (same);Rubenstein v. Collins, 20 F.3d 160, 171 (5th Cir. 1994) (“[T]o warn that the untoward may occur when theevent is contingent is prudent; to caution that it is only possible for the unfavorable events to happen when theyhave already occurred is deceit.”). Accordingly, courts may refuse to apply the doctrine at the pleading stagewhere defendants are alleged to have information that makes even the asserted cautionary statementsfraudulent. See, e.g., Sides v. Simmons, No. 07-80347-CIV, 2007 WL 2819371, at *6 (S.D. Fla. Sept. 24, 2007)(finding that the bespeaks caution doctrine was not available as a defense in connection with a circularmisrepresenting the ownership of real estate because language included in the disclaimer did not warn ofdangers inherent in the investment, and the only cautionary language was designed to protect the distributor ofdocument, not the public).

h. Projections

Before Congress enacted the Reform Act, numerous circuits had addressed the materiality of earnings forecastsor projections. For example, the Ninth Circuit held that projections and general statements of optimism may beactionable under the federal securities laws because such statements contain “at least three implicit factualassertions: (1) that the statement is genuinely believed; (2) that there is a reasonable basis for that belief; and(3) that the speaker is not aware of any undisclosed facts tending to seriously undermine the accuracy of thestatement.” In re Apple Computer Sec. Litig., 886 F.2d 1109, 1113 (9th Cir. 1989). To the extent that “one ofthese implied assertions is inaccurate,” a projection or statement of belief may be actionable. Id.; see also In reVeriFone Sec. Litig., 11 F.3d 865, 870 (9th Cir. 1993); Isquith v. Middle South Utils., Inc., 847 F.2d 186, 203-04 (5th Cir. 1988) (liability depends on whether predictive statement was “false” when made, and “falsity isdetermined by examining the nature of the prediction”). The SEC’s policy of encouraging the disclosure ofprojections is currently set forth in 17 C.F.R. § 229.1(b) and has been further endorsed by the Safe Harborprovisions in the Reform Act which preclude liability for projections that are accompanied by meaningfulcautionary language. See 15 U.S.C. § 78u-5(c)(1)(A).

Under the standard articulated in Apple, even if projections are unaccompanied by meaningful cautionarylanguage, they are not actionable, so long as they are genuinely believed by the speaker unless they lack anyreasonable basis or unless the speaker was aware of undisclosed facts tending to seriously undermine theaccuracy of the statement. See In re Convergent Techs. Sec. Litig., 948 F.2d 507, 516 (9th Cir. 1991) (holdingdefendants not obliged to disclose detailed internal projections that are not reasonably certain); In re LyondellPetrochem. Co. Sec. Litig., 984 F.2d 1050, 1052-53 (9th Cir. 1993) (holding no duty to disclose projectionsindicating that 1989 income and revenues would be below 1988 levels, reasoning that “[a] corporation may becalled upon to make confidential projections for a variety of sound purposes where public disclosure would beharmful”).

As discussed supra, projections of revenues, income, earnings per share, capital expenditures, dividends, capitalstructure, or other financial items are subject to the Reform Act’s Safe Harbor for forward-looking statements. Ronconi v. Larkin, 253 F. 3d 423 (9th Cir. 2001); Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir. 2001); In reAdvanta Corp. Sec. Litig., 180 F.3d 525 (3d Cir. 1999) (citing 15 U.S.C. § 78u-5(i)(1)(A)). In Winer FamilyTrust v. Queen, 503 F.3d 319, 331-33 (3d Cir. 2007), the court found that flawed preliminary cost estimates forrenovating a meat processing facility, which were made before acquisition of the facility was final and weresubsequently revised, did not support a strong inference of scienter. Rather, the most plausible inference to bedrawn was that the estimates were revised to reflect new information and subsequent negotiations. The courtconcluded that “[a] reasonable person would not deem the inference of scienter cogent and at least ascompelling as any non-culpable inference,” as required under Tellabs.

In In re Syntex Corp. Sec. Litig., 95 F.3d 922, 930 (9th Cir. 1996), the Court determined that a prediction thatthe over-the-counter product Naprosyn would be approved “well in advance of” the 1993 patent expiration wasmerely a forecast and plaintiffs failed to plead facts showing that the statement was false when made as requiredunder Rule 9(b). The court distinguished Warshaw v. Xoma Corp., 74 F.3d 955 (9th Cir. 1996), noting that inWarshaw the company stated that approval of an E-5 drug was imminent when it knew that approval wasunlikely. The Court concluded that any statements related to future sales of new products were merelyforecasts. Quoting VeriFone, the court stated that “because defendants’ predictions proved to be wrong inhindsight does not render the statements untrue when made.” Syntex, 95 F.3d at 934; see also In re VeriFoneSec. Litig., 784 F. Supp. 1471, 1487 (N.D. Cal. 1992), aff’d, 11 F.3d 865 (9th Cir. 1993) (explaining“[p]laintiffs must show why the projection disclosed lacked a reasonable basis” and existence of contradictoryinternal projections will not support inference that disclosed projection was unreasonable); accord Steiner v.Tektronix, Inc., 817 F. Supp. 867, 878 (D. Or. 1992) (“[F]ailure to be clairvoyant is not a sign of Tek’s lack ofsincerity.”). Cf. Provenz v. Miller, 102 F.3d 1478 (9th Cir. 1996) (reversing grant of summary judgment fordefendants where company executive, disregarding reliable internal spreadsheet predicting a $4 million loss forthe quarter, predicted quarterly earnings of approximately $624,000).

Decisions in other circuits are consistent with the approach espoused by the Ninth Circuit and have generallyrequired that a plaintiff allege that a projection was made without a reasonable basis. See, e.g., Searls v.

Glasser, 64 F.3d 1061, 1066-1067 (7th Cir. 1995) (summary judgment for defendants affirmed because “loosepredictions” are “not actionable,” and CEO’s characterization of corporation as “recession resistant” was toovague to constitute material statement of fact); In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357, 368 (3dCir. 1993) (characterizing forecasts as “soft information [which] may be actionable misrepresentations if thespeaker does not genuinely and reasonably believe them”); Raab v. Gen. Physics Corp., 4 F.3d 286, 287-90 (4thCir. 1993) (holding “prognostications [were] not the specific guarantees necessary to make such predictionsmaterial” and vague statements of opinion are not actionable because they are considered immaterial anddiscounted by the market as “puffing”); Arazie v. Mullane, 2 F.3d 1456, 1468 (7th Cir. 1993) (granting motionto dismiss where plaintiffs failed to allege adequately that projections lacked a “reasonable basis”); Wielgos v.Commonwealth Edison Co., 892 F.2d 509, 515-16 (7th Cir. 1989) (granting summary judgment wheredefendant’s projections drastically underestimated certain operating costs because plaintiffs failed todemonstrate strong facts showing that there was no reasonable basis for the company’s predictions).

i. Mosaic Misrepresentation Thesis

Where statements in isolation appear accurate but collectively appear misleading, courts are in disagreementover how much context may appropriately be considered in determining whether a given statement isactionable. One view examines each statement in isolation without regard to other alleged misstatements. Seegenerally In re Apple Computer Sec. Litig., 886 F.2d 1109, 1118 (9th Cir. 1989). At the other end of thespectrum is the “mosaic misrepresentation thesis.”

In Isquith v. Middle South Utils., Inc., 847 F.2d 186 (5th Cir. 1988), the Fifth Circuit adopted a “mosaicmisrepresentation thesis,” holding that a plaintiff need not link each and every alleged omission of material factto an affirmative statement. Rather, accurate statements may be misleading if the statements, in the aggregate,create a misleading impression. “[C]ourts interpreting the securities laws have long recognized that reviewingthe context in which a disclosure appears is an essential part of determining the disclosure’s adequacy.” Id. at201; see also Fecht v. Price Co., 70 F.3d 1078, 1081 (9th Cir. 1995) (reversing dismissal because “the mix ofinformation contained in the public documents issued by the Company does not clearly preclude ‘reasonableminds’ from differing on the question of whether they included misleading statements”); Warshaw v. XomaCorp., 74 F.3d 955, 958-59 (9th Cir. 1996) (following Fecht); S.E.C. v. Fitzgerald, 135 F. Supp. 2d 992, 1028(N.D. Cal. 2001) (“A defendant’s statements ‘must be viewed as part of a ‘mosaic’ to see if those statements, inthe aggregate, created a misleading impression.’”) (quoting In re Genentech, Inc. Sec. Litig., No. C-88-4038-DLJ, 1989 WL 106834, at *3 (N.D. Cal. July 7, 1989).

Many courts have questioned the legitimacy of the mosaic thesis following passage of the Reform Act. See Inre Harmonic, Inc. Sec. Litig., 163 F. Supp. 2d 1079, 1093 n.12 (N.D. Cal. 2001) (questioning whether themateriality standard in Isquith survived the passage of the Reform Act); see also In re Convergent Techs. Sec.Litig., 948 F.2d 507, 512 (9th Cir. 1991) (“[T]o prevail, the plaintiffs must demonstrate that a particularstatement, when read in light of all the information then available to the market … conveyed a false ormisleading impression.”).

j. Statements In Analyst Reports

In the absence of any statement on a subject by a given defendant, plaintiffs may attempt to attribute todefendants the statement of somebody else, generally an analyst. A defendant can be liable for the false ormisleading statements of third parties, including analysts, if the defendant either (1) expressly or impliedlyadopts or endorses the statements (the “adoption” or “entanglement” theory) (see In re Syntex Corp. Sec. Litig.,95 F.3d 922, 934 (9th Cir. 1996)), or (2) provides the analyst with false or misleading information with theintent that the analyst communicate that information to the market (the “conduit” theory). See Cooper v.Pickett, 137 F.3d 616, 624-25 (9th Cir. 1997); Warshaw v. Xoma Corp., 74 F.3d 955, 959 (9th Cir. 1996). These theories of liability are typically employed where defendants have not directly made misleading

statements to the market, but “put [their] imprimatur, express or implied” on the third-party’s statements. In reStac Elecs. Sec. Litig., 89 F.3d 1399, 1410 (9th Cir. 1996) (quoting In re VeriFone Sec. Litig., 784 F. Supp.1471, 1486 (N.D. Cal. 1992), aff’d, 11 F.3d 865 (9th Cir. 1993)); see also Nursing Home Pension Fund v.Oracle Corp., 380 F.3d 1226, 1234-35 (9th Cir. 2004) (“[W]hen statements in analysts’ reports clearlyoriginated from the defendants, and do not represent a third party’s projection, interpretation, or impression, thestatements may be held to be actionable even if they are not exact quotations.”).

1) The “Adoption” Or “Entanglement” Theory

To succeed under the adoption theory of liability, plaintiffs must show that “the company adopted, endorsed orsufficiently entangled itself with the [analyst’s opinions] to render them attributable to [the company].” In reSyntex Corp. Sec. Litig., 855 F. Supp. 1086, 1097 (N.D. Cal. 1994), aff’d, 95 F.3d 922 (9th Cir. 1996). Thecomplaint “should (1) identify specific forecasts and name the insider who adopted them; (2) point to specificinteractions between the insider and the analyst which gave rise to the entanglement; and (3) state the dates onwhich the acts which allegedly gave rise to the entanglement occurred.” See In re Caere Corp. Sec. Litig., 837F. Supp. 1054, 1059 (N.D. Cal. 1993). The complaint also “must allege a two-way flow of informationbetween the analyst and the insider, such as review and approval of the report by the insider.” In re HarmonicInc. Sec. Litig., 163 F. Supp. 2d 1079, 1095 (N.D. Cal. 2001).

The policy behind the adoption or entanglement requirement is that a company should not be held responsiblefor the opinions of a third party over which it has no control. See In re Cirrus Logic Sec. Litig., 946 F. Supp.1446 (N.D. Cal. 1996) (granting summary judgment because no evidence that Cirrus adopted analyst reports atissue and the only corporate defendants permitted to speak with analysts never commented on analysts’financial projections, nor provided internal earnings or revenue forecasts or other specific financial guidance);In re Seagate Tech. II Sec. Litig., No. C-89-2493(A)-VRW, 1995 WL 66841 (N.D. Cal. Feb. 8, 1995), aff’d, 98F.3d 1346 (9th Cir. 1996) (holding corporation and its officers and directors could not be liable for projectionsmade by securities analysts where the company had a strict policy not to comment upon analysts’ financialprojections and plaintiff failed to offer any proof that defendant departed from this policy); Raab v. Gen.Physics Corp., 4 F.3d 286, 288 (4th Cir. 1993) (“The securities laws require General Physics to speak truthfullyto investors; they do not require the company to police statements made by third parties for inaccuracies.”). Management’s statement of “comfort” with analyst predictions generally cannot be deemed actionable. SeeMalone v. Microdyne Corp., 26 F.3d 471, 479 (4th Cir. 1994).

2) The “Conduit” Theory

A defendant is also liable for false or misleading statements made by a third-party analyst if the defendantprovides the analyst with false or misleading information with the intent that the analyst will communicate thatinformation to the market. See Cooper v. Pickett, 137 F.3d 616, 620 (9th Cir. 1997). In Cooper, the Courtfound that the complaint properly alleged that the defendant company “endorsed the reports by distributingthem to potential investors” and that insiders faxed a specific internal forecast detailing specific earningsinformation to a specific analyst. Id.; see also In re Secure Computing Corp. Sec. Litig., 184 F. Supp. 2d 980,990 (N.D. Cal. 2001) (finding that plaintiff had sufficiently pled conduit theory of liability where plaintiffalleged a specific false and misleading statement, directly communicated to analysts at a specific place andtime, followed by analyst recommendations to buy stock, and which identified defendants’ specific statements,locations, speakers, content, and date of false or misleading statements, and contents and speakers of analysts’statements).

7. Omissions

An omission is actionable under the securities laws only when: (1) there is a duty to disclose the allegedly

omitted information (see, for example, Basic Inc. v. Levinson, 485 U.S. 224, 239 n.17 (1988)), or (2) the allegedomissions render an affirmative statement misleading. Glazer v. Formica Corp., 964 F.2d 149, 157 (2d Cir.1992); Backman v. Polaroid Corp., 910 F.2d 10, 12-13 (1st Cir. 1990); see also In re Time Warner Inc. Sec.Litig., 9 F.3d 259, 267 (2d Cir. 1993); In re Seagate Tech. II Sec. Litig., No. C-89-2493(A) MHP, 1990 WL134963 (N.D. Cal. June 19, 1990), aff’d, 98 F.3d 1346 (9th Cir. 1996).

a. The Requirement Of Identifying A Duty To Disclose

A material omission may be actionable under Rule 10-b-5 where defendants have a duty to disclose theinformation in question. Basic Inc. v. Levinson, 485 U.S. 224, 239, n.17 (1988). Silence, absent a duty todisclose, is not misleading under Rule 10b-5. For example, in In re Optionable Securities Litigation, 577 F.Supp. 2d 681, 692 (S.D.N.Y. 2008), defendants’ failure to disclose that the former CEO and companyconsultant had been convicted of credit card fraud and tax evasion was not an actionable omission because noregulations gave rise to a duty to disclose his crimes. Thus, “[t]he initial inquiry in each case is what duty ofdisclosure the law should impose upon the person being sued.” Chris-Craft Indus. Inc. v. Piper Aircraft Corp.,480 F.2d 341, 363 (2d Cir. 1973).

A duty to disclose may arise in a number of ways. Under the securities laws, the duty to disclose is primarilystatutory. See In re Initial Pub. Offering Sec. Litig., 241 F. Supp. 2d 281, 381 (S.D.N.Y. 2003) (citing H.L.Federman & Co. v. Greenberg, 405 F. Supp. 1332, 1336 (S.D.N.Y. 1975)). A duty to disclose may also ariseupon choosing to speak, for one has an obligation to be “both accurate and complete.” Caiola v. Citibank, N.A.,New York, 295 F.3d 312, 331 (2nd Cir. 2000); Lormand v. U.S. Unwired, Inc., 565 F.3d 228, 248-49 (5th Cir.2009) (noting that upon choosing to publicly discuss the prospective benefits from a future course of action, onehas a duty to disclose all material risks that will affect the actual outcome of that course of action); In re DynexCapital, Inc. Sec. Litig., No. 05 CIV. 1897 (HB), 2009 WL 3380621, at *9 (S.D.N.Y. Oct. 19, 2009) (statingthat once defendant chose to speak about what caused losses in bond collateral, it had a duty to disclose allcontributing causes). The duty to disclose can also arise under a fiduciary relationship between two parties to asecurities transaction. See Chiarella v. United States, 445 U.S. 222, 227-29 (1980); see also R2 Investments v.Phillips, No. CIV. A. 302CV0323N, 2003 WL 22862762, at *5 (N. D. Tex. Dec. 3, 2003), aff’d, 401 F.3d 638(5th Cir. 2005) (“In determining whether the duty to speak arises, we consider the relationship between theplaintiff and defendant, the parties’ relative access to the information to be disclosed, the benefit derived by thedefendant from the purchase or sale, defendant’s awareness of plaintiff’s reliance on defendant in making itsinvestment decisions, and defendant’s role in initiating the purchase or sale.”); Garvey v. Arkoosh, 354 F. Supp.2d 73, 83 (D. Mass. 2005) (holding while there is a duty to disclose payments made by the issuer to analysts forfavorable stock recommendations, such a duty falls on the one who publishes the analyst report, and not on theissuer who has paid for the puffery).

b. Affirmative Misstatements May Trigger A Duty To Disclose

A duty to disclose also exists “when disclosure is necessary to make prior statements not misleading.” TimeWarner, 9 F.3d at 268. In such a case, “[t]he inquiries as to duty and materiality coalesce. The undisclosedinformation is material if there is ‘a substantial likelihood that the disclosure of the omitted fact would havebeen viewed by the reasonable investor as having significantly altered the ‘total mix’ of informationavailable.’” Id. at 267-68 (citing TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). The duty todisclose arises “whenever secret information renders prior public statements materially misleading, not merelywhen that information completely negates the public statements.” Id. at 268; see In re Credit Suisse-AOL Sec.Litig., 465 F. Supp. 2d 34, 56 (D. Mass. 2006) (holding that analysts have a duty to disclose where they makematerial statements on the value of a company); Beleson v. Schwartz, 599 F. Supp. 2d 519, 525-26 (S.D.N.Y.2009) (company’s failure to disclose its imminent bankruptcy planning did not render statements regarding itsfinancial condition misleading as to its viability because enough information was available in the market to putinvestors on notice of its bankruptcy filing); cf. Higginbotham v. Baxter Int’l, Inc., 495 F.3d 753, 760-61 (7th

Cir. 2007) (finding no duty to disclose before managers had a reasonable time to investigate potentialmisstatement).

Whether a public statement is misleading is a “mixed question to be decided by the trier of fact.” Freedman v.Louisiana Pac. Corp., 922 F. Supp. 377, 388 (D. Or. 1996) (citing Durning v. First Boston Corp., 815 F.2d1265, 1268 (9th Cir. 1987)); see also TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 450 (1976).

c. No Duty To Disclose Mismanagement

The principle that corporate mismanagement, and the failure to disclose such mismanagement is not actionableunder the securities laws if the alleged wrongdoing does not include “any deception, misrepresentation, ornondisclosure” of otherwise material facts is well established. Santa Fe Indus., Inc. v. Green, 430 U.S. 462,476 (1977); see also Galati v. Commerce Bancorp, Inc., 220 F. App’x 97, 101 (3d Cir. 2007) (finding generalstatements about company’s performance and growth did not give rise to duty to disclose criminal malfeasanceof three senior officers); Garfield v. NDC Health Corp., 466 F.3d 1255 (11th Cir. 2006) (finding thatallegations about misrepresentations in financial statements amounted to nothing more than corporatemismanagement); In re Marsh & McLennan Cos., Inc. Sec. Litig., 501 F. Supp. 2d 452 (S.D.N.Y. 2006)(finding that allegation that company misstated earnings merely by failing to disclose misconduct at itssubsidiary is not actionable because there was no allegation that the company reported income it did notactually receive – misleading statements about the sources of revenue do not make the company’s statements ofrevenue figure misleading); In re Citigroup, Inc. Sec. Litig., 330 F. Supp. 2d 367, 375-77 (S.D.N.Y. 2004)(holding that corporation’s failure to disclose that its revenues were derived from illegitimate sources was notactionable, “for the federal securities laws do not require a company to accuse itself of wrongdoing”). But seeIn re Van der Moolen Holding, N.V. Sec. Litig., 405 F. Supp. 2d 388 (S.D.N.Y. 2005) (finding statementsputting sources of defendant’s revenue at issue when revenue was generated, at least in part, by tradingpractices that violated NYSE rules, sufficient to give rise to 10(b) liability); In re Providian Fin. Corp. Sec.Litig., 152 F. Supp. 2d 814, 824-25 (E.D. Pa. 2001) (holding that although a defendant does not have a duty tospeculate about the risk of future investigation or litigation, if it puts the topic of the cause of its financialsuccess at issue, then it is “obligated to disclose information concerning the source of its success, sincereasonable investors would find that such information would significantly alter the mix of availableinformation.”) (citing Shapiro v. UJB Fin. Corp., 964 F.2d 272, 281-82 (3d Cir. 1992)).

In In re Immucor Inc. Securities Litigation, No. 1:05-CV-2276-WSD, 2006 WL 3000133 (N.D. Ga. Oct. 4,2006), the court allowed claims of misleading representations of foreign criminal investigations, where thestatements made by the company omitted information about the significance of corruption at a foreignsubsidiary and omitted potential criminal liability.

d. Duty To Update And Duty To Correct

The court in Backman v. Polaroid Corp., 910 F.2d 10 (1st Cir. 1990) (en banc), distinguished betweendisclosures that were misleading when made and disclosures that become misleading in light of subsequentevents. With respect to statements that become misleading in light of subsequent events, the court opined that ifthere is a “forward intent and connotation” to the disclosure, further disclosure “may be called for.” Id. at 17. The Backman court found that the disclosure at issue had been and remained “precisely correct,” noting that torequire corrections of statements which were correct when made may “inhibit disclosures altogether.” Id.; seealso In re Time Warner, Inc. Sec. Litig., 9 F.3d 259, 267 (2d Cir. 1993) (finding that disputed statements lacked“the sort of definite positive projections that might require later correction”).

The Third Circuit in In re Burlington Coat Factory Securities Litigation, 114 F.3d 1410, 1431 (3d Cir. 1997),held that a voluntary disclosure of an earnings forecast does not trigger any duty to update. See also Stransky v.Cummins Engine Co., 51 F.3d 1329, 1331 (7th Cir. 1995) (rejecting the duty to update forward-lookingstatement; “mere silence about even material information is not fraudulent absent a duty to speak”); San

Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., Inc., 75 F.3d 801, 811 (2d Cir.1996) (finding no duty to update “subdued general comments” of optimism); In re Abbott Labs. Sec. Litig., 813F. Supp. 1315, 1319 (N.D. Ill. 1992) (finding no duty to update statements that were not forward-looking andthat were not false or misleading when made). But see Weiner v. Quaker Oats Co., 129 F.3d 310, 315 (3d Cir.1997) (holding corporation had duty to update statements regarding its total debt-to-total capitalization ratioguideline when such statements became unreliable).

The Reform Act specifically does not impose a duty to update forward-looking statements. 15 U.S.C. §77z-2(d); 15 U.S.C. § 78u-5(d). The Third Circuit in U.S. v. Schiff, 602 F.3d 152 (3d Cir. 2010) dismissedcriminal securities fraud claims, rejecting the government’s theory that an officer has a duty to correctmisrepresentations by others.

e. No Duty To Disclose Forecasts

As a general rule, companies are not required to disclose internal forecasts. See Heliotrope Gen., Inc. v. FordMotor Co., 189 F.3d 971, 980 (9th Cir. 1999) (holding no duty to disclose “internal financial projectionsregarding the expected dollar values of tax costs and benefits, the date on which the tax-strategy benefits wereexpected to be outweighed by its costs, or the date on which a merger was most likely”); In re VeriFone Sec.Litig., 11 F.3d 865, 869 (9th Cir. 1993) (“[A]bsent allegations that VeriFone withheld financial data or otherexisting facts from which forecasts are typically derived … the forecasts need not have been disclosed.”); seealso In re Ford Motor Co. Sec. Litig., 381 F. 3d 563, 572 (6th Cir. 2004) (holding that the future recall coststhat the defendant agreed to pay need not be disclosed in prior financial statements since no asset wasdiminished nor liability incurred at the date of the financial statements); In re Syntex Corp. Sec. Litig., 95 F.3d922, 929-30 (9th Cir. 1996) (holding that statement in 1991 annual report about the effect of a consent decreeon future sales for fiscal year 1992 was nothing more than a forecast on future sales and profits and, hence, wasnot actionable under VeriFone; similarly, prediction that over-the-counter Naprosyn would be approved “wellin advance of” the 1993 patent expiration was merely a forecast, and plaintiffs failed to plead facts showing thatthe statement was false when made as required under Rule 9(b)); In re Convergent Tech. Sec. Litig., 948 F.2d507, 516 (9th Cir. 1991) (holding company not required to disclose internal projections); In re Sybase, Inc. Sec.Litig., 48 F. Supp. 2d 958, 963 (N.D. Cal. 1999).

In In re Verity, Inc. Securities Litigation, No. C 99-5337 CRB, 2000 WL 1175580 (N.D. Cal. Aug. 11, 2000),the court found that defendant had no duty to update financial forecasts, reasoning that a judicially-created dutyof continuous disclosure of all material information every time a single specific earnings forecast is disclosedwould likely result in a drastic reduction in the number of such projections made by companies. Because such aduty would thwart the type of disclosure encouraged by the Congress and the SEC, the court refused to find aduty to update. See also Grossman v. Novell, Inc., 120 F.3d 1112, 1124 (10th Cir. 1997) (holding defendanthad no duty to disclose third quarter earnings forecasts prior to disclosure of actual third quarter earnings, whichshowed them to be disappointing); In re Lyondell Petrochemical Co. Sec. Litig., 984 F.2d 1050, 1052-53 (9thCir. 1993) (finding no duty to disclose projections indicating that 1989 income and revenues would be below1988 levels, reasoning that “[a] corporation may be called upon to make confidential projections for a variety ofsound purposes where public disclosure would be harmful”); Grossman v. Novell, Inc., 120 F.3d 1112, 1124(10th Cir. 1997) (holding defendant had no duty to disclose third quarter earnings forecasts prior to disclosureof actual third quarter earnings, which showed them to be disappointing). But see In re Netsmart Techs., Inc.,924 A.2d 171, 199-200 (Del. Ch. 2007) (finding material omission and breach of fiduciary duty of candor whenproxy statement did not include financial projections used by the financial advisor to assess the fairness of deal,and instead used different projections not used by the financial advisor).

Failure to disclose projected or potential changes in the company’s product market has been rejected as thebasis for a 10b-5 claim. The court in In re VeriFone Sec. Litig., 11 F.3d 865, 869 (9th Cir. 1993), declared thatsuch an allegation amounts to nothing more than a failure to disclose forecasts and the disclosure of forecasts isnot required under the 1934 Act. Similarly, courts have held that there is no duty to predict future actions of

independent government agencies. See Epstein v. Wash. Energy Co., 83 F.3d 1136, 1142 (9th Cir. 1996)(finding no duty to predict action of public utility commission); In re Viropharma, Inc. Sec. Litig., No. CIV. A.02-1627, 2003 WL 1824914 (E.D. Pa. Apr. 7, 2003) (suggesting that there was no duty to predict FDAapproval of drug and that investors should not rely on a company’s prediction about the future actions ofindependent government agencies); Fanni v. Northrop Grumman Corp., No. CV98-6197 DT, 2000 U.S. Dist.LEXIS 21626, at *32-37 (C.D. Cal. Apr. 10, 2000) (finding no duty to predict whether Justice Departmentwould approve merger).

On the other hand, if companies disclose internal forecasts, they must have a reasonable basis for believing theforecasts to be accurate. See In re Convergent Tech. Sec. Litig., 948 F.2d 507, 516 (9th Cir. 1991); see alsoProvenz v. Miller, 95 F.3d 1376, 1386 (9th Cir. 1996) (reversing grant of summary judgment for defendantswhere company executive, disregarding reliable internal spreadsheet predicting $4 million loss for the quarter,predicted quarterly earnings of approximately $624,000).

f. Duty To Disclose Triggered By Insider Trading

“Insiders” may have a duty to disclose material non-public information prior to selling their stock. Whenseeking to trade in the company’s stock, even where a duty to disclose does not otherwise exist, an insider inpossession of material non-public information is required to either “abstain or disclose.” That is, the insidermust either abstain from trading in the stock or publicly disclose the material information that the insiderpossesses. Failure to do so may result in liability, in an action by the SEC, under Rule 10b-5. Dirks v. S.E.C.,463 U.S. 646, 654 (1983) (10b-5 liability requires a duty of disclosure arising from the relationship betweenthe parties); Chiarella v. United States, 445 U.S. 222, 228 (1980) (10b-5 liability for silence “is premised upona duty to disclose arising from a relationship of trust and confidence between the parties to a transaction”); seealso Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299 (1985) (holding tippee using nonpublicinformation does not violate 10b-5 “unless the tippee owes a corresponding duty to disclose the information”);cf. United States v. O’Hagan, 521 U.S. 642 (1997) (holding criminal liability under Section 10(b) may bepredicated on misappropriation theory, which permits imposition of liability on person who trades in securitiesfor personal profit using material, confidential information without disclosing such use to the source of theinformation).

Standing problems will often preclude class treatment of Section 10(b) claims premised on the argument thatinsider trading by executives created a broad duty to disclose. This is because standing to bring private insidertrading claims is limited. In 1988, Congress enacted Section 20A of the Securities Exchange Act of 1934 toprovide expressly for private suits against insiders who trade on non-public material informationcontemporaneously with private party plaintiffs. Section 20A does not preempt existing remedies such as Rule10b-5. Neubronner v. Milken, 6 F.3d 666, 669-70 (9th Cir. 1993) (holding plaintiff may properly elect toproceed against insider trading defendant under Rule 10b-5 even though Section 20A remedy also available).

Nevertheless, in order to establish a violation of Section 20A, a plaintiff must establish three elements: (1) aprimary violation of the 1934 Act; (2) a contemporaneous trade with defendant; and (3) defendant’s possessionof material nonpublic information. 15 U.S.C. § 78t-1(a); In re Advanta Corp. Sec. Litig., 180 F.3d 525, 541(3d Cir. 1999) (explaining Section 20A liability is predicated on showing of underlying independent securitiesviolation); Wilson v. Bernstock, 195 F. Supp. 2d 619, 642 (D.N.J. 2002) (dismissing Section 20A claim whereprimary Rule 10b-5 violation could not be established); Manavazian v. Atec Group, Inc., 160 F. Supp. 2d 468,485-86 (E.D.N.Y. 2001) (holding complaint satisfies requirements of Section 20A where underlying securitiesfraud claims do not warrant dismissal).

Significantly, for an insider to be liable for trades under either Rule 10b-5 or Section 20A, the plaintiff mustplead with specificity that he or she traded contemporaneously with defendants. Wilson v. Comtech Telecomms.Corp., 648 F.2d 88, 94-95 (2d Cir. 1981) (holding in Rule 10b-5 context that plaintiff could not bring claim

where he did not trade “contemporaneously with the insider,” reasoning that “non-contemporaneous traders donot require the protection of the ‘disclose or abstain’ rule because they do not suffer the disadvantage of tradingwith someone who has superior access to information”); Neubronner, 6 F.3d at 670 (requiring that in Rule10b-5 context contemporaneous trading must be pled with particularity under Rule 9(b)).

Courts agree that a plaintiff’s trade must have occurred after the wrongful insider transaction, although theexact contours of contemporaneous trading are not uniform from court to court. See id., 6 F.3d at 670. Inestablishing this rule, the Ninth Circuit adopted the Second Circuit’s reasoning in a case holding that tradesoccurring approximately a month apart were not contemporaneous. Id. at 669-70. In In re Silicon Graphics,Inc. Securities Litigation, No. C 96-0393, 1996 WL 664639 (N.D. Cal. Sept. 25, 1996), the court interpretedthis requirement even more strictly, holding that only purchases within six days of insider sales are trulycontemporaneous. Other courts in claims brought under Section 20A have held that plaintiffs’ trades must haveoccurred within one to five days after defendant’s trades. See, e.g., In re MicroStrategy, Inc. Sec. Litig., 115 F.Supp. 2d 620, 663-64 (E.D. Va. 2000) (finding in Section 20A claim that three days separation in trading is notcontemporaneous and noting that “the growing trend among district courts in a number of circuits … is to adopta restrictive reading of the term ‘contemporaneous’ at least with respect to shares heavily traded on a nationalexchange”); Feldman v. Motorola, Inc., No. CIV. A. 90 C 5887, 1993 WL 497228, at *14 (N.D. Ill. Oct. 14,1993) (holding trades are not contemporaneous for Section 20A unless they take place within one day ofinsider’s trades); Gerstein v. Micron Tech., No. CIV. 89-1262, 1993 WL 735031, at *8 (D. Idaho Jan. 9, 1993)(holding trade must take place no more than four days after); In re Cypress Semiconductor Sec. Litig., 836 F.Supp. 711, 714 (N.D. Cal. 1993) (five-day limit).

Accordingly, it is doubtful that a broad class of investors could assert a broad duty to disclose based uponexecutives’ insider trading. Only a small subset of such investors can meet the “contemporaneous tradingrequirement,” with most investors lacking standing to assert a claim based upon such a duty of disclosure.

g. Attorneys’ And Accountants’ Duty To Disclose Misconduct

Under certain circumstances, attorneys and accountants are required to raise issues of their client’s misconductwith the client’s management and the SEC.

1) Section 10A Of The Exchange Act

Section 10A requires auditors to implement procedures for detecting illegal acts that would have a direct andmaterial effect on the determination of financial statement amounts, identify material related party transactions,and evaluate whether there is substantial doubt about the issuer’s ability to continue as a going concern. Anauditor must inform his or her client’s management, audit committee, or board of directors of any such illegalact detected. If the auditor is not satisfied that the management or board have taken appropriate steps to addressthe findings, the auditor must report his or her conclusions directly to the board, which, in turn, must make areport to the SEC within one business day. If the board does not inform the SEC, the auditor must do so orresign from the engagement. Auditors are protected from liability for reports they make under this provision.

Auditors are subject to civil penalties for failing to conform to the Section 10A reporting requirements. However, Section 10A does not provide a private right of action making accountants liable to third parties forfailing to make reports under the section.

2) Section 307 Of The Sarbanes-Oxley Act

Sarbanes-Oxley Act Section 307 imposes disclosure requirements on both accountants and attorneys. On

January 24, 2003, the SEC adopted a final rule to implement Section 307. The rules adopted:

(a) “require an attorney to report evidence of a material violation, determined according to an objectivestandard, ‘up-the-ladder’ within the issuer to the chief legal counsel or the chief executive officer or theequivalent;”

(b) “require an attorney if the chief legal counsel or [CEO] … do not respond appropriately to the evidence,to report the evidence to the audit committee, another committee of independent directors, or the fullboard of directors;”

(c) “clarify that the rules cover attorneys providing legal services to an issuer who have an attorney-clientrelationship with an issuer, and who have notice that the documents that they are preparing will be filedwith or submitted to the Commission;”

(d) “provide that foreign attorneys who are not admitted in the United States, and who do not advise clientsregarding U.S. law, would not be covered by the rule, while foreign attorneys who provide legal adviceregarding U.S. law would be covered to the extent they are appearing and practicing before theCommission, unless they provide such advice in consultation with U.S. counsel;”

(e) “allow an issuer to establish a ‘qualified legal compliance committee’ (QLCC) as an alternativeprocedure for reporting evidence of a material violation;”

(f) “allow an attorney, without consent of an issuer client, to reveal confidential information related to his orher representation to the extent the attorney reasonably believes necessary (1) to prevent the issuer fromcommitting a material violation likely to cause substantial financial injury to the financial interests orproperty of the issuer or investors; (2) to prevent the issuer from committing an illegal act; or (3) torectify the consequences of a material violation or illegal act in which the attorney’s services have beenused;”

(g) “state that its provisions govern in the event the rule conflicts with state law, but will not preempt theability of a state to impose more rigorous obligations;” and

(h) “affirmatively state that it does not create a private cause of action and that authority to enforcecompliance with the rule is vested exclusively with the Commission.”

SEC Adopts Attorney Conduct Rule Under Sarbanes-Oxley Act, SEC NEWS DIGEST 2003-16, CommissionAnnouncements, January 24, 2003.

The final rules also provide that by the phrase “evidence of a material violation,” the Commission intends “anobjective, rather than a subjective, triggering standard, involving credible evidence, based upon which it wouldbe unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it isreasonably likely that a material violation has occurred, is ongoing, or is about to occur.” Id.

However, the Commission declined to impose the obligation of “noisy withdrawals,” which “would permit anattorney, if an issuer failed to comply with the disclosure requirement, to inform the Commission that theattorney has withdrawn from representing the issuer or provided the issuer with notice that the attorney has notreceived an appropriate response to a report of a material violation.” Id.

3) Auditors’ Duty To Correct Prior Audit Opinions

The Second Circuit has held that an accountant has a duty to correct its past audit opinions, and may in somecircumstances incur primary liability under § 10(b) and Rule 10b-5 if it fails to do so. In Overton v. Todman &Co., 478 F.3d 479 (2d Cir. 2007), plaintiffs alleged that, over several years, Todman & Co. issued opinionscertifying that a broker-dealer’s financial statements were accurate. Plaintiffs further alleged that Todman &Co. then failed to correct those prior opinions despite “red flags” indicating that the broker-dealer’s financial

statements understated a material liability. The Second Circuit ruled that plaintiffs could proceed with theirclaim and held that an accountant may violate the so-called “duty to correct” and become primarily liable under§ 10(b) and Rule 10b-5 if it: (1) makes a statement in its audit opinion that is false or misleading when made;(2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading;(3) knows or should know that potential investors are relying on the opinion and financial statements; (4) failsto take reasonable steps to correct or withdraw its opinion and/or the financial statements; and (5) all the otherrequirements for § 10(b) and Rule 10b-5 liability are satisfied. However, in Lattanzio v. Deloitte & ToucheLLP, 476 F.3d 147, 155-56 (2d Cir. 2007), the Second Circuit held that an auditor owed no duty to correctfinancial misstatements in unaudited quarterly reports despite the fact that it was required by regulation toreview them. The Court held that section 10(b) liability is limited to those who make misstatements or whoviolate a duty to disclose. The purpose of regulations requiring auditor review of quarterly reports is tominimize large year-end adjustments to quarterly statements that historically have been uncovered in the annualaudit process, not to detect fraud.

h. Duty To Disclose Under Item 303

Item 303 of Regulation S-K governs certain filings required by the Securities Act and the Exchange Act. Regulation S-K requires that issuers of securities disclose trends, demands, commitments, events, oruncertainties known to the issuer that are likely to affect the corporation’s liquidity, net sales, or revenues. 17C.F.R. § 229.303(a)(1)-(3). Instruction 7 to Item 303 provides that corporations “are encouraged, but notrequired, to supply forward-looking information” and that any forward-looking information disclosed isprotected by the Rule 175 “safe harbor.” 17 C.F.R. § 229.303, Instruction 7. S.E.C. Rule 175, 17 C.F.R. §230.175(c)(1), provides a “safe harbor” from liability under both the 1933 and 1934 Acts for good faith,voluntary disclosures “containing a projection of revenues, income (loss), earnings (loss) per share, capitalexpenditures, dividends, capital structure or other financial items” if they were made with a reasonable basis,even if they ultimately prove to be wrong.

A majority of courts have found that a mere “failure to comply with the disclosure duties under Item 303” maynot be the basis of a Section 10(b) action. Oran v. Stafford, 226 F.3d 275, 288 (3d Cir. 2000) (holding violationof Item 303 “does not lead inevitably to the conclusion that such disclosure would be required under Rule10b-5” because materiality standards for Rule 10b-5 and SK-303 “differ significantly”); In re Marsh &McLennan Cos., Inc. Sec. Litig., 501 F. Supp. 2d 452 (S.D.N.Y. 2006) (holding no duty to disclose under SK-303 or SEC Staff Accounting Bulletins Nos. 99 or 101); Iron Workers Loc. 16 Pens. v. Hilb Rogal & Hobbs,432 F. Supp. 2d 571 (E.D. Va. 2006) (holding no duty to disclose under Reg. S-K because no private right ofaction; materiality standard different from 10b-5; violation of S-K does not amount to material omission under10b-5); Menkes v. Stolt-Nielsen S.A., No. 3:03 CV 409 (DJS), 2005 WL 3050970, at *6 (D. Conn. Nov. 10,2005) (holding that, although management may be compelled to disclose uncharged illegal conduct when thereis insider trading, when a statute or regulation requires disclosure, or when disclosure is necessary to preventanother statement from misleading the public, neither Reg. S-K nor the SEC instructions for completing Form10-F required such disclosure in these circumstances); In re Quintel Entm’t, Inc. Sec. Litig., 72 F. Supp. 2d 283,293 (S.D.N.Y. 1999) (citing In re Sofamor Danek Group, Inc., 123 F.3d 394, 402 (6th Cir. 1997), for theproposition that “violations of Item 303 do not necessarily create a private right of action” but finding that suchviolations “may be relevant to determining when a false or misleading omission has been made”); In re SunMicrosystems, Inc. Sec. Litig., No. C-89-20351-RPA, 1990 WL 169140 (N.D. Cal. Aug. 20, 1990) (holding noduty under Item 303(a)(3) to discuss competitive position except in annual report).

Plaintiff bears the burden of persuasion on both the good faith and reasonable basis issues. Roots P’ship v.Lands’ End, Inc., 965 F.2d 1411, 1418 (7th Cir. 1992) (discussing the Rule 175 Safe Harbor and stating “simpledifferences between the company’s stated earnings goal and its internal earnings estimates do not alone suggestthat the defendants’ statements lacked a reasonable basis”). Courts often find that this burden is not satisfied. See, e.g., In re Lyondell Petrochem. Co. Sec. Litig., 984 F.2d 1050, 1052-53 (9th Cir. 1993) (holdingcorporation need not disclose internal financial projections where it had disclosed forecasts to potential lender

banks but not to public generally); Roots, 965 F.2d at 1417-18; accord Glassman v. Computervision Corp., 90F.3d 617, 631 (1st Cir. 1996); In re Convergent Techs. Sec. Litig., 948 F.2d 507, 516 (9th Cir. 1991); Wright v.Int’l Bus. Mach. Corp., 796 F. Supp. 1120, 1126 (N.D. Ill. 1992) (citing, inter alia, Wielgos v. CommonwealthEdison Co., 892 F.2d 509, 516 (7th Cir. 1989)) (“Firms need not disclose tentative internal estimates eventhough they conflict with published estimates, unless the internal estimates are so certain that they reveal thepublished figures as materially misleading.”). Partial disclosures of financial projections, however, ifmisleading, may be actionable. See Steiner v. Tektronix, Inc., 817 F. Supp. 867, 883 (D. Or. 1992) (citingVaughn v. Teledyne, Inc., 628 F.2d 1214, 1221 (9th Cir. 1980)).

i. Duty To Disclose Under Item 103

Item 103 of Regulation S-K governs what companies must disclose to investors regarding pending litigation. 17 C.F.R. § 229.103. Under Item 103, if an issuer or its subsidiary is a party to material pending litigation, theissuer must disclose the tribunal, principal parties, date instituted, underlying facts, and relief sought. Id. However, Item 103 does not require an issuer to disclose its own internal assessment of the outcome of thepending litigation. See In re Boston Scientific Corp. Sec. Litig., 490 F. Supp. 2d 142, 154 (D. Mass. 2007)(refusing to impose liability where issuer disclosed the pending litigation and potential risks), rev’d on othergrounds sub nom. Miss. Public Employees’ Retirement Sys. v. Boston Scientific Corp., 523 F.3d 75 (1st Cir.2008).

j. No Duty To Disclose Business, Products And Plans Of Competitors

Federal securities laws “do not ordain that the issuer of a security compare itself in myriad ways to itscompetitors, whether favorably or unfavorably.” In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1419 (9thCir. 1994) (quoting In re Donald J. Trump Casinos Sec. Litig., 7 F.3d 357, 375 (3d Cir. 1993)); see also In reStac Elecs. Sec. Litig., 89 F.3d 1399, 1406-07 (9th Cir. 1996) (holding no duty to disclose the products or plansof competitors); Castillo v. Dean Witter Discover & Co., No. 97 CIV. 1272 (RPP), 1998 WL 342050, at *8(S.D.N.Y. June 25, 1998) (citing In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357, 375-76 (3d Cir. 1993));In re DSP Group, Inc. Sec. Litig., No. C 95-4025-CAL, 1997 WL 678151 (N.D. Cal. Mar. 5, 1997) (holding noduty to disclose competitor’s market advantage); In re Silicon Graphics Inc., Sec. Litig., No. C 96-0393, 1996WL 664639 (N.D. Cal. Sept. 25, 1996) (holding that plaintiff’s allegation that defendants withheld informationthat their products were not competitive with those of Sun Microsystems not actionable).

k. Duty To Disclose Technical Or Development Problems

A duty to disclose technical or developmental problems with a product may arise where a company makesstrongly optimistic or concrete statements about that product that are in stark contrast to its internal reports. SeeHanon v. Dataproducts Corp., 976 F.2d 497, 504 (9th Cir. 1992) (finding company obligated to disclose severeand persisting technical problems with its printer when making enthusiastic promotional statements about theprinter’s performance); In re Apple Computer Sec. Litig., 886 F.2d 1109, 1118-19 (9th Cir. 1989) (notingcompany executives stated that new computer product would be “phenomenally successful the first year out ofthe chute” and would make company’s “growth before this look small”); cf. Glassman v. ComputervisionCorp., 90 F.3d 617, 634-35 (1st Cir. 1996) (holding cautiously optimistic statements expressing at most thehope that product will eventually gain acceptance in the market do not trigger a duty to disclose initialdevelopmental problems the product was facing); In re Carter-Wallace, Inc. Sec. Litig, 150 F.3d 153, 157 (2ndCir. 1998) (holding that drug manufacturers have no duty to disclose isolated reports of illnesses suffered byusers of their drugs until those reports provide statistically significant evidence that the ill effects may be causedby use of the drugs and thus giving reason to believe that the commercial viability of the drug is threatened).

8. Market Manipulation

In proscribing the use of a “manipulative or deceptive device or contrivance,” Section 10(b) prohibits not onlymaterial misrepresentations and omissions, but also manipulative acts. 15 U.S.C. § 78j(b); Central Bank ofDenver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 177 (1994). Manipulation “connotesintentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting theprice of securities.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199 (1976). The Second Circuit requires aplaintiff to prove manipulation by showing that “an alleged manipulator engaged in market activity aimed atdeceiving investors as to how other market participants have valued a security.” ATSI Commc’ns, Inc. v. ShaarFund, Ltd., 493 F.3d 87, 100 (2d Cir. 2007); see also Mobil Corp. v. Marathon Oil Co., 669 F.2d 366, 374 (6thCir. 1981) (stating that the Supreme Court has indicated that manipulation under Section 10(b) refers to “meansunrelated to the natural forces of supply and demand”). However, a market manipulation claim cannot be basedsolely upon misrepresentations or omissions. ATSI Commc’ns, Inc., 493 F.3d at 101. There must be somemarket activity, such as “wash sales, matched orders, or rigged prices.” See Santa Fe Indus. v. Green, 430 U.S.462, 476 (1977).

Because a claim of market manipulation is a claim for fraud, the plaintiff must satisfy the requirements of Rule9(b) and plead the following with particularity: the nature, purpose, and effect of the fraudulent conduct as wellas the roles of the defendants. ATSI Commc’ns, Inc., 493 F.3d at 101-02. However, because a claim ofmanipulation can include facts that are solely within the defendant’s knowledge, the plaintiff need not pleadmanipulation with the same degree of specificity as a claim of misrepresentation. Id. at 102. Nevertheless, theplaintiff must satisfy the PSLRA’s heightened standard for scienter by pleading with particularity facts thatcreate “a strong inference that the defendant intended to deceive investors by artificially affecting the marketprice of securities.” Id. at 102-03 (finding claim that manipulation may be inferred from a stock price drop inreaction to positive news is insufficient to show a particular connection between the price and defendants’actions).

9. The “In Connection With” Element

To give rise to liability, the misrepresentation or omission must be made “in connection with” the purchase orsale of a security. Although, as previously noted, the Supreme Court relied on the “in connection with”language to limit the class of possible plaintiffs, in general, attempts to use this language as a broad limitingmechanism have failed. “[I]n its role enforcing the Act, the SEC has consistently adopted a broad reading ofthe phrase … [and] has maintained that a broker who accepts payment for securities that he never intends todeliver, or who sells customer securities with intent to misappropriate the proceeds violates 10(b) and Rule10b-5.” S.E.C. v. Zandford, 535 U.S. 813, 819 (2002) (citing In re Bauer, 26 S.E.C. 770 (1947)); In re Se. Sec.Corp., 29 S.E.C. 609 (1949). In Zandford, the Supreme Court explained that, “while the statute must not beconstrued so broadly as to convert every common-law fraud that happens to involve a violation of § 10(b),” abroad construction of the phrase is reasonable. 535 U.S. at 820. The Court has been clear that the statuteshould be “‘construed not technically and restrictively, but flexibly to effectuate its remedial purposes.’” Id.(quoting Affiliated Ute Citizens of Utah v. U.S., 406 U.S. 128, 151 (1972)). Zanford has also been interpreted toconclude that an investor plaintiff need not identify a specific security in order to meet the “in connection with”requirement of federal and state securities laws. Grippo v. Perazzo, 357 F.3d 1218, 1223-24 (11th Cir. 2004);see S.E.C. v. Trabulse, 526 F. Supp. 2d 1001, 1006 (N.D. Cal. 2007) (noting that this requirement is met if “thefraud alleged somehow touched upon or has some nexus with any securities transaction,” and that the NinthCircuit explicitly stated in S.E.C. v. Rana Research, Inc., 8 F.3d 1358, 1362 (9th Cir. 1993) that the “inconnection with” requirement in SEC actions “remains as broad and flexible as is necessary to accomplish thestatute’s purpose of protecting investors” (internal quotation marks omitted)).

Other Supreme Court decisions have held in favor of a broad interpretation of the “in connection with” clause. In Wharf (Holdings) Ltd. v. United International Holdings, Inc., 532 U.S. 588 (2001), the Court’s decision thata seller had violated Section 10(b) focused on the “secret intent of the seller when the sale occurred.” Theplaintiff had asserted its claim as an ownership dispute and therefore no one argued that the complaint lackedthe requisite connection with a sale of securities. The Court nevertheless held that the appropriate claim wasthat the defendant sold a security while never intending to honor its agreement. In both Wharf and Zandford,

the Court held that, where fraudulent intent deprived the purchaser (Wharf) or the seller (Zandford) of thebenefit of the sale, the “in connection with” clause was satisfied because the complaint “describe[d] afraudulent scheme in which securities transactions and breaches of fiduciary duty coincided.” Zandford, 535U.S. at 814.

Most circuit courts have also adopted broad interpretations of the “in connection with” clause. For example, inS.E.C. v. Texas Gulf Sulphur Co., the Second Circuit held that false and misleading assertions are made “inconnection with” securities trading “whenever [such] assertions are made … in a manner reasonably calculatedto influence the investing public[.]” 401 F.2d 833, 858-62 (2d Cir. 1968) (en banc). In adopting an expansiveinterpretation of “in connection with,” the court declined to interpret the phrase as requiring that the maker ofthe misleading statement “participated in pertinent securities transactions,” or that the maker “was motivated bya plan to benefit the corporation or themselves” at the public’s expense. Id. at 860; see also Dujardin v. LibertyMedia Corp., 359 F. Supp. 2d 337, 353 (S.D.N.Y. 2005) (holding fraudulent promise to make plaintiff head of adivision after the merger was complete, which induced plaintiff into selling his company, satisfied the “inconnection with” requirement).

Several other circuits also have adopted Texas Gulf’s interpretation of the “in connection with” language ofSection 10(b). See S.E.C. v. Savoy Indus., Inc., 587 F.2d 1149, 1171 (D.C. Cir. 1978); Gottlieb v. Sandia Am.Corp., 452 F.2d 510, 516 (3d Cir. 1971); Akin v. Q-L Invs., Inc., 959 F.2d 521, 528 (5th Cir. 1992); Wessel v.Buhler, 437 F.2d 279, 282 (9th Cir. 1971); Mitchell v. Tex. Gulf Sulphur Co., 446 F.2d 90, 100-01 (10th Cir.1971).

The Supreme Court has never squarely addressed the validity of the Texas Gulf test. However, in discussingthe materiality of merger discussions for the purposes of Section 10(b), the Court favorably quoted Texas Gulf’sinterpretation of the “in connection with” language. Basic Inc. v. Levinson, 485 U.S. 224, 235 n.13 (1988). Additionally, the Ninth Circuit held that the Supreme Court’s decision in Cent. Bank of Denver, N.A. v. FirstInterstate Bank of Denver, N.A., 511 U.S. 164 (1994), precluding aider and abettor liability for securities fraud,did not undermine Texas Gulf’s holding that there could be direct liability under Section 10(b) for actions “inconnection with” the purchase or sale of securities, even though the actor did not trade in securities. McGann v.Ernst & Young, 102 F.3d 390, 393 (9th Cir. 1996) (holding the “in connection with” requirement satisfied byallegation that Ernst & Young produced a fraudulent audit report for corporation knowing the latter wouldinclude it in its Form 10K, and observing that “reports of Texas Gulf’s demise are greatly exaggerated”). Butsee In re Enron Corp. Sec. Derivative & ERISA Litig., No. MDL 1446, 2003 WL 230688, at *16 (S.D. Tex. Jan.28, 2003) (stating that accountant’s alleged document destruction did not constitute a primary violation ofSection 10(b) made in connection with the purchase or sale of securities).

The Supreme Court and other circuits also have adopted a broad interpretation of the “in connection” language,but the plaintiffs must have “suffered an injury as a result of deceptive practices touching [the purchase or] saleof securities.” Superintendent of Ins. of State of N.Y. v. Bankers Life and Cas. Co., 404 U.S. 6, 12-13 (1971);see also Gavin v. AT&T Corp., 464 F.3d 634, 639 (7th Cir. 2006) (“[W]hat happens to shares after they are soldis not ‘in connection with’ the sale.”); Lawrence v. Cohn, 325 F.3d 141 (2d Cir. 2003) (holding that wherealleged misrepresentations resulted in plaintiffs foregoing the purchase of securities, the misrepresentations didnot “touch” the actual purchase made by plaintiffs and were therefore not “in connection with” the purchase orsale of securities).

Some courts, including the Second Circuit, have recognized that the “in connection with” language requires that“misrepresentations or omissions involved in securities transactions but not pertaining to the securitiesthemselves cannot form the basis of a Section 10(b) or Rule 10b-5 claim.” Bernstein v. Misk, 948 F. Supp.228, 242 (E.D.N.Y. 1997) (citing Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 943 (2d Cir. 1984)). In Bernstein, plaintiffs merely alleged that defendants made misrepresentations about their own financialpositions and omitted certain facts concerning their backgrounds and intentions. The Court held theseallegations did not in any way implicate the characteristics or attributes of the company’s shares and hence werenot made “in connection with” the purchase and sale of securities. Id. Thus, “a ‘de minimus’ relationshipbetween the fraudulent scheme and the purchase or sale of securities is insufficient.” Id.

Not only must there be a causal connection between the alleged fraudulent conduct and the specific securitiestransaction at issue, the misrepresentations or omissions involved in the transaction must also pertain to thesecurities themselves. This generally means that the misrepresentations go to “the value of the stock at issue orthe value of the consideration in return for it.” Gurwara v. LyphoMed, Inc., 937 F.2d 380, 383 (7th Cir. 1991);see also U.S. v. Russo, 74 F.3d 1383 (2d Cir. 1996) (short sales of high value stock were “in connection with”the purchase or sale of securities within the meaning of Rule 10b-5 because the short sales enabled defendantto create a false impression of demand for the stock and to shield prices from the realities of the market);Melder v. Morris, 27 F.3d 1097 (5th Cir. 1994); Hunt v. Robinson, 852 F.2d 786 (4th Cir. 1988); Chem. Bank v.Arthur Andersen & Co., 726 F.2d 930, 943 (2d Cir. 1984); Adam v. Silicon Valley Bancshares, 884 F. Supp.1398 (N.D. Cal. 1995) (holding “in connection with” requirement does not preclude claims against accountantsfor alleged misstatements in prospectus’s financials); Abrash v. Fox, 805 F. Supp. 206 (S.D.N.Y. 1992); S.E.C.v. Roanoke Tech. Corp., No. 6:05-cv-1880-Orl-31KRS, 2006 WL 3813755, at *4-5 (M.D. Fla. Dec. 6, 2006)(holding that receiving payments in the form of stock in an alleged illicit scheme does not satisfy the “inconnection with” element).

Some courts have found, in particular circumstances, that misrepresentations made by a company other than theissuer are sufficient to meet the “in connection with” requirement. For example, the court in In re ImperialCredit Indus., Inc., No. CV 98-8842, 2000 WL 1049320, at *3-4 (C.D. Cal. Feb. 23, 2000) found thatmisrepresentations by a subsidiary were “in connection with” the sale of the parent’s securities. Further, inZelman v. JDS Uniphase Corp., the “in connection requirement” was met when the purchaser of an equity-linked debt security sued the issuer of the equity securities to which the debt was linked. 376 F. Supp. 2d 956(N.D. Cal. 2005).

Some courts have held that the “in connection with” statutory language requires a “nexus” between theallegedly misleading statement and the plaintiff investors. In Hudson v. Capital Mgmt. Int’l, Inc., 565 F. Supp.615, 621 (N.D. Cal. 1983), the court held that plaintiffs in a tax shelter class action “must plead what allegedlydeceptive information they had access to in order to demonstrate the requisite transactional nexus with thealleged fraud” to meet the statutory “in connection with” requirement. See also Landy v. F.D.I.C., 486 F.2d139, 168 (3d Cir. 1973) (holding misleading accountants’ report which was not disseminated to public or toplaintiff investors was not made in connection with purchase or sale of security); Wessel v. Buhler, 437 F.2d279, 282 (9th Cir. 1971) (holding misleading financial statement was not made “in connection with” sale ofsecurity if plaintiff investor did not see statement until after litigation began); In re Ramada Inns Sec. Litig., 550F. Supp. 1127, 1130 (D. Del. 1982) (finding nexus established by showing “plaintiff’s personal exposure to theoffending statements”).

10. Causation

The element of causation helps ensure that Rule 10b-5 does not become “an insurance plan for the cost ofevery security purchased in reliance upon a material misstatement or omission.” Huddleston v. Herman &MacLean, 640 F.2d 534, 549 (5th Cir. 1981), rev’d in part on other grounds, 459 U.S. 375 (1983). TheSupreme Court’s decision in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), that only apurchaser or seller has standing to sue under Section 10(b), highlights the causation requirement. Both “losscausation” (also referred to as “proximate causation” and “legal causation”) and “transaction causation” (alsoreferred to as “cause in fact” and “but for” causation) are necessary for a 10b-5 claim. Suez Equity Investors,L.P. v. Toronto-Dominion Bank, 250 F.3d 87, 95-96 (2d Cir. 2001); Binder v. Gillespie, 184 F.3d 1059, 1065(9th Cir. 1999) (“[Plaintiffs] must show that the fraud caused, or at least had something to do with the decline inthe value of the investment after the securities transaction took place.”); Bastian v. Petren Res. Corp., 892 F.2d680, 685-86 (7th Cir. 1990) (finding no loss causation where decline in value of stock due to national economicforces). In McGonigle v. Combs, 968 F.2d 810, 820 (9th Cir. 1992), the Ninth Circuit explained that losscausation requires the plaintiffs to show that the alleged misrepresentation reduced the value of theirinvestment, while transaction causation requires proof that defendants’ misrepresentations about the quality ofthe investment induced plaintiffs to buy the shares, which later declined in value. This means that the allegedmisrepresentation or omission must be both the cause in fact and the legal cause of plaintiff’s alleged loss.

a. Transaction Causation

Transaction causation has been characterized as a type of “causation in fact” or “but for” causation. Transaction causation requires that plaintiff show that the violations in question caused plaintiff to engage in thetransaction. See, e.g., Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F.3d 154, 172 (3d Cir. 2001);Suez Equity Investors, L.P. v. Toronto Dominion Bank, 250 F.3d 87, 95-96 (2d Cir. 2001); Weiner v. QuakerOats Co., 129 F.3d 310, 315 (3d Cir. 1997); Robbins v. Koger Props., Inc., 116 F.3d 1441, 1447 (11th Cir.1997). Transaction causation conceptually overlaps with the element of reliance, since a showing of transactioncausation hinges on a determination that plaintiff relied on the violation. See Basic Inc. v. Levinson, 485 U.S.224, 243 (1988) (“Reliance provides the requisite causal connection between a defendant’s misrepresentationand a plaintiff’s injury.”); Newton, 259 F.3d at 172 (“[T]ransaction causation is generally understood asreliance.”); AUSA Life Ins. Co. v. Ernst & Young, 206 F.3d 202, 209 (2d Cir. 2000) (analogizing transactioncausation to reliance); In re Salomon Smith Barney Mutual Fund Litig., 441 F. Supp. 2d 579 (S.D.N.Y. 2006)(finding that plaintiffs’ assertion that they would not have purchased the shares had they known of thecomplained-of practices was sufficient to show transaction causation, but not loss causation). Cromer Fin. Ltd.v. Berger, 205 F.R.D. 113, 128 (S.D.N.Y. 2001) (“In [the Second] Circuit, the element of reliance isencapsulated in the concept of causation.”).

b. Loss Causation

Loss causation is often referred to as “proximate causation” or “legal causation.” It involves a determinationthat the misstatement caused the harm suffered by the investor. See, e.g., Ambassador Hotel Co., Ltd., v. Wei-Chuan Inv., 189 F.3d 1017, 1027 (9th Cir. 1999) (“‘Loss causation’ is an exotic name – perhaps an unhappyone – for the standard rule of tort law that the plaintiff must allege and prove that, but for the defendant’swrongdoing, the plaintiff would not have incurred the harm of which he complains.”); see also In re GileadSciences Sec. Litig., 536 F.3d 1049, 1050-53, 1056-58 (9th Cir. 2008) (investors’ allegations of loss causationlinking a pharmaceutical company’s misrepresentations about a drug marketed for non-FDA approved uses andthe reduction in value of the company’s stock price months after the marketing practices were revealed wassufficient to survive a 12(b)(6) motion); Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261,269-70 (5th Cir. 2007) (requiring plaintiffs to establish loss causation before triggering the presumption ofreliance, because the assumption that every material misrepresentation will move a stock in an efficient marketis unfounded); Nathenson v. Zonagen Inc., 267 F.3d 400, 413 (5th Cir. 2001) (“‘[L]oss causation’ refers to adirect causal link between the misstatement and the claimant’s economic loss”) (citations omitted); Castellanov. Young & Rubicam, Inc., 257 F.3d 171, 186 (2d Cir. 2001) (holding plaintiff must allege that “the subject ofthe fraudulent statement or omission was the cause of the actual loss suffered”); Semerenko v. Cendant Corp.,223 F.3d 165, 184 (3d Cir. 2000) (explaining there must be a “sufficient causal nexus between the loss and thealleged misrepresentation”); Bastian v. Petren Res. Corp., 892 F.2d 680, 685 (7th Cir. 1990); In re OmnicomGroup, Inc. Sec. Litig., 541 F. Supp. 2d 546 (S.D.N.Y. 2008) (holding negative press characterizations are notcorrective disclosures and cannot establish loss causation where the underlying facts were already known to themarket and did not themselves affect stock price), aff’d, 597 F.3d 501 (2d Cir. 2010); Shanahan v. Vallat, No.03 Civ. 3496(PAC), 2008 WL 4525452, at *5 (S.D.N.Y. Oct. 3, 2008) (no loss causation because “industry-wide phenomena” caused plaintiffs’ losses; “‘[w]hen the plaintiff’s loss coincides with a marketwidephenomenon causing comparable losses to other investors, the prospects that the plaintiff’s loss was caused bythe fraud decreases’” (quoting First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 722 (2d. Cir.1994))); In re Polaroid Corp. Sec. Litig., 134 F. Supp. 2d 176, 189 (D. Mass. 2001) (dismissing complaintwhere plaintiffs failed to allege that violation of GAAP “was a substantial factor in the decline of the stockprice”).

c. Dura Pharmaceuticals

In 2005, the Supreme Court in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), resolved a split in

the circuits by unanimously rejecting a “price inflation” approach to loss causation employed in the Eighth andNinth Circuit as insufficient. Under the price inflation approach, plaintiffs could establish loss causation byrelying on the fraud-on-the-market theory to plead and prove that the price of the security on the date of thepurchase was inflated because of the misrepresentation. See, e.g., Broudo v. Dura Pharms., Inc., 339 F.3d 933,937-38 (9th Cir. 2003); Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824, 832 (8th Cir. 2003). The SupremeCourt, in rejecting that approach, stated that “as a matter of pure logic, at the moment the transaction takesplace, the plaintiff has suffered no loss; the inflated purchase payment is offset by ownership of a share that atthat instant possesses equivalent value.” Dura, 544 U.S. at 342. Accordingly, if the purchaser sells the shares“before the relevant truth begins to leak out, the misrepresentation will not have led to any loss.” Id.

Instead, the Court adopted the “price correction” approach employed in the Second, Third, Seventh andEleventh Circuits. The Court explained that a person who misrepresents the financial condition of a corporationin order to sell its stock becomes liable to a relying purchaser for the loss the purchaser sustains when the truefacts become generally known and, as a result, share value depreciates. Id. at 1633; see also Lentell v. MerrillLynch & Co., Inc., 396 F.3d 161, 170-71 (2d Cir. 2005); Emergent Capital Inv. Mgmt., LLC v. StonepathGroup, Inc., 343 F.3d 189 (2d Cir. 2003) (rejecting the argument that pleading artificial inflation of the marketwill, by itself, satisfy loss causation); Semerenko v. Cendant Corp., 223 F.3d 165, 185 (3d Cir. 2000) (“Wherethe value of the security does not actually decline as a result of an alleged misrepresentation, it cannot be saidthat there is in fact an economic loss attributable to that misrepresentation.”); Robbins v. Koger Props., Inc.,116 F.3d 1441 (11th Cir. 1997) (holding that a showing of price inflation does not satisfy the loss causationrequirement, and that a connection between the misrepresentation and the investment’s subsequent decline mustbe shown); Bastian v. Petren Res. Corp., 892 F.2d 680 (7th Cir. 1990).

In explaining the required causal connection between a misrepresentation and a loss, the Dura Court observedthat the mere fact that a purchaser later sells his or her shares at a lower price does not automatically equate to afinding of loss causation. Dura, 544 U.S. at 336. Justice Breyer, writing for the Court, elaborated that “[w]henthe purchaser subsequently resells such shares, even at a lower price, that lower price may reflect not the earliermisrepresentation, but changed circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other related events which, taken separately or together, account for all of thatlower price.” Id. at 342-43. Thus, Dura complements the widely publicized decision by Judge Pollack in theSouthern District of New York rejecting the theory that loss causation may be based upon a fraud-on-the-market theory and finding that the reduction in value of plaintiffs’ shares was caused by an intervening force:the bursting of the Internet bubble. In re Merrill Lynch & Co., Inc., 273 F. Supp. 2d 351 (S.D.N.Y. 2003), aff’dsub nom. Lentell v. Merrill Lynch & Co., Inc., 396 F.3d 161 (2d Cir. 2005).

In Merrill Lynch, the plaintiff had invested in Internet stocks and argued that material misstatements in MerrillLynch’s optimistic analyst reports concerning these stocks caused plaintiffs’ losses after a drop in value of thesestocks. Plaintiffs employed a fraud on the market theory, claiming that they effectively relied on these reportseven though they had not actually seen or read them. Defendants contended that any reduction in the price ofshares held by plaintiffs was caused by the collapse of the Internet market and the resultant market-wide pricedrop, not the content of analyst reports. The court found that plaintiffs failed to make a showing that “each ofthe challenged [analyst report] ratings was the substantial cause of artificial inflation [of the stock price].” Id. at368 n.29. The Second Circuit affirmed the dismissal, finding that there was no allegation “that the subject ofthe false [investment] recommendations … or any corrective disclosure regarding the falsity of thoserecommendations … is the cause of the decline in stock value.” Lentell, 396 F.3d at 175 (emphasis inoriginal). But see DeMarco v. Robertson Stephens, Inc., 318 F. Supp. 2d 110 (S.D.N.Y. 2004) (denying motionto dismiss based on holding that the Internet market collapse was not an intervening cause of plaintiffs’ loss).

d. Dura’s Effect In The Eighth And Ninth Circuits

Dura’s effect is most acutely felt in the Eighth and Ninth Circuits. Under the price inflation approachemployed in those circuits, plaintiffs were required to plead and prove only that the defendants committed afraud that caused the security price, at the time of purchase, to be artificially inflated. Plaintiffs did not need to

plead or prove that the artificial inflation was removed from the stock price during the class period. Thus,under pre-Dura standards, loss causation was established even if the market never learned the truth about thefraud and the stock price never dropped upon disclosure of the truth. After Dura, however, plaintiffs mustshow that the “misrepresentation touches upon the reasons for the investment’s decline in value” by pleadingand proving a corrective disclosure of the false information and the manner in which the stock price inflationwas removed from the stock price during the class period, usually in the form of a stock price drop.

Dura’s impact is apparent in the Ninth Circuit’s decisions in In re Daou Systems, Inc., 411 F.3d 1006 (9th Cir.2005), subsequently amended at 411 F.3d 1006 (9th Cir. 2005). In Daou, the plaintiffs alleged that thedefendants fraudulently overstated earnings by, among other things, misapplying the percentage of completionmethod of recognizing revenue. As a result, the company’s share price allegedly was inflated to as high as $34;from there, the share price declined to $18.50. Upon the defendants’ announcement of deteriorating earningsand other negative financial metrics from recognizing revenue prematurely, the share price quickly fell from$18.50 to $3.25. On these allegations, the Ninth Circuit cited Dura to hold that shareholder losses arising fromthe price drop from $34 to $18.50 were not recoverable under Rule 10b-5 because the drop to $18.50 occurredbefore the company revealed the truth about its earnings situation. However, the court held that loss causationwas adequately pled as to the post-disclosure price decline from $18.50 to $3.25.

In another Ninth Circuit case applying Dura, Metzler Investment GMBH v. Corinthian Colleges, Inc., 540 F.3d1049, 1054-55 (9th Cir. 2008), plaintiff brought a fraud claim against defendant based on questionable practicesat one of defendant’s privately owned universities. Plaintiff based its loss causation theory on a newspaperarticle and a financial disclosure made by defendant. Id. at 1059. However, plaintiff did not meet the standardfor pleading loss causation because plaintiff was not permitted to “plead loss causation through ‘euphemism’and thereby avoid alleging the necessary connection between defendant’s fraud and the actual loss. So long asthere is a drop in a stock’s price, a plaintiff will always be able to contend that the market ‘understood’ adefendant’s statement precipitating a loss as a coded message revealing the fraud. Enabling a plaintiff toproceed on such a theory would effectively resurrect what Dura discredited—that loss causation is establishedthrough an allegation that a stock was purchased at an inflated price.” Id. at 1063-63.

Nevertheless, the Ninth Circuit has also circumscribed Dura’s impact. In Daou, the Court noted that, despiteDura, a plaintiff is not required to show that the misrepresentations are the “sole reason” for the decline in shareprice in order to plead loss causation. Rather, all that is required is that the misrepresentation is “one substantialcause” of the decline. Daou, 411 F.3d at 1025. The Ninth Circuit has also held that in the case of a private saleof a privately traded company, “Dura is not controlling.” Livid Holdings, Ltd v. Salomon Smith Barney, Inc.,416 F.3d 940, 949 n.2 (9th Cir. 2005).

The Eighth Circuit cited extensively to and applied Dura in Schaaf v. Residential Funding Corp., 517 F.3d 544(8th Cir. 2008). The Eighth Circuit followed the Second Circuit’s “materialization of the risk” approach(discussed below), stating that to recover for securities fraud “a plaintiff must show ‘that the loss [was]foreseeable and that the loss [was] caused by the materialization of the concealed risk.’” Id. at 550 (quotingLentell v. Merrill Lynch & Co., Inc., 396 F.3d 161, 173 (2nd Cir. 2005)).

e. Dura’s Effect In Other Circuits

Dura has had a lesser impact on the circuits that followed the “price correction” approach because those circuitsalready required plaintiffs to plead and prove more than just an artificially inflated share price. “While theSupreme Court rejected the Ninth Circuit’s lenient test for economic loss and loss causation as inadequatepleading in fraud on the market cases, it did not address, and thus left intact, more stringent requirements thathad been established by other Circuit Courts of Appeals, including the Second, Third, Seventh, and Eleventh.”In re Enron Corp. Sec., Derivative & ERISA Litig., No. MDL-1446, Civ.A. H013624, Civ.A. H040087, 2005WL 3504860, at *14 (S.D. Tex. Dec. 22, 2005). Post-Dura decisions from these jurisdictions have emphasizedthe need for a corrective disclosure to establish loss causation. See, e.g., Tricontinental Indus. v.PricewaterhouseCoopers, LLP, 475 F.3d 824, 843 (7th Cir. 2007) (holding that in the wake of Dura, plaintiffs

cannot overcome the lack of a corrective disclosure specific to the alleged fraud with allegations of a broaderfraudulent scheme); Teachers’ Ret. Sys. v. Hunter, 477 F.3d 162, 185 (4th Cir. 2007) (holding that causationcannot be shown where facts in the alleged corrective disclosure have already been disclosed in public filings);In re Williams Sec. Litig. – WCG Subclass, 558 F.3d 1130, 1138 (10th Cir. 2009) (“The inability to point to asingle corrective disclosure does not relieve the plaintiff of showing how the truth was revealed; he cannot say,‘Well, the market must have known.’” (emphasis in original)); Schleicher v. Wendt, No. 1:02CV1332DFHTAB,2005 WL 1656871 (S.D. Ind., July 14, 2005); Joffee v. Lehman Bros., Inc., No. 04 CIV. 3507 RWS, 2005 WL1492101 (S.D.N.Y., June 23, 2005); In re Initial Pub. Offering Sec. Litig., 399 F. Supp. 2d 261 (S.D.N.Y.2005).

One issue that has arisen in the Third Circuit is the question whether plaintiffs must have sold shares toestablish loss causation, a question that was not reached in Dura. One district court held that they do not,reasoning that imposition of a requirement of sales would conflict with the policy of the Exchange Act and leadto a market imbalance by causing “additional precipitous drops in the stock’s market price.” In re RoyalDutch/Shell Transport Sec. Litig., 404 F. Supp. 2d 605 (D.N.J. 2005).

Another question that Dura left unresolved is the issue of how to treat in-and-out stock traders (investors whobought and sold their shares before the corrective disclosure). In a post-Dura class certification decision, In reBearingPoint, Inc. Securities Litigation, 232 F.R.D. 534, 544 (E.D. Va. 2006), the district court for the EasternDistrict of Virginia determined that in-and-out traders are appropriately counted as members of the proposedclass because they could conceivably prove loss causation. One example noted by the court would be wherethere are multiple disclosures. Id. Another instance would be where the inflationary effect of amisrepresentation diminished over time, even without a corrective disclosure. Id.; see also In re CIGNA Corp.Sec. Litig., 459 F. Supp. 2d 338 (E.D. Pa. Aug. 18, 2006) (denying motion for summary judgment dismissal ofclaim on allegation that plaintiff made a net profit, losing on some trades but also gaining on other trades,including short sales, during the class period and holding that Dura did not speak to the situation). But see In reOrganogenesis Sec. Litig., 241 F.R.D. 397 (D. Mass. 2007) (rejecting in-and-out trader as proposed classrepresentative because, under Dura and the specific facts of the case, such an investor could show no losses); Inre Comverse Tech., Inc. Sec. Litig., No. 06-CV-1825 NGG, 2007 WL 680779, at *4 (E.D.N.Y. Mar. 2, 2007)(holding that in-and-out losses must not be considered in the recoverable losses calculation in which courtsengage when selecting lead plaintiff).

f. “Corrective Disclosure” Approach To Pleading Loss Causation Since Dura

Courts have also clarified and curtailed the scope of “corrective disclosure” allegations. The mere existence ofa disclosure that has a negative effect on the share price, without more, is insufficient to plead loss causation. Rather, the share price decline must result from the disclosure to the market of the true state of affairs that alsoreveals the falsity of prior disclosures. See, e.g., In re Initial Pub. Offering Sec. Litig., 399 F. Supp. 2d 261(S.D.N.Y 2005) (“If downturns in stock prices based on such mundane events as failures to meet forecasts anddownward revisions of forecasts were legally sufficient to constitute disclosures of securities fraud, then anyinvestor who loses money in the stock market could sue to recover for those losses without alleging that afraudulent scheme was ever disclosed and that the disclosure caused their losses.”); Lentell v. Merrill Lynch &Co., Inc., 396 F.3d 161, 175 n.4 (2d Cir. 2005) (holding that stock price drop following downgrade of stock didnot amount to a corrective disclosure because the downgrades did not reveal to the market the falsity of theprior recommendations).

Most courts have found that the corrective disclosure does not have to mirror the alleged fraudulent scheme toadequately plead loss causation, so long as when taken as a whole, the disclosure in question was congruent tothe alleged fraud. See In re Williams Sec. Litig. – WCG Subclass, 558 F.3d 1130, 1140 (10th Cir. 2009) (“Tobe corrective, the disclosure need not precisely mirror the earlier misrepresentation, but it must at least relateback to the misrepresentation and not to some other negative information about the company.”); Alaska Elec.Pension Fund v. Flowserve Corp., 572 F.3d 221, 230 (5th Cir. 2009) (stating that a corrective disclosure neednot mirror the alleged misrepresentations but must disclose information that “reflect[s] part of the ‘relevant

truth’ – the truth obscured by the fraudulent statements.”); see also In re Take-Two Interactive Sec. Litig., 551F. Supp. 2d 247, 285-86 (S.D.N.Y. 2008) (“if a plaintiff relies upon a particular disclosure as the basis for hisloss causation allegations, that disclosure must somehow reveal to the market some part of the truth regardingthe alleged fraud,” even though it does not have to “precisely mirror” the alleged fraud). Thus, the disclosuredoes not have to state that the company was committing fraud, but rather can state facts that would give rise to acausal connection. See Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261, 271 (5th Cir.2007) (holding that when multiple negative items are announced contemporaneously, plaintiffs must “offersome empirically-based showing” that some percentage of the stock drop was attributable to correctivedisclosure); Lapin v. Goldman Sachs Group, Inc., 506 F. Supp. 2d 221 (S.D.N.Y. 2006) (holding that theannouncement of investigations against the defendant by the New York Attorney General, the JusticeDepartment and the SEC was the corrective disclosure, which need not come from the defendant company); Inre Hienergy Tech., Inc., No. SACV04-1226 DOC (JTLX), 2005 WL 3071250, at *4 (C.D. Cal. Oct. 25, 2005)(holding that a disclosure indicating that the SEC was going to file charges against the company was sufficientto plead a causal connection). But see In re Maxim Integrated Prods., Inc. Sec. Litig., 639 F. Supp. 2d 1038,1046 (N.D. Cal. 2009) (holding that disclosures regarding compliance with an SEC investigation, subpoenasfrom the U.S. Attorney’s office, and the formation of special committee to investigate options backdatingpractices were not corrective disclosures because they did not indicate anything more than a risk or potentialthat defendants engaged in widespread fraudulent conduct).

A disclosure need not come from the defendants to be corrective; a plaintiff “may plead loss causation based ontruth about the alleged fraud disclosed to the market by persons other than the defendants.” Lormand v. U.S.Unwired, Inc., 565 F.3d 228, 264 (5th Cir. 2009); In re StockerYale, 453 F. Supp. 2d 345 (D.N.H. 2006)(holding that the Dura standard for loss causation does not mandate that the source of the misrepresentationalso be the source of the corrective disclosure). And a corrective disclosure need not take the form of a singleannouncement, but rather can occur through a series of disclosing events. See Lormand, 565 F.3d at 261;Metzler Inv. GMBH v. Corinthian Colls., Inc., 540 F.3d 1049, 1063 n.6 (9th Cir. 2008). Finally, at the pleadingstage, the fact that a disclosure is not followed immediately by a stock price decrease is insufficient to warrantdismissal where the complaint properly alleges a specific causal link between the defendant’s fraud and theplaintiff’s economic loss. Lormand, 565 F.3d at 267 n.33 (“The market could plausibly have had a delayedreaction; a delayed reaction can still satisfy the pleading requirements for ‘loss causation’”); In re Gilead Sci.Sec. Litig., 536 F.3d 1049, 1058 (9th Cir. 2008) (“A limited temporal gap between the time themisrepresentation is publicly revealed and the subsequent decline in stock value does not render a plaintiff’stheory of loss causation per se implausible.”).

g. The “Materialization Of Risk” Approach To Pleading Loss Causation

The Second Circuit has also developed an alternate framework for pleading and proving loss causation, knownas the “materialization of risk” approach. Under that framework, “a misstatement or omission is the ‘proximatecause’ of an investment loss if the risk that caused the loss was within the zone of risk concealed by themisrepresentations and omissions alleged by the disappointed investor.” Lentell v. Merrill Lynch & Co., Inc.,396 F.3d 161, 173 (2d Cir. 2005). Thus, a plaintiff can plead and prove loss causation if the loss is foreseeableand caused by the materialization of the concealed risk. See Catton v. Defense Tech. Sys., Inc., No. 05 CIV.6954 (SAS), 2006 WL 27470 (S.D.N.Y. Jan 3, 2006). This approach recognizes that a plaintiff’s injury from adrop in the value of a security may be caused by the misstatement or omissions made about it, or by theemergence of the underlying circumstance that was concealed or misstated.

Plaintiffs may cite to the “materialization of risk” approach to pleading loss causation in some cases –particularly where a company’s stock price declined, not in response to a disclosure, but in response to acorporate crisis or event. This approach is well illustrated in Suez Equity Investors, L.P. v. Toronto-DominionBank, 250 F.3d 87 (2d Cir. 2001). Defendants, in soliciting plaintiffs’ investment in a company, providedplaintiffs with an edited version of a report on one of the company’s principal executives. The edited versionomitted important negative events in the executive’s financial and business history, such as multiple tax liens,delinquent credit accounts, an involuntary bankruptcy proceeding, and pending civil lawsuits. Plaintiffs claimed

that the concealed events reflected the executive’s inability to manage debt and maintain adequate liquidity. Plaintiffs also alleged that their investment ultimately became worthless because of the company’s eventualliquidity crisis and expressly attributed that crisis to the executive’s inability to manage the company’sfinances. Thus, plaintiffs specifically alleged a causal connection between the concealed information – theexecutive’s profile – and the materialization of the foreseeable risk of the true facts, i.e., the ultimate failure ofthe enterprise due to the inability to manage debt and liquidity.

Similarly, in In re Vivendi Universal, S.A. Sec. Litig., 605 F. Supp. 2d 586 (S.D.N.Y. 2009), under a very broad“materialization of the risk” theory, plaintiffs argued that defendants’ false and misleading statements concealedthe company’s risk of a liquidity crisis, and that subsequent events, such as credit ratings downgrades and quickasset sales, gradually revealed the company’s deteriorating liquidity condition. Because the subject ofdefendants’ statements concerned matters relating to liquidity, including the company’s debt load, its incomestream, and ability to convert assets into cash, the district court found that the “revealing” events identified bythe plaintiffs had a reasonable relationship to liquidity risks and to a trier of fact therefore could be seen asmaterializations of such risks. Id. at 601-02.

Further, the loss causation requirement also imposes a burden on plaintiffs to rebut any showing that the losswas the result of an intervening event, like, for example, the bursting of the internet bubble, rather than amaterialization of the undisclosed risk. In re Merrill Lynch & Co. Inc., 273 F. Supp. 2d 351 (S.D.N.Y. 2003),aff’d sub nom. Lentell, 396 F.3d 161; In re Acterna Corp. Sec. Litig., 378 F. Supp. 2d 561, 588 (D. Md. 2005)(“This decline, however, was not unique to Acterna, as evidenced by the near 50% drop in the Dow Jones U.S.Telecommunications Index during the Class Period.”); Lentell, 396 F.3d at 174 (“[W]hen the plaintiff’s losscoincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that theplaintiff’s loss was caused by the fraud decreases, and a plaintiff’s claim fails when it has not adequately pledfacts which, if proven, would show that its loss was caused by the alleged misstatements as opposed tointervening events.”); In re Moody’s Corp. Sec. Litig., 612 F. Supp. 2d 397, 399 (S.D.N.Y. 2009) (a plaintiff“must make a more detailed showing of loss causation when there is evidence of an industry-wide downturn, orwhen the record indicates that the company’s stock lost almost all its value before the first alleged correctivedisclosure” (internal citations omitted)).

h. Pleading Standard For Loss Causation After Dura

Apart from what facts a plaintiff must plead, Dura raises the question of how specifically the plaintiff mustplead them. In Dura, the Supreme Court declined to answer this question. Instead, the Court stated that itwould assume for the sake of argument that the notice pleading standard of Rule 8 of the Federal Rules of CivilProcedure governs pleading loss causation because the allegations in Dura failed even to meet that minimumbar.

In the wake of Dura, lower courts have generally applied Rule 8 to loss causation pleading. See In re Elec. ArtsInc. Sec. Litig., No. C-05-1219-MMS, 2006 WL 27201, at *1 (N.D. Cal. Jan 5, 2006); In re Immucor Inc. Sec.Litig., No. 1:05-CV-2276-WSD, 2006 WL 3000133 (N.D.Ga. Oct. 4, 2006) (holding allegations of losscausation are evaluated under notice pleading standard); Ong ex rel. Ong v. Sears, Roebuck & Co., 459 F. Supp.2d 729 (N.D. Ill. 2006) (same); In re Unumprovident Corp. Sec. Litig., 396 F. Supp. 2d 858, 899 (E.D. Tenn.2005). But see In re First Union Corp. Sec. Litig., No. CIV. 3:99 CIV. 237-H, 2006 WL 163616, at *5(W.D.N.C. Jan. 20 2006) (applying particularity requirements to loss causation).

In Bell Atl. Corp. v. Twombly, 550 U.S. 544, 556 (2007), an antitrust case, the Supreme Court, partially relyingon Dura, decided that Rule 8 implies a “plausibility” standard that any complaint must meet in order to state aclaim for relief. That is, the complaint must contain sufficient factual matter, accepted as true, to “state a claimto relief that is plausible on its face.” Id. at 570. In Ashcroft v. Iqbal, 129 S. Ct. 1937, 1953 (2009), the Courtclarified that the “facial plausibility” requirement applies in all civil actions, not just in the antitrust context. Since Twombly, the Fifth, Eighth, and Ninth Circuits have applied the “facial plausibility” standard to losscausation pleading. See Lormand, 565 F.3d at 258 (“[F]rom Dura’s holding … as well as Twombly’s

explanation of the plausibility standard, we conclude that Rule 8(a)(2) requires the plaintiff to allege, in respectto loss causation, a facially ‘plausible’ causal relationship between the fraudulent statements or omissions andplaintiff’s economic loss, including allegations of a material misrepresentation or omission, followed by theleaking out of relevant or related truth about the fraud that caused … plaintiff’s economic loss.”); McAdams v.McCord, 584 F.3d 1111, 1115 (8th Cir. 2009) (dismissing claimants’ loss causation allegations because theylacked “plausibility”); In re Gilead Sci. Sec. Litig., 536 F.3d 1049, 1057 (9th Cir. 2008) (citing Twombly andnoting that “so long as the complaint alleges facts that, if taken as true, plausibly establish loss causation, a Rule12(b)(6) dismissal is inappropriate.”).

The Fourth Circuit, on the other hand, suggests that loss causation must be pled under Rule 9(b). In Teachers’Retirement System of Louisiana v. Hunter, 477 F.3d 162 (4th Cir. 2007), the Fourth Circuit noted that “[n]eitherthe PSLRA nor the Supreme Court has established whether loss causation is a significant part of an ‘avermentof fraud’ to fall within the requirements of [Rule 9(b)]. A strong case can be made that [it does].” Id. at 185-86. The Fourth Circuit reiterated this view in In re Mutual Funds Investment Litigation, 566 F.3d 111 (4th Cir.2009), stating that while the pleading requirements of the PSLRA do not apply to loss causation, loss causationallegations must be pled with specificity. Id. at 119.

i. Limitations On The Scope Of Dura

In the wake of Dura, courts have mostly limited Dura’s application to fraud on the market type cases. See,e.g., McCabe v. Ernst & Young, LLP, No. CIV. 01-5747 (WHW), 2006 WL 42371, at *7 (D.N.J. Jan. 6, 2006),aff’d, 484 F.3d 418 (3d Cir. 2007); Livid Holdings Ltd. v. Salomon Smith Barney, Inc., 416 F.3d 940, 949 n.2(9th Cir. 2005). Further, courts have held Dura inapplicable in market manipulation cases because the “value”of the share purchased by the plaintiff is not the market price, but rather the price that would have existed hadthe market not been manipulated. See In re NYSE Specialists Sec. Litig., 405 F. Supp. 2d 281 (S.D.N.Y. 2005),vacated in part on other grounds, 503 F.3d 89 (2d Cir. 2007). Thus, in market manipulation cases, a plaintiffmay plead and prove an artificially inflated share purchase price to demonstrate loss causation, with the lossbeing the difference between the manipulated price and the actual value of the stock. Id.

Other cases have also found substantial limitations on Dura’s application. Notably, a New Jersey district courtheld that Dura does not impose a “sell-to-sue” requirement, i.e., a plaintiff does not actually have to sellsecurities in order to have standing to plead loss causation. In re Royal Dutch/ShellTransport Sec. Litig., 404 F.Supp. 2d 605 (D.N.J. 2005). The court narrowly construed Dura based on the plain language of Section 21D(e)of the Reform Act and in reliance on the Supreme Court’s express statement that it did not “consider otherproximate cause or loss related questions,” other than whether pleading an artificially inflated purchase pricealone, was sufficient for loss causation. Id. (citing Dura, 544 U.S. at 346-47). But see In re Citigroup AuctionRate Sec. Litig., No. 08 Civ. 3095 (LTS)(FM), 2009 WL 2914370, at *8 (S.D.N.Y. Sept. 11, 2009) (findingplaintiff’s loss causation allegations insufficient because plaintiff did not specifically allege that he tried to sellhis securities). Subsequent courts have also focused on this limiting language to justify limiting Dura. See,e.g., Freeland v. Iridium World Commc’ns, Ltd., 233 F.R.D. 40, 46 (D.D.C. 2006) (finding that Dura does notdefeat a lead plaintiff’s typicality requirement in a class action, even if the lead plaintiff is particularlysusceptible to a loss causation defense); In re CMS Energy Sec. Litig., 403 F. Supp. 2d 625, 629 (E.D. Mich.2005) (holding that Dura only applies to loss causation, and not transaction causation); In re WRT Energy Sec.Litig., No. 96 CIV. 3610, 2005 WL 3288142, at *1 (S.D.N.Y. Dec. 1, 2005) (stating that Dura is not applicableto § 11 claims, as there is no requirement to plead loss causation in such claims). But see Collier v. Aksys Ltd.,2005 WL 1949868, at *11 (D.Conn. Aug. 15, 2005) (finding that Dura applies not only to the typical situationwhere the share prices declines, but also to situations where the share price increases as a result of the truthemerging, e.g., where the plaintiff is a short-seller), aff’d, 179 F. App’x 770 (2d Cir. 2006).

11. Reliance

A plaintiff must rely on the alleged material misstatement in making the investment decision; reliance is a

“critical element for recovery under 10b-5.” Central Bank of Denver, N.A. v. First Interstate Bank of Denver,N.A., 511 U.S. 164, 180 (1994); see also Nathenson v. Zonagen Inc., 267 F.3d 400, 413 (5th Cir. 2001) (holdingreliance generally requires that the plaintiff knew of the misrepresentation at issue, believed it to be true, andbecause of that knowledge and belief, purchased or sold the security in question).

Reliance is a multi-faceted element in Rule 10b-5 cases, particularly because courts have afforded plaintiffs apresumption of reliance under certain circumstances. See, e.g., Semerenko v. Cendant Corp., 223 F.3d 165, 178(3d Cir. 2000) (“Recognizing that the requirement of showing direct reliance presents an unreasonableevidentiary burden in a securities market where face-to-face transactions are rare and where lawsuits arebrought by classes of investors … this court has adopted a rule that creates a presumption of reliance in certaincases.”).

Courts are mindful, however, that “reliance is and long has been an element of common law fraud,” (Basic Inc.v. Levinson, 485 U.S. 224, 243 (1988)) and that Rule 10b-5 is not meant to create “insurers against nationaleconomic calamities.” Bastian v. Petren Res. Corp., 892 F.2d 680, 685 (7th Cir. 1990).

Courts carefully consider what facts trigger a presumption of reliance, see e.g., Cammer v. Bloom, 711 F. Supp.1264, 1286-87 (D.N.J. 1989), and how the presumption may be rebutted by defendants. See e.g., Basic, 485U.S. at 248; see also Chase Manhattan Mortg. Corp v. Advanta Corp., No. CIV. A. 01-507, 2004 WL 422681(D. Del. Mar. 4, 2004) (holding that a non-reliance clause does not establish per se that reliance wasunreasonable).

a. Fraud On The Market Presumption Of Reliance

In class actions alleging misrepresentations concerning publicly traded securities, reliance by the class generallywill be presumed based on the “fraud on the market” doctrine. Under that doctrine, investors do not have toprove individual reliance on a company’s false or misleading statements. Instead, the doctrine creates arebuttable presumption that plaintiffs relied on the integrity of the market and were defrauded even if they didnot rely specifically on the false or misleading statements at issue in the complaint.

A plurality of the Supreme Court approved the “fraud on the market” theory in Basic Inc. v. Levinson, 485 U.S.224 (1988). According to the Court, the key to the “fraud on the market” theory is that “in an open anddeveloped securities market, the price of a company’s stock is determined by the available material informationregarding the company and its business .… Misleading statements will therefore defraud purchasers of stockeven if the purchasers do not directly rely on the misstatements.” Id. at 241-42 (citation omitted). The theory isthus founded upon an efficient capital market hypothesis. Id. at 253 (White, J., concurring) (criticizing theplurality’s view, which was adopted “with no staff economists, no experts schooled in the ‘efficient-capital-market hypothesis,’ [and] no ability to test the validity of empirical market studies”).

The Basic plurality explained that the doctrine did not eliminate the reliance requirement. Rather, since modernsecurities markets, involving millions of transactions daily, differ from the face-to-face transactionscontemplated by early fraud cases, an understanding of the reliance requirement of Rule 10b-5 must encompassthose differences. “With the presence of a market, the market is interposed between seller and buyer and,ideally, transmits information to the investor in the processed form of a market price.… The market is acting asthe unpaid agent of the investor, informing him that given all the information available to it, the value of thestock is worth the market price.” Id. at 244 (citation omitted). The Court concluded that “[a]n investor whobuys or sells stock at the price set by the market does so in reliance on the integrity of that price. Because mostpublicly available information is reflected in market price, an investor’s reliance on any public materialmisrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action.” Id. at 247; accord In reBurlington Coat Factory Sec. Litig., 114 F.3d 1410, 1419 n.8 (3d Cir. 1997) (recognizing that the fraud-on-the-market theory, on which that suit was grounded, “accords … a rebuttable presumption of reliance if plaintiffsbought or sold their securities in an efficient market,” “the presumption of reliance [being] based on the theory

that in an efficient market the misinformation directly affects the stock prices at which the investor trades andthus, through the inflated or deflated price, causes injury even in the absence of direct reliance”); In re ClearlyCanadian Sec. Litig., 875 F. Supp. 1410, 1414-16, 1418-19 (N.D. Cal. 1995); see also, In re Salomon AnalystMetromedia Litig., 544 F.3d 474, 481-82 (2d Cir. 2008) (extending the “fraud on the market presumption” tomisinformation and omissions transmitted to the market by a secondary actor, noting that nothing in thelanguage of Basic limits its holding to issuer statements).

The fraud on the market presumption is also available to purchasers of other types of securities, such asoptions. For instance, in Moskowitz v. Lopp, 128 F.R.D. 624, 630-31 (E.D. Pa. 1989), defendants attacked classcertification on the ground of typicality, claiming that plaintiff could not avail himself of the fraud on themarket presumption because he had engaged in takeover speculation. Defendants asserted that plaintiff did notrely on market price as an indication of the value of the securities but, instead, sought to profit from short-termmovements in price arising from takeover speculation. The Court rejected defendants’ theory, holding that first,the possible availability of a unique defense does not foreclose class certification, and second, “[t]raders in putsand calls rely on the integrity of information disseminated in the market just as do purchasers and sellers of theunderlying security.” Id. (quoting Tolan v. Computervision Corp., 696 F. Supp. 771, 779 (D. Mass. 1988)). Furthermore, the fraud on the market presumption has been held to apply to convertible bonds. Argent ClassicConvertible Arbitrage Fund v. Rite Aid Corp., 315 F. Supp. 2d 666, 675-77 (E.D. Pa. 2004) (holding that theinvestor’s strategy of selling company’s stock short as a hedge against possible declines in convertible bondprices did not defeat the fraud on the market allegation of reliance); see also Levie v. Sears, Roebuck & Co., 496F. Supp. 2d 944, 949 (N.D. Ill. 2007) (holding that short sellers, options traders and day traders may rely on thefraud-on-the-market presumption of reliance).

The fraud on the market doctrine does not apply to claims brought by investors in mutual funds. In Siemers v.Wells Fargo & Co., 243 F.R.D. 369, 373-74 (N.D. Cal. 2007), the court noted that the presumption that theprice of a stock reflects all public information does not apply to mutual funds because the daily share value of amutual fund does not fluctuate with the public opinion of the fund. Id. The daily share value of the fund isbased on the fund’s underlying portfolio and the number of shares the fund holds. Id. Therefore, bad newsabout the fund’s management will not affect the daily share value of the fund. Id. at 374. Thus, the presumption that misleading statements concerning a company will inflate a stock price does not apply tomutual funds.

1) Existence Of An Efficient Market

The fraud on the market doctrine is grounded on the assumption that the market price “incorporates into astock’s price all publicly available information.” Heliotrope Gen. Inc. v. Ford Motor Co., 189 F.3d 971, 977(9th Cir. 1999) (explaining efficient market is presumed to incorporate into stock price all publicly availableinformation, including, for example, all provisions of the Federal Tax Code, no matter how arcane); In rePolyMedica Sec. Litig., 432 F.3d 1 (1st Cir. 2005) (noting efficient market requires only informationalefficiency, not value efficiency); Nathenson v. Zonagen, Inc., 267 F.3d 400 (5th Cir. 2001); Newton v. MerrillLynch, Pierce, Fenner & Smith, 259 F.3d 154 (3d Cir. 2001); Binder v. Gillespie, 184 F.3d 1059, 1064 (9th Cir.1999) (holding presumption of reliance under fraud on the market theory available only when plaintiff allegesthat defendant made material misrepresentations or omissions concerning a security that is traded in an efficientmarket); Longman v. Food Lion, Inc., 197 F.3d 675, 682 n.1 (4th Cir. 1999); Robbins v. Koger Props., Inc., 116F.3d 1441 (11th Cir. 1997). Accordingly, the doctrine rests on the efficient market hypothesis, i.e., theassumption that the underlying security is being traded on an efficient market in which all public information,truthful or otherwise, is reflected in the market price. See Barbara Black, Fraud on the Market: A Criticism ofDispensing with Reliance Requirements in Certain Open Market Transactions, 62 N.C. L. REV. 435, 437(1984); Peter J. Dennin, Note, Which Came First, The Fraud Or The Market: Is The Fraud-Created-The-Market Theory Valid Under Rule 10b-5?, 69 FORDHAM L. REV. 2611 (2001).

When analyzing the applicability of the fraud on the market doctrine, courts have traditionally considered at

least five factors to determine whether a company’s stock is sold in an “efficient market:” (1) whether the stocktrades at a high weekly volume; (2) whether securities analysts follow and report on the stock; (3) whether thestock has market makers and arbitrageurs; (4) whether the company is eligible to file SEC registration form S-3,rather than forms S-1 or S-2; and (5) whether there are “empirical facts showing a cause and effect relationshipbetween unexpected corporate events or financial releases and an immediate response in the stock price.” Cammer v. Bloom, 711 F. Supp. 1264, 1285-87 (D.N.J. 1989). Numerous courts have adopted these so-called“Cammer factors” in analyzing whether a given market is “efficient” for these purposes. See, e.g., Binder v.Gillespie, 184 F.3d 1059, 1064 (9th Cir. 1999) (using Cammer five-factor analysis to determine whether marketis efficient; concluding that the mere existence of market makers and arbitrageurs is insufficient under this test);Hayes v. Gross, 982 F.2d 104, 107 n.1 (3d Cir. 1992) (adopting Cammer’s “thorough analysis”); Freeman v.Laventhol & Horwath, 915 F.2d 193, 199 (6th Cir. 1990) (same); In re USA Talks.com Sec. Litig., No. 99-CV-0162-L (JA), 2000 WL 1887516 (S.D. Cal. Sept. 14, 2000); In re Healthsouth Corp. Sec. Litig., 261 F.R.D.616, 632-38 (N.D. Ala. 2009) (applying Cammer to the market for defendant corporation’s bonds and findingample indicia of an efficient market).

2) Misrepresentation Must Be A Public Presentation

The alleged misrepresentation also must be publicly made so that it could theoretically have some impact onmarket price. In re LTV Sec. Litig., 88 F.R.D. 134, 144 (N.D. Tex. 1980) (“[T]he price of the stock appears toreflect all publicly available information, but not all privately held information.”); accord Grossman v. WasteMgmt., Inc., 589 F. Supp. 395, 403 (N.D. Ill. 1984) (explaining theory assumes that market price of stockreflects “all publicly available information”). Available public information includes, for example, researchanalysts’ reports. DeMarco, Inc. v. Lehman Bros., Inc., 309 F. Supp. 2d 631, 635-36 (S.D.N.Y. 2004) (holdingthat such reports were not exempt from the reach of the fraud on the market presumption); DeMarco v.Robertson Stephens Inc., 318 F. Supp. 2d 110, 120 (S.D.N.Y. 2004) (rejecting defendant’s argument that thefraud on the market theory applies only to misrepresentations by corporate insiders and not opinions publishedin analyst reports). Personal involvement in the dissemination by the defendant is not required. Simpson v.AOL Time Warner, 452 F.3d 1040 (9th Cir. 2006), vacated by Simpson v. Homestore.com, Inc., 519 F.3d 1041(9th Cir. 2008). But see In re Credit Suisse First Boston Corp. (Lantronix, Inc.) Analyst Sec. Litig., 250 F.R.D.137 (S.D.N.Y. 2008) (when the misleading statements are made by an analyst and the statements do not impactstock price, no presumption of reliance arises). Closed public lawsuits are not considered public information. JHW Greentree Capital, L.P., v. Whittier Trust Co., No. 05 CIV. 2985, 2005 WL 3008452, at *4 (S.D.N.Y.Nov. 10, 2005) ([“I]t is unrealistic to expect a party to a transaction, even a sophisticated private equity firm, toscour the dockets of every court in the nation for closed actions involving an acquisition target.”). Thus,defense counsel should consider whether the fraud on the market doctrine should apply to Rule 10b-5allegations concerning nonpublic misrepresentations, i.e., private opinion letters of counsel, feasibility studiesand other materials not disseminated to the public and thus unavailable to the market “transmission belt.”

3) Application Of Fraud On The Market Theory To Short Sellers

In Zlotnick v. TIE Communication, 836 F.2d 818, 823 (3d Cir. 1988), the court held that short sellers are notentitled to the presumption of reliance because, unlike typical investors who rely on the market to be efficientand therefore reflect the true value of stock, short sellers rely on an inefficient market. Nonetheless, a shortseller can still show “actual indirect reliance” by “demonstrating a change in investment strategy and actualreliance on the ‘integrity’ of the inflated market price at the time of cover.” Rocker Mgmt. L.L.C. v. Lernout &Hauspie Speech Prods. N.V., No. CIV. A. 00-5965, 2005 WL 1365772, at *5 (D.N.J. June 8, 2005). In Rocker,the court found such actual indirect reliance where the plaintiffs alleged that a rise in stock price “increased therisk of loss beyond acceptable levels, [and] caused one to enter into a cover transaction.” Id. At least two othercourts have allowed short sellers to utilize the fraud-on-the-market presumption. See Argent ClassicConvertible Arbitrage Fund v. Rite Aid Corp., 315 F. Supp. 2d 666, 675-77 (E.D. Pa. 2004); Levie v. Sears,

Roebuck & Co., 496 F. Supp. 2d 944, 949 (N.D. Ill. 2007).

4) Application Of Fraud On The Market Theory To State Securities Law And StateCommon Law Fraud Claims

The fraud on the market theory may be available to establish reliance under state securities statutes. At leasttwo federal courts have extended the fraud on the market theory to establish reliance with respect to pendentstate common law fraud claims. In Hurley v. FDIC, 719 F. Supp. 27, 34 (D. Mass. 1989), the Court held thatthe fraud on the market presumption was applicable to plaintiff’s fraud claims arising under Massachusettscommon law, even though no Massachusetts state court had adopted the theory. Similarly, in Minpeco S.A. v.Hunt, 718 F. Supp. 168, 176 (S.D.N.Y. 1989), the court applied the fraud on the market presumption to acommon law fraud claim arising under New York law without any New York court having decided the issue. See also In re Sumitomo Copper Litig., 995 F. Supp. 451, 458 (S.D.N.Y. 1998) (citing Minpeco and In re BlechSec. Litig., 961 F. Supp. 569, 587 (S.D.N.Y. 1997)).

However, several district courts and state supreme courts have held that the fraud on the market theory is notapplicable to state common law claims. See, e.g., Kaufman v. i-Stat Corp., 754 A.2d 1188, 1189 (N.J. 2000);Malone v. Brincat, 722 A.2d 5 (Del. 1998); Zuckerman v. Foxmeyer Health Corp., 4 F. Supp. 2d 618 (N.D.Tex. 1998); In re Information Res., Inc. Sec. Litig., No. 89 C 3772, 1994 WL 124890, at *4 (N.D. Ill. Apr. 11,1994); Mirkin v. Wasserman, 5 Cal. 4th 1082, 1089-91 (1993).

b. Rebutting The Presumption Of Reliance

Although it preceded Basic, Blackie v. Barrack, 524 F.2d 891, 906 (9th Cir. 1975), delineated four basic waysthat a defendant can rebut the presumption of reliance: (1) disproving materiality; (2) despite materiality,showing that an insufficient number of traders relied to inflate the price (i.e., the market was not efficient);(3) showing that an individual plaintiff purchased despite knowledge of the falsity of a representation; or(4) showing that an individual plaintiff would have purchased anyway had he known of the falsity of therepresentation. Id.; Kalnit v. Eichler, 85 F. Supp. 2d 232, 241 (S.D.N.Y. 1999) (holding fraud on the markettheory creates rebuttable, not absolute, presumption of reliance); see also DeMarco v. Lehman Brothers Inc.,222 F.R.D. 243, 245-46 (S.D.N.Y. 2004) (the fraud on the market doctrine applies only where there is ashowing that the statements materially impacted the market price in a reasonably quantifiable respect); OscarPrivate Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261, 265 (5th Cir. 2007) (“We now require more thanproof of a material misstatement; we require proof that the misstatement actually moved the market.”)(emphasis in original). Where the plaintiffs consist of a class of persons as opposed to an individual,defendants can rebut the presumption of reliance by showing that “many” of the class members did not rely onthe representation. Jaffe Pension Plan v. Household Int’l, Inc., No. 02 C 5893, 2005 U.S. Dist. LEXIS 8610, at*12 (E.D. Ill. April 18, 2005). However, showing that only one individual or a “handful” of persons did notrely on the integrity of the market when purchasing or selling their stock is insufficient to rebut thepresumption. Id. (citing In re Lucent Techs. Inc. Sec. Litig., No. 00-621 (JAP), 2002 U.S. Dist. LEXIS 8799, at*4 (D.N.J. May 7, 2002) (“[T]he investment behavior of a handful of plaintiffs … cannot be extrapolated torepresent the experience of a class of hundreds of thousands of individuals of which the putative class iscomprised.”)).

Defendants may also be able to rebut the presumption of reliance in a fraud on the market action by showingthat sophisticated buyers, or “marketmakers,” were not taken in by the misrepresentations at issue. Cione v.Gorr, 843 F. Supp. 1199, 1202 (N.D. Ohio 1994); see also Phillips v. LCI Int’l, Inc., 190 F.3d 609, 617 (4thCir. 1999) (“‘[E]ven lies are not actionable’ when an investor ‘possesses information sufficient to call the[mis]representation into question.’”) (second alteration in original)); Marksman Partners, L.P. v. ChantalPharms. Corp., 927 F. Supp. 1297, 1307 n.6 (C.D. Cal. 1996). But see Hanon v. Dataproducts Corp., 976 F.2d497, 506 (9th Cir. 1992) (“Sophisticated investors are as entitled to rely on the fraud-on-the-market theory as

anyone else.”).

1) Underdeveloped Or Inefficient Markets

As noted above, defendants can rebut the presumption of reliance by, inter alia, showing that a plaintiff’sdecision to purchase or sell shares was not influenced by the misstatements or that the misrepresentation did notin fact distort the price of the stock. In developing the fraud on the market theory, the Supreme Court in Basicemphasized “well-developed markets” which “reflect all publicly traded information and, hence, any materialmisrepresentations.” Basic Inc. v. Levinson, 485 U.S. 224, 246 (1988); see also In re Polymedica Corp. Sec.Litig., 224 F.R.D. 27, 43 (D. Mass. 2004) (deriving from Basic the definition of “efficient market” as that inwhich market professionals generally consider most publicly announced material statements about companies,not one in which stock price rapidly reflects all publicly available information).

The critical factor in determining whether a market is open, developed, and efficient for purposes of the fraudon the market presumption is the trading characteristics of the individual stock itself. The location of where thestock trades may be relevant, but location is not dispositive of whether the current market price reflects allavailable information. Cammer v. Bloom, 711 F. Supp. 1264, 1281 (D.N.J. 1989) (applying fraud on the marketpresumption to claims of investors who purchased stock in the over-the-counter market and noting thatineligibility of issuer to file S-3 registration statement was not fatal to applicability of presumption); Hurley v.FDIC, 719 F. Supp. 27 (D. Mass. 1989) (holding the fraud on the market presumption applies to an over-the-counter traded security so long as the market for that security is an efficient and developed one, i.e., one thataccurately reflects all public material information about a company in the price of the security).

An initial public offering presents an interesting question as to whether the security is trading in an efficientmarket. See Comment, Robert G. Newkirk, Sufficient Efficiency: Fraud on the Market in the Initial PublicOffering Context, 58 U. CHI. L. REV. 1393, 1422 (1991). Some courts have held that the market for an initialpublic offering is not efficient. In In re Initial Public Offering Securities Litigation, 471 F.3d 24 (2d Cir. 2006),the Second Circuit concluded that the “fraud on the market” presumption could not be applied because themarket for IPO shares cannot be efficient under any circumstances. As “just one example” of why an efficientmarket could not be established with an IPO, the court pointed to the 25-day “quiet period” during whichanalysts cannot report concerning securities. Id. at 43. This “quiet period” necessarily precluded thecontemporaneous “significant number of reports by securities analysts” that are characteristic of an efficientmarket. Id. (citing Freeman v. Laventhol & Horwath, 915 F.2d 193,199 (6th Cir. 1990)); see also Chavin v.McKelvey, 25 F. Supp. 2d 231, 238-39 (S.D.N.Y. 1998), aff’d, 182 F.3d 898 (2d Cir. 1999) (pre-IPOrelinquishment of conversion rights not part of an efficient market); Gruber v. Price Waterhouse, 776 F. Supp.1044 (E.D. Pa. 1991) (“Given this theoretical underpinning, the ‘fraud on the market’ theory cannot apply toinitial public offerings.”); see generally In re Res. Am. Sec. Litig., 202 F.R.D. 177 (E.D. Pa. 2001) (providingextended analysis of Cammer factors and theory of efficient markets). But see In re Initial Public Offering Sec.Litig., 544 F. Supp. 2d 277, 295-96 (S.D.N.Y. 2008) (holding that while the primary market for IPO shares isnot efficient, the secondary market that had developed in the days and weeks after the IPO, in which plaintiffsbought their shares, was efficient).

Other cases have considered efficient markets in different securities contexts. See Chavin v. McKelvey, 25 F.Supp. 2d 231 (S.D.N.Y. 1998), aff’d, 182 F.3d 898 (2d Cir. 1999) (declining to apply fraud on the markettheory when the stock was not publicly traded); Freeman v. Laventhol & Horwath, 915 F.2d 193, 198-99 (6thCir. 1990) (finding primary market for newly issued municipal bonds not an efficient market); Lipton v.Documation, Inc., 734 F.2d 740, 746 (11th Cir. 1984) (“[I]t is not necessarily reasonable to presume thatmisinformation will affect the market price, as information on an undeveloped market does not readily affectmarket prices and, in the case of new securities, the price will be set by the offeror and underwriters, not themarket.”); Epstein v. Am. Reserve Corp., No. 79 C 4767, 1988 WL 40500, at *5 (N.D. Ill. Apr. 21, 1988) (“Webelieve that the over-the-counter market is incapable of meeting the Supreme Court’s test in Basic Inc. v.Levinson for an efficient market.”). But see In re Am. Cont’l Corp./Lincoln Sav. & Loan Sec. Litig., 140 F.R.D.425, 431-34 (D. Ariz. 1992) (applying fraud on the market theory to an offering of newly issued bonds,emphasizing the financial strength of the promoters and presumption of reliance on the “regulatory process”);In re Healthsouth Corp. Sec. Litig., 261 F.R.D. at 630-31 (finding market for defendant corporation’s bonds

was efficient). While the fraud on the market theory generally has not been applied to initial public offerings,some courts have recognized the related “fraud created the market” theory in limited circumstances, asdiscussed infra.

2) Truth On The Market Defense

Courts also have adopted a “truth on the market” defense to rebut the “fraud on the market” presumption. If theinformation that is alleged to have been withheld from or misrepresented to the market has entered the marketthrough other channels, the market will not have been misled and plaintiff’s claims will fail. See, e.g., Ganinov. Citizens Utilities Co., 228 F.3d 154, 167 (2d Cir. 2000) (“[A] misrepresentation is immaterial if theinformation is already known to the market because the misrepresentation cannot then defraud the market.”);Provenz v. Miller, 102 F.3d 1478, 1492 (9th Cir. 1996); Associated Randall Bank v. Griffin, Kubik, Stephens &Thompson, Inc., 3 F.3d 208, 213-14 (7th Cir. 1993); In re Apple Computer Sec. Litig., 886 F.2d 1109, 1111 (9thCir. 1989) (“[T]he defendants’ failure to disclose material information may be excused where the informationhas been made credibly available to the market by other sources.”); Ley v. Visteon Corp., No. 05-CV-70737-DT, 2006 WL 2559795 (E.D. Mich. Aug. 31, 2006) (dismissing claims based on defendants’ operations issuesbecause the issues were discussed in analyst reports and newspaper articles during the class period), aff’d, 543F.3d 801 (6th Cir. 2008); Iron Workers Local 16 Pension v. Hilb Rogal & Hobbs, 432 F. Supp. 2d 571, 582(E.D. Va. 2006) (holding that the fraud on the market theory can cut both ways for a plaintiff because it notonly includes information supporting a plaintiff’s theory of nondisclosure, but also information from otherpublicly available sources that may discredit that theory). Some courts have held that this defense is notavailable at the pleading stage, as it is fact-specific and best resolved on summary judgment motion or at trial. Asher v. Baxter Int’l Inc., 377 F.3d 727 (7th Cir. 2004) (reversing dismissal when there was a sharp drop in thestock price, despite defendant’s contention that the full truth had reached the market); Freeland v. IridiumWorld Commc’ns, Ltd., 545 F. Supp. 2d 59, 79 (D.D.C. 2008) (“Whether the purported corrective informationwas conveyed to the public with a degree of intensity and credibility sufficient to effectively counterbalance anymisleading information created by the alleged misstatements is a fact-intensive inquiry.”); In re Globalstar Sec.Litig., No. 01 CIV. 1748, 2003 WL 22953163 (S.D.N.Y. Dec. 15, 2003); see also Kaplan v. Rose, 49 F.3d1363, 1376-78 (9th Cir. 1994) (following Apple standard but finding that genuine issue of fact remained as towhether market was misled by misrepresentations and omissions). The information need only be retrievable bya “reasonable investor.” In re Discovery Labs. Sec. Litig., No. 06-1820, 2006 WL 3227767 (E.D. Pa. Nov. 1,2006) (holding alleged misstatements were not actionable because of the widely known fact that the companywould have to comply with FDA regulations and public reports of facility problems).

In In re Stac Electronics Sec. Litig., 89 F.3d 1399, 1409 (9th Cir. 1996), the Ninth Circuit found that ifcustomers knew that upgraded operating systems were likely to include data compression, the market wasaware that Stac’s product could become obsolete. The court also noted that even without such disclosures,investors could easily have predicted that if Stac’s key product were to lose its market share, the companywould be in serious trouble. Accordingly, the court held the foregoing “market awareness” precluded plaintiffs’Section 10(b) claim for fraud on the market. Id. But see Kaplan v. Rose, 49 F.3d 1363, 1376-78 (9th Cir.1994); In re Newbridge Networks Sec. Litig., 962 F. Supp. 166, 178 (D.D.C. 1997) (holding defendants had noteffectively demonstrated that corrective information had credibly entered the market by pointing to a change inone analyst’s growth estimates); Marksman Partners, L.P. v. Chantal Pharms. Corp., 927 F. Supp. 1297, 1306-08 (C.D. Cal. 1996) (holding misleading statements were not counterbalanced by the marketing agreementattached to the 10-K where nothing in the body of the 10-K discussed the marketing agreement, explained thesignificance of its terms, or disclosed that revenues were being recognized while the buyer had a right of returnor before the buyer was actually obligated to make payment).

c. Variations On The Fraud On The Market Presumption

1) “Fraud Created The Market”

Under the “fraud created the market” theory, investors are presumed to rely not on the integrity of the marketprice, but on the existence of a market for the security. Ross v. Bank South N.A., 885 F.2d 723, 729 (11th Cir.1989). The “fraud created the market” theory is distinct from its more often discussed cousin, “fraud on themarket,” and not as widely accepted. To invoke the “fraud created the market” presumption, plaintiffs mustallege facts establishing that “but for” the fraud, the securities would never have been marketed at all. Id. at729-30; Joseph v. Wiles, 223 F.3d 1155, 1164 (10th Cir. 2000) (“[I]n order to invoke the presumption ofreliance” on the doctrine, the securities must have either “economic unmarketability” or “legalunmarketability.”); Kirkpatrick v. J.C. Bradford & Co., 827 F.2d 718, 723 (11th Cir. 1987). The theory hasbeen attacked on several grounds and remains controversial. See, e.g., Ross v. Bank South, N.A., 885 F.2d 723,732-45 (11th Cir. 1989) (Tjoflat, J., concurring).

(a) Evolution Of The “Fraud Created The Market” Theory

In Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981) (en banc), a sharply divided Fifth Circuit (12-10) extended thefraud on the market doctrine under special circumstances to create a presumption of reliance in a case arisingfrom an initial offering of unregistered tax-exempt bonds. Plaintiff had not reviewed an allegedly misleadingoffering circular. The Fifth Circuit, focusing on subsections (1) and (3) of Rule 10b-5 (schemes to defraud orcourse of business operating as a fraud) held that plaintiff could state a 10b-5 cause of action despite his lack ofactual reliance if he could prove three conjunctive elements: (1) the defendants knowingly conspired to bringsecurities onto the market which were not entitled to be marketed, intending to defraud purchasers; (2) plaintiff reasonably relied on the bonds’ availability on the market as an indication of their apparentgenuineness; and (3) plaintiff suffered a loss as a result of the scheme to defraud. Id. at 469-70.

The Shores court observed that plaintiff would not recover if he proved only that the bonds would have beenoffered at a lower price or higher rate. Rather, plaintiff had to show that they would never have been issued atall. Id. at 470. The complaint in Shores met this requirement by alleging that defendants engaged in anelaborate scheme to create a bond issue that appeared genuine but was so lacking in basic requirements that theissue would never have been approved by the Board or presented by the underwriters except that theparticipants in the scheme acted with intent to defraud or reckless disregard for whether the other defendantswere perpetrating a fraud. Id. at 468.

(b) Courts Utilizing The “Fraud Created The Market” Theory

In T.J. Raney & Sons, Inc. v. Fort Cobb, Oklahoma Irrigation Fuel Authority, 717 F.2d 1330 (10th Cir. 1983),the Tenth Circuit found Shores persuasive and held that “plaintiff has stated grounds for relief by alleging thatthe defendants knowingly conspired to bring unlawfully issued Series C bonds to market with the intent todefraud, that it reasonably relied on the availability of the bonds as indicating their lawful issuance, and that itsuffered injury resulting from the purchase of the bonds.” Id. at 1333; see also Arena Land & Inv. Co. v. Petty,906 F. Supp. 1470, 1481 (D. Utah 1994), aff’d, 69 F.3d 547 (10th Cir. 1995) (finding that the theory is limitedto situations where plaintiffs allege some illegality in the process of issuing the securities); Gruber v. PriceWaterhouse, 776 F. Supp. 1044, 1052 (E.D. Pa. 1991) (holding doctrine applies only if business is an “absolutesham, worthless from the beginning”).

The Tenth Circuit affirmed the “fraud created the market” theory’s validity but adopted the Sixth Circuit’sapproach to narrowly constrain its scope. Joseph v. Wiles, 223 F.3d 1155, 1164 (10th Cir. 2000) (citing

Ockerman v. May Zima & Co., 27 F.3d 1151, 1160 (6th Cir. 1994)). This approach dictates that in order toqualify for a presumption of reliance, a security must be “unmarketable” in either an “economic” or “legal”respect. Joseph, 223 F.3d at 1164. The Joseph court cautioned, however, that “cases discussing the [fraudcreated the market] issue define ‘unmarketable’ strictly.” Id. To be economically unmarketable, a securitymust be “patently worthless;” to be legally unmarketable, issuance of a security must be legally prohibited by aregulatory or municipal agency. Id. Thus, where plaintiff suffered a “substantial loss,” but his debentures didnot lack all economic value and were issued with legal authority, plaintiff is not entitled to a presumption ofreliance. Id. at 1164-65.

Additionally, in Rosenthal v. Dean Witter Reynolds, Inc., 945 F. Supp. 1412, 1418, 1420 (D. Colo. 1996), thecourt applied the “fraud-created-the-market” doctrine to securities-related allegations concerning the publicoffering of bonds. However, the court held that the doctrine “is reserved for those cases in which fraud ‘truly’created the market.” Id. at 1419. The court ultimately rejected plaintiffs’ claims, finding that merely allegingthat the bonds were “unworthy” of trading (instead of alleging that the bonds were unlawfully issued) could notestablish that the fraud created the market. Id.; see also Dalton v. Alston & Bird, 741 F. Supp. 1322 (S.D. Ill.1990) (rejecting a “no chance of success test” for fraud on the market in the new issue context, stating thatalmost any venture has some potential for success; the court held that, under Shores, a new issue is marketableat some price “if it is what it claims to be: a validly issued security, the terms of which are the same as theterms at which it is offered, the proceeds of which are intended to be used to finance some project; beyond this,investors in a new venture issue cannot rely on the integrity of an underdeveloped market to protect them fromrisk”). But see In re Healthsouth Corp. Sec. Litig., 261 F.R.D. at 642-44 (applying fraud-created-the-markettheory where but for defendant’s fraud, its bonds could not have been issued at any price).

(c) Cases Rejecting Or Uncertain About The Fraud Created The Market Theory

In Ross v. Bank South, N.A., 885 F.2d 723 (11th Cir. 1989), the Eleventh Circuit, sitting en banc, refused tooverrule Shores and the fraud created the market theory. Id. at 730 n.11. Four of the judges who concurred inthe result argued, however, that Shores should be overruled. One of the concurring judges argued that theShores “reliance on marketability” holding should be overruled because (1) reliance on a primary market toexclude “unmarketable” bonds is unreasonable, (2) juries will find the distinctions drawn by Shores to bearbitrary and meaningless, and (3) the calculation of damages under Shores is problematic. Id. at 732-45(Tjoflat, J., concurring). Nonetheless, the Court affirmed summary judgment in favor of defendants, holdingthat plaintiffs had failed to generate a genuine issue of fact as to marketability, finding that most of the factsabout which plaintiffs were complaining were actually disclosed in the offering documents without any adverseeffect on marketability. Id. at 730.

In Desai v. Deutsche Bank Secs. Ltd., 573 F.3d 931 (9th Cir. 2009), the court called into question the continuedviability of the “fraud created the market” theory. In George v. Cal. Infrastructure etc. Bank, 2010 U.S. Dist.LEXIS 57401 (E.D. Cal. June 10, 2010), the court relied on Desai in rejecting the doctrine. And in Malack v.BDO Seidman, LLP, 617 F.3d 743 (3d Cir. 2010), the court affirmed the district court’s refusal to certify a classbased on rejection of the “fraud created the market” theory.

Defendants can and should make several additional arguments that the Shores extension of the fraud on themarket doctrine should not be adopted. First, defendants should argue that the theory ignores that a market fornewly issued securities is not efficient and developed in the same manner as rational secondary markets becausethe price of newly issued securities is set primarily by the underwriter and the offeror, not the market. SeeFreeman v. Laventhol & Horwath, 915 F.2d 193 (6th Cir. 1990).

Second, defendants should argue that the theory should be rejected because, by requiring a knowing conspiracyto market otherwise unmarketable securities, a Shores fraud on the market claim really is a species of traditionaltort-conspiracy law and not a legitimate claim under the federal securities laws. Ross v. Bank South, N.A., 885

F.2d 723, 732-45 (11th Cir. 1989) (Tjoflat, J., concurring).

Third, defendants may follow the lead of the Seventh Circuit. In Eckstein v. Balcor Film Investors, 8 F.3d 1121(1993), aff’d, 58 F.3d 1161 (7th Cir. 1995), the Seventh Circuit rejected the fraud-created-the-market theory. The court held that the Shores doctrine (but for the fraud, the securities would be “unmarketable”) wronglypresupposes that requiring full disclosure of bad information keeps securities off the market. The court notedthat shares of bankrupt companies and penny stocks trade freely.

Finally, as an alternative, defendants should argue that, if adopted, the theory’s use should be highly limited andnarrowly construed, i.e., applying only if plaintiffs establish that an illegality existed in the process of issuingthe securities. See, e.g., Rosenthal v. Dean Witter Reynolds, Inc., 945 F. Supp. 1412 (D. Colo. 1996); ArenaLand & Inv. Co., 906 F. Supp. 1470, 1481 (D. Utah 1994), aff’d, 69 F.3d 547 (10th Cir. 1995); In re T.J. Raney& Sons, Inc. v. Fort Cobb, Okla. Irrigation Fuel Auth., 717 F.2d 1330, 1333 (10th Cir. 1983).

2) Reliance On Integrity Of Regulatory Process

Another variation of the “fraud on the market” theory is “fraud on the regulatory process.” This theory hasbeen heavily criticized, however, and only a few cases (all within the Ninth Circuit) recognize its validity. SeeJoseph v. Wiles, 223 F.3d 1155, 1165 (10th Cir. 2000). The theory itself is grounded on the view that aninvestor’s decision relies “at least indirectly, on the integrity of the regulatory process and the truth of anyrepresentations made to the appropriate agencies and investors.” Sec. Investor Prot. Corp. v. BDO Seidman,LLP, 222 F.3d 63, 72 (2d Cir. 2000) (citation omitted) (rejecting theory in context of New York state commonlaw claim). The primary criticism of the theory is that it expands the SEC’s role beyond its scope, and “appearsto create a form of investor’s insurance.” Joseph, 223 F.3d at 1165.

The “fraud on the regulatory process” theory was established in Arthur Young & Co. v. District Court, 549 F.2d686 (9th Cir. 1977). In Arthur Young, the Ninth Circuit extended the fraud on the market doctrine to initialofferings of securities registered with the SEC. “The standardized statements appearing in the prospectuseswere sent or shown to every investor in the partnerships. Just as the open market purchaser relies on theintegrity of the market and the price of the security traded on the open market to reflect the true value of thesecurities in which he invests, so the purchaser of an original issue security relies, at least indirectly, on theintegrity of the regulatory process and the truth of any representations made to the appropriate agencies and theinvestors at the time of the original issue.” Id. at 695; see also In re Am. Cont’l Corp./Lincoln Sav. & Loan Sec.Litig., 140 F.R.D. 425, 433-34 (D. Ariz. 1992).

Arthur Young has been the object of attack, and, in his separate opinion in Basic, Justice White specificallycited the case as an example of the discredited version of the fraud on the market theory. Basic Inc. v.Levinson, 485 U.S. 224, 251 n.2 (1988) (White, J., concurring and dissenting); see also Joseph v. Wiles, 223F.3d 1155, 1165 (10th Cir. 2000); In re Keegan Mgmt. Co. Sec. Litig., No. CIV. 91-20084 SW, 1991 WL253003 (N.D. Cal. Sept. 10, 1991) (courts have been “hesitant to affirm [theory’s] continued validity afterBasic”). Additionally, Arthur Young can be construed as improperly equating loss causation with transactioncausation, both of which are separately necessary for a Rule 10b-5 claim. See, e.g., Bastian v. Petren Res.Corp., 892 F.2d 680, 683-84 (7th Cir. 1990).

Finally, because regulators do not pass on the appropriateness of an IPO offering price, or on the truth ofdisclosures in a prospectus, the analytical underpinning for the Arthur Young presumption is absent.

d. Reliance On Omissions And The Affiliated Ute Presumption

In Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972), the Supreme Court held that where afiduciary in a face-to-face transaction elected to “stand mute” and failed to disclose material facts, “positive

proof of reliance is not necessary to recovery. All that is necessary is that the facts withheld be material in thesense that a reasonable investor might have considered them important in the making of this [investment]decision.” Id. at 153-54. The Supreme Court held that the plaintiffs were entitled to a presumption of reliance,holding that in cases “involving primarily a failure to disclose [material facts], positive proof of reliance is not aprerequisite to recovery.” Id.; see also Joseph v. Wiles, 223 F.3d 1155, 1162 (10th Cir. 2000) (“[The] AffiliatedUte presumption of reliance exists in the first place to aid plaintiffs when reliance on a negative would bepractically impossible.”).

Despite the unique circumstances of Affiliated Ute (i.e., a fiduciary relationship between defendant and plaintiff,a face-to-face transaction, and defendant’s election to stand mute rather than partially disclose materialinformation), many courts have interpreted Affiliated Ute to hold that a defendant’s alleged failure to disclosematerial information while under a duty to speak creates a rebuttable presumption of reliance See, e.g., Newtonv. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F.3d 154, 174 (3d Cir. 2001) (featuring extended discussionof cases applying Affiliated Ute); Rifkin v. Crow, 574 F.2d 256, 262 (5th Cir. 1978); Blackie v. Barrack, 524F.2d 891, 905-06 (9th Cir. 1975).

A duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic marketinformation. See Chiarella v. United States, 445 U.S. 222, 234 (1980). A duty arises only where one party hasinformation that the other party is entitled to know because of a fiduciary or other relation of trust andconfidence between them. Id. at 228. This rule applies to corporate insiders who have obtained confidentialinformation by reason of their position in the corporation, and guarantees that those insiders, who have anobligation to place the shareholders’ welfare above their own, will not benefit personally through fraudulent useof material, nonpublic information. Id. at 230. Thus, a duty to speak arises only where a defendant has somerelationship with the purchasers or sellers of the company’s securities. See id. at 232-33. Even absent a duty tospeak, however, a party who discloses material facts in connection with securities transactions assumes a dutyto speak fully and truthfully on those subjects. See In re Ford Motor Co. Sec. Litig., 381 F.3d 563, 569 (6thCir. 2004).

Not all courts have agreed with a liberal reading of the Affiliated Ute presumption of reliance. See, e.g., Desaiv. Deutsche Bank Sec. Ltd., 573 F.3d 931, 941 (9th Cir. 2009) (“We cannot allow concealment to transform thealleged malfeasance into an omission rather than an affirmative act. To do otherwise would permit theAffiliated Ute presumption to swallow the reliance requirement almost completely.” (quoting Joseph v. Wiles,223 F.3d 1155, 1163 (10th Cir. 2000))); Heliotrope Gen. Inc. v. Ford Motor Co., 189 F.3d 971, 975 (9th Cir.1999) (“In a fraud-on-the-market case, an omission is actionable under Section 10(b) and Rule 10(b)(5) ‘only ifthe [allegedly undisclosed] information has not already entered the market;” moreover, Affiliated Ute does notapply to “mixed claims” that allege both misstatements and material omissions (quoting In re ConvergentTechs. Sec. Litig., 948 F.2d 507, 513 (9th Cir. 1991))); Cavalier Carpets, Inc. v. Caylor, 746 F.2d 749, 756(11th Cir. 1984) (“In order to be entitled to an Affiliated Ute presumption of reliance upon an omissionobviating the requirement that plaintiffs must prove specific reliance upon a particular nondisclosure, plaintiffsmust demonstrate that they generally relied upon the defendant in order to recover in a Rule 10b-5 case.”); butsee Levitt v. J.P. Morgan Secs., Inc., 2010 U.S. Dist. LEXIS 68257 (E.D.N.Y. June 24, 2010) (disagreeing withDesai and applying Affiliated Ute to grant class certification).

Most circuits now agree that “the Affiliated Ute presumption should not be applied to [mixed] cases that allegeboth misstatements and omissions unless the case can be characterized as one that primarily allegesomissions.” Binder v. Gillespie, 184 F.3d 1059, 1064 (9th Cir. 1999). Significantly, where there are “mixedclaims” of both misstatements and omissions, the burden is on the plaintiff to show “that the gravamen of theircase is [defendant’s] failure to disclose material facts, as contrasted with misrepresentation.” Krogman v.Sterritt, 202 F.R.D. 467, 478 (N.D. Tex. 2001). Thus, courts considering the Affiliated Ute presumption mustengage in a close analysis of plaintiff’s allegations to determine whether a 10b-5 claim is predicated onaffirmative misrepresentations requiring proof of reliance, or on omissions resulting in a rebuttable presumptionof reliance.

Not surprisingly, then, plaintiffs will often characterize a case which appears to be a misrepresentations case

(and thus not entitled to the Affiliated Ute presumption) as an omissions case. See, e.g., Griffin v. GKIntelligent Sys., Inc., 196 F.R.D. 298, 307 (S.D. Tex. 2000) (“Notwithstanding Plaintiffs’ belated attempt torecharacterize their complaint as one involving primarily a failure to disclose,” complaint predominantly wasone involving misrepresentation). Plaintiff may go so far as to argue that the “omission” is the failure to revealthat the statement was false. Cavalier Carpets, 746 F.2d at 757; Vervaecke v. Chiles, Heider & Co., Inc., 578F.2d 713, 717-18 (8th Cir. 1978). But see Little v. First Cal. Co., 532 F.2d 1302, 1304 n.4 (9th Cir. 1976)(“The categories of ‘omission’ and ‘misrepresentation’ are not mutually exclusive.”).

e. Additional Issues Relating To Reliance

1) Effect Of Central Bank

The Supreme Court eliminated private aiding and abetting causes of action under Section 10(b) in Central Bankof Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). In so ruling, the Courtemphasized the importance of reliance. Id. at 180 (calling reliance an “element critical for recovery under10b-5”). Thus, claims against secondary actors (such as attorneys and accountants) must allege that thesecondary actor is actually a primary violator of the securities laws who made material misrepresentations (oromitted to disclose material information while under a duty to speak on which investors relied. See, e.g., In reEnron Sec., Derivative & ERISA Litig., Nos. H-01-3624, H-03-1087, H-03-3320, H-03-5332, H-03-5333, H-03-5334, H-03-5335, H-04-3330, 04-3331, 04-4455, H-01-3914, 2006 WL 3716669 (S.D. Tex. Dec. 12, 2006)(holding no primary liability for providing loans to entities that were part of Enron’s fraudulent scheme becauseactual fraud occurred only in the subsequent accounting violations), aff’d, 535 F.3d 325 (5th Cir. 2008); seealso Simpson v. AOL Time Warner, 452 F.3d 1040 (9th Cir. 2006) vacated by Simpson v. Homestore.com, Inc.,519 F.3d 1041 (9th Cir. Mar. 26, 2008); Cromer Fin. Ltd. v. Berger, 205 F.R.D. 113, 131-32 (S.D.N.Y. 2001).

In 2008, the Supreme Court again focused on reliance in rejecting a theory of “scheme liability,” whichinvolved the concept that secondary actors, such as bankers, creditors, and attorneys, who do not themselvesmake misleading statements, are liable for assisting the company that does make misleading statements. SeeStoneridge Inv. Partners, LLC v. Scientific-Atlantics, 552 U.S. 148 (2008). Because the secondary actors inStoneridge had no duty to speak, and no member of the public had actual or presumed knowledge of theallegedly false statements made by the secondary actors, the plaintiffs could not show reliance on any of thesecondary actors’ actions except in a manner that was too remote to find liability. Since the secondary actors infact had made false statements, Stoneridge can be interpreted as an expansion of Central Bank. See also Desaiv. Deutsche Bank Sec. Ltd., 573 F.3d 931, 942 (9th Cir. 2009) (affirming denial of class certification becausethe court determined that based on Stoneridge, a district court is not obligated to recognize theories ofpresumptive reliance beyond the two recognized in Stoneridge).

2) Plaintiff’s Diligence To Discover The True Facts

Laser Mortg. Mgmt., Inc. v. Asset Securitization Corp., No. 00 CIV 8100 (NRB), 2001 WL 1029407, at *9(S.D.N.Y. Sept. 6, 2001) (“An investor may not justifiably rely on a misrepresentation if, through minimaldiligence, he should have discovered the truth.”); see also Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020,1032 (2d Cir. 1993) (citing Royal Am. Managers, Inc. v. IRC Holding Corp., 885 F.2d 1011, 1015-16 (2d Cir.1989)). In determining whether an investor acted recklessly, and thus without justifiable reliance, courtsconsider the following factors: (1) the sophistication and expertise of the plaintiff in financial and securitiesmatters; (2) the existence of longstanding business or personal relationships; (3) access to the relevantinformation; (4) the existence of a fiduciary relationship; (5) concealment of the fraud; (6) the opportunity todetect the fraud; (7) whether the plaintiff initiated the stock transaction or sought to expedite the transaction;and (8) the generality or specificity of the misrepresentations. Brown, 991 F.2d at 1032 (citations omitted). In

considering these factors, “no single factor is dispositive and all relevant factors must be considered andbalanced.” Id. Other factors that shed light on the reasonableness of a plaintiff’s reliance, such as the context,complexity and magnitude of the transaction, may also counter the presumption of reliance. Emergent CapitalInv. Mgmt., LLC v. Stonepath Group Inc., 343 F.3d 189, 195 (2d Cir. 2003) (stating that the entire context ofthe transaction, including factors such as its complexity and magnitude, sophistication of the parties, andcontext of any agreement should be considered when determining reasonableness of plaintiff’s reliance); seealso AES Corp. v. Dow Chem. Co., 325 F.3d 174, 179 (3d Cir. 2003) (holding that the terms of any agreementbetween parties may be among circumstances relevant to reliance in the context of establishing the effect of anon-reliance clause).

3) Forced Sale Doctrine

Although reliance provides the necessary causal connection in a fraud case, reliance is not always synonymouswith causation. Courts in “forced sale” cases recognize that even if a plaintiff knows a defendant hasmisrepresented or omitted material facts before he sells, such misrepresentation can be the cause in fact ofplaintiff’s injury because misrepresentation is what places him in the position of having to sell. See Vine v.Beneficial Fin. Co., 374 F.2d 627 (2d Cir. 1967) (first articulating doctrine); Stitt v. Williams, 919 F.2d 516, 525(9th Cir. 1990) (holding refinancing which damaged underlying equity of limited partnership but not theownership interest not a forced sale). But see Grace v. Rosenstock, 228 F.3d 40, 49 (2d Cir. 2000) (holdingplaintiffs do not meet forced sale test because “[n]o vote, sale of shares, or other action was required ofminority shareholders in order to accomplish the merger”).

The “forced sale” doctrine has been limited, significantly, to cases in which the transaction at issue effected a“fundamental change” in the plaintiff’s holdings. Rathborne v. Rathborne, 683 F.2d 914 (5th Cir. 1982); seealso Isquith by Isquith v. Caremark Int’l, Inc., 136 F.3d 531, 535 (7th Cir. 1998) (“[T]he ‘forced seller’ doctrineis seen to be limited to situations in which the nature of the investor’s holding is so far altered as to allow thealteration to be characterized as a sale, as in the exchange of stock for cash.”); 7547 Corp. v. Parker & ParsleyDev. Partners, L.P., 38 F.3d 211, 229 (5th Cir. 1994) (“There is no question but that the plaintiffs’ allegationsdescribe a complete alteration of their limited partnership investment.”).

12. Scienter

a. Scienter Defined

In a Rule 10b-5 fraud action, a plaintiff must allege that a defendant acted with “scienter,” i.e., an intent todefraud. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976). The Supreme Court in Ernst defined scienteras “a mental state embracing intent to deceive, manipulate, or defraud” but did not decide whether recklessnesssatisfied the scienter requirement under Section 10(b) and Rule 10b-5. Id. at 194 n.12. Nevertheless, courts inevery federal circuit have found that a sufficient showing of recklessness satisfies the scienter requirement. Thecircuits differ, however, on how they define “recklessness” and on the type of conduct sufficient to qualify asevidence of scienter. See, e.g., Lipton v. Pathogenesis Corp., 284 F.3d 1027, 1034-39 (9th Cir. 2002); Aldridgev. A.T. Cross Corp., 284 F.3d 72, 78-84 (1st Cir. 2002); Abrams v. Baker Hughes Inc., 292 F.3d 424, 430-32(5th Cir. 2002); Helwig v. Vencor, Inc., 251 F.3d 540, 550-52 (6th Cir. 2001); City of Philadelphia v. FlemingCos., 264 F.3d 1245, 1259-63 (10th Cir. 2001); Novak v. Kasaks, 216 F.3d 300, 310-13 (2d Cir. 2000); In reAdvanta Corp. Sec. Litig., 180 F.3d 525, 534 (3d Cir. 1999); Bryant v. Avado Brands, Inc., 187 F.3d 1271,1283-84 (11th Cir. 1999), rev’d sub nom. Bryant v. Dupree, 252 F.3d 1161 (11th Cir. 2001).

Most courts have adopted the Seventh Circuit’s recklessness standard, set forth in Sundstrand Corp. v. SunChem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977). That standard defined reckless conduct as, “a highlyunreasonable omission, involving not merely simple, or even inexcusable, negligence, but an extreme departure

from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is eitherknown to the defendant or is so obvious the actor must have been aware of it.” Id. The Ninth Circuit, whileagreeing that recklessness may satisfy the scienter requirement under Section 10(b), requires in the wake of theReform Act a showing of “deliberate recklessness,” or particularly egregious conduct that reflects some degreeof conscious or intentional misconduct. See In re Silicon Graphics Inc., Sec. Litig., 183 F.3d 970 (9th Cir.1999).

In the Second Circuit, sufficiently reckless behavior is merely one basis from which intent may be inferred, but“[t]his showing of recklessness must be such that it gives rise to a strong inference of fraudulent intent.” Chillv. General Elec. Co., 101 F.3d 263, 267 (2d Cir. 1996).

b. Pleading Scienter Prior To The Reform Act

Before the Reform Act, courts differed as to the degree of specificity required for pleading scienter. The NinthCircuit held that scienter may be averred generally, “that is, simply by saying that scienter exists.” In reGlenFed, Inc. Sec. Litig, 42 F.3d 1541, 1547 (9th Cir. 1994). The First Circuit required plaintiffs to plead factsgiving rise to an “inference” of fraudulent intent. The Second Circuit went further, demanding a “stronginference” of intent. O’Brien v. Nat’l Prop. Analyst Partners, 936 F.2d 674, 676 (2d Cir. 1991). The SecondCircuit recognized two distinct ways in which a plaintiff may plead scienter. Plaintiffs could either (1) “allegefacts establishing a motive to commit fraud and an opportunity to do so,” or (2) “allege facts constitutingcircumstantial evidence of either reckless or conscious behavior.” In re Time Warner Inc. Sec. Litig., 9 F.3d259, 269 (2d Cir. 1993); Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994); Chill v. Gen.Elec. Co., 101 F.3d 263, 267 (2d Cir. 1996).

c. The Reform Act Pleading Standard For Scienter

In 1995, Congress passed the Private Securities Litigation Reform Act of 1995. The Reform Act requires thatcomplaints in all securities fraud actions, not just class actions, allege with particularity facts giving rise to a“strong inference” that defendants acted with scienter. 15 U.S.C. § 78u-4(b)(2); see also Klein v. Autek Corp.,147 F. App’x 270, 273 (3d Cir. 2005) (“We note that 15 U.S.C. § 78u-4(b), which contains the heightenedpleading requirements applicable to this matter, is titled ‘Requirements for securities fraud actions’ and plainlystates that it applies to ‘any private action under this chapter,’ without reference to whether the action is broughtas a class action or not.”).

The Reform Act changed the pleading standard in several key ways:

1) The Reform Act clarified and amplified Rule 9(b) by requiring a complaint to “specify each statementalleged to have been misleading, [and] the reason or reasons why the statement is misleading.” 15 U.S.C§ 78u-4(b)(1). Where a plaintiff alleges on “information and belief,” the Reform Act requires that thecomplaint “state with particularity all facts on which that belief is formed.” 15 U.S.C. § 78u-4(b)(1).

2) The Reform Act imposed additional requirements for pleading scienter, requiring that a plaintiff “statewith particularity facts giving rise to a strong inference that the defendant acted with the required state ofmind.” 15 U.S.C § 78u-4(b)(2).

3) The Reform Act ensures strict compliance with its standards by mandating that a complaint that does notmeet them shall be dismissed. 15 U.S.C. § 78u-4(b)(3)(A).

While the Reform Act resolved the debate over the strength of the “inference” of scienter, the Act left open therelated issues of (1) what degree of “recklessness,” if any, satisfies the unspecified “state of mind” requirement,and (2) whether “motive and opportunity” allegations can provide, or even contribute to, the requisite “stronginference” of scienter. Since the Reform Act was enacted, courts have taken divergent views of the post-

Reform Act standards for pleading scienter and the extent to which Congress meant to codify fully the SecondCircuit’s case law has been vigorously debated. See Section II.C.7 above for related discussion.

d. The Post-Reform Act Debate

The “strong inference” language was taken from Second Circuit case law interpreting the requirements ofFederal Rules of Civil Procedure 8 and 9(b) in the context of securities fraud cases. See In re Time Warner, Inc.Sec. Litig., 9 F.3d 259, 269 (2d Cir. 1993). President Clinton cited this provision in his veto of the Reform Actbecause, in his view, the language in the Act’s legislative history indicated that Congress was adopting astandard that was more stringent than the Second Circuit’s standard at the time. After President Clinton’s vetoand its subsequent Congressional override, commentators and courts for years debated whether the Reform Actcodified the Second Circuit’s test for pleading scienter or set a higher standard.

1) The Supreme Court’s Decision In Tellabs

As discussed in further detail below, plaintiffs, defendants and the appellate courts alike relied on statutorylanguage and legislative history of the Reform Act to support their interpretations of the Reform Act, creating asplit in the Circuits over the requirements for pleading a “strong inference” of scienter. In 2007, the UnitedStates Supreme Court addressed and resolved the split of authority in Tellabs, Inc. v. Makor Issues & Rights,551 U.S. 308 (2007). The question presented in Tellabs was “whether, and to what extent, a court mustconsider competing inferences in determining whether a securities fraud complaint gives rise to a ‘stronginference’ of scienter.” Id. at 317-18. In reaching its conclusion, the Supreme Court found that the SeventhCircuit had failed to give sufficient weight to possible innocent explanations for the alleged fraud, and held thatthe “strong inference” standard requires consideration of both fraudulent inferences as well as innocentinferences. Id. at 324 (“[A] court must consider plausible nonculpable explanations for the defendant’s conductas well as inferences favoring the plaintiff.”). To qualify as “strong,” an inference of scienter must be “cogentand at least as compelling as any opposing inference of nonfraudulent intent.” Id. at 314. The Court noted that“omissions and ambiguities count against inferring scienter,” but a court must assess all the allegations“holistically” rather than in isolation. Id. at 326. The Court rejected Justice Scalia’s view that the inference ofscienter should be more plausible than the inference of innocence. Id. at 324 n.5; see id. at 329 (Scalia, J.,concurring). But see id. at 334 (Alito, J., concurring) (“[F]acts not stated with the requisite particularity cannotbe considered in determining whether the strong-inference test is met.”).

The lower courts generally read Tellabs to provide a three-step process for evaluating motions to dismissSection 10(b) claims for failure to plead scienter sufficiently. First, the court must accept all allegations astrue. Second, the court must consider whether all of the facts alleged, taken together, give rise to a stronginference of scienter. Third, the court must take into account plausible opposing inferences of nonfraudulentintent. This last requirement has had the most significant impact on district and circuit courts’ consideration ofcomplaints asserting claims of securities fraud. Once the three steps are taken, the court determines whether theinference of scienter is cogent and at least as compelling as any plausible opposing inference. In most circuits,Tellabs appears to have made it harder for plaintiffs to plead scienter.

2) The Pre-Tellabs Circuit Split

Before Tellabs was decided, the Second and Third Circuits had found that Congress meant to codify existingmethods of pleading scienter, thus allowing plaintiffs to show scienter by alleging either motive andopportunity or evidence of reckless or conscious behavior sufficient to raise a strong inference of scienter. SeeNovak v. Kasaks, 216 F.3d 300 (2d Cir. 2000); In re Advanta Corp. Sec. Litig., 180 F.3d 525, 531 (3d Cir.1999). Other courts had concluded that, in passing the Reform Act, Congress specifically sought to prohibit

plaintiffs from alleging mere motive and opportunity to commit fraud. See, e.g., In re Silicon Graphics Inc.,Sec. Litig., 183 F.3d 970 (9th Cir. 1999); Bryant v. Avado Brands, Inc., 187 F.3d 1271 (1999), rev’d sub nom.Bryant v. Dupree, 252 F.3d 1161 (11th Cir. 2001). Still other circuits had taken a middle position and declinedto “categorize” fact patterns; those courts called for more individualized, case-based fact analyses to determinewhether the facts alleged in any particular complaint satisfied the requirement of pleading a strong inference ofscienter under the Reform Act. See Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999); Helwig v.Vencor, Inc., 251 F.3d 540 (6th Cir. 2001). Since Tellabs was decided in July 2007, several courts have had theopportunity to address the impact of the Supreme Court’s decision on their own interpretation of the “stronginference” requirement. Others have yet to undertake that analysis. Therefore, a summary of the standard ineach circuit before Tellabs and, where possible, post-Tellabs is appropriate.

e. First Circuit

Prior to the Reform Act, the First Circuit, like most circuits, adopted the Seventh Circuit’s recklessness standardin Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977). After the Reform Act wasenacted, the First Circuit held that the statute had not altered the state of mind requirement, and continued toutilize the Sundstrand recklessness test. GreebeL, 194 F.3d at 199-200. The court did find, however, that theReform Act had heightened the standard for joint and several liability to actual knowledge, but stressed that theexisting definition still sufficed for individual liability. Id. at 200-01.

The Greebel court emphasized the importance of the Reform Act’s requirement that pleaded facts represent a“strong inference” rather than a mere “reasonable inference” of scienter, but indicated that fact pattern analysiswould continue on a case-by-case basis to determine whether allegations supported scienter. Greebel, 194 F.3dat 196; see also Ezra Charitable Trust v. Tyco Int’l, Ltd., 466 F.3d 1 (1st Cir. 2006) (finding the fact thatofficers had recently assumed their positions undermined the inference of scienter). The court continued todisagree with other courts that concluded that the Reform Act specifically permits or forbids certain formalisticcategories of scienter pleading, such as “motive and opportunity.” Id. at 197.

The First Circuit allied itself with the Sixth Circuit’s holding in In re Comshare, Inc. Securities Litigation, 183F.3d 542, 550 (6th Cir. 1999) (see below). Both courts held that evidence of motive and opportunity arerelevant to pleading facts establishing scienter and “on occasion, could ‘rise to the level of creating a stronginference of reckless or knowing conduct.’” Greebel, 194 F.3d at 197 (citing In re Comshare, 183 F.3d at 551);accord Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1282-83 (1999), rev’d sub nom. Bryant v. Dupree, 252F.3d 1161 (11th Cir. 2001). The First Circuit rejected the notion that a showing of motive and opportunity cannever be enough to permit the drawing of a strong inference of scienter. Nevertheless, the court cautioned that“merely pleading motive and opportunity, regardless of the strength of the inferences to be drawn of scienter, isnot enough.” Greebel, 194 F.3d at 197.

The same day as the Supreme Court announced its Tellabs decision, the First Circuit issued an opinion inRodriguez-Ortiz v. Margo Caribe, Inc., 490 F.3d 92 (1st Cir. 2007), holding that an inference of scienter is notstrong when “there are legitimate explanations for the behavior that are equally convincing.” Id. at 96. TheFirst Circuit’s conclusion is consistent with the Supreme Court’s analysis of “strong inference.” Nevertheless,the decision reaffirmed that the First Circuit avoids the use of any “rigid pleading formula” for determining thesufficiency of allegations of scienter, “instead ‘preferring to rely on a “fact-specific approach” that proceedscase by case. Id.

On January 8, 2008, the First Circuit had its “first occasion to apply the Supreme Court’s recent guidanceregarding the standards for pleadings under the PSLRA” in ACA Financial Guaranty Corp. v. Advest, Inc., 512F.3d 46, 52 (1st Cir. 2008). The First Circuit concluded that Tellabs had “altered this circuit’s prior standard …for determining the sufficiency of pleadings of scienter in securities fraud cases.” Id. The First Circuitconcluded that under Tellabs, and unlike prior circuit law, “where there are equally strong inferences for andagainst scienter, Tellabs now awards the draw to the plaintiff.” Id. at 59. In the past, the defendant enjoyed thebenefit of equally strong inferences, and the complaint would be dismissed. Id. Nevertheless, the court noted

that Tellabs “affirms our case law that plaintiffs’ inferences of scienter should be weighed against competinginferences of non-culpable behavior” and “our rule that the complaint is considered as a whole rather thanpiecemeal.” Id. at 52. See also Miss. Public Employee’s Retirement Sys. v. Boston Scientific Corp., 523 F.3d75 (1st Cir. 2008) (reversing district court’s dismissal for failure to adequately plead scienter and holding underTellabs, the inference of scienter was at least as likely as the opposing nonculpable inference, and rejecting aninference negating scienter based on 10b5-1 trading plans due to insufficient facts regarding the plans).

f. Second Circuit

Before Tellabs, the Second Circuit interpreted the Reform Act pleading standard for scienter in Press v.Chemical Investment Services., Corp., 166 F.3d 529, 538 (2d Cir. 1999), stating that the PSLRA heightened therequirement for pleading scienter to the level already used by the Second Circuit. See also Novak v. Kasaks,216 F.3d 300 (2d Cir. 2000); In re Philip Servs. Corp. Sec. Litig., 383 F. Supp. 2d 463 (S.D.N.Y. 2004).

In Novak, the Second Circuit concluded that “the PSLRA effectively raised the nationwide pleading standard tothat previously existing in this circuit and no higher (with the exception of the ‘with particularity’requirement).” Novak, 216 F.3d at 310. The court cited Congress’s specific incorporation of the SecondCircuit’s “strong inference” language and agreed with the Third Circuit’s holding in Advanta, discussed infra,that use of that language in the Act “establishes a pleading standard approximately equal in stringency to that ofthe Second Circuit.” Id. (citing In re Advanta Corp. Sec. Litig., 180 F.3d 525, 534 (3d Cir. 1999)).

Noting prior case law, the court stated that a “strong inference” of scienter may be established either (a) byalleging facts showing that defendants had motive and opportunity to commit fraud; or (b) by alleging factsconstituting strong circumstantial evidence of conscious misbehavior or recklessness. Novak, 216 F.3d at 307. The inference may arise where the complaint sufficiently alleges that the defendants: (1) benefited in a concreteand personal way from the purported fraud, (2) engaged in deliberately illegal behavior, (3) knew facts or hadaccess to information suggesting that their public statements were not accurate, or (4) failed to checkinformation they had a duty to monitor. Novak, 216 F.3d at 311; see also In re WorldCom, Inc. Sec. Litig., 294F. Supp. 2d 392 (S.D.N.Y. 2003).

The Second Circuit explained that a plaintiff cannot base allegations of motive on generic incentives possessedby almost all corporate executives, such as “the desire to maintain a high corporate credit rating or otherwisesustain the appearance of corporate profitability or of the success of an investment … [or] the desire to maintaina high stock price in order to increase executive compensation or prolong the benefits of holding corporateoffice.” Novak, 216 F.3d at 307 (citations and internal quotation marks omitted); see also In re PXRE Group,Ltd., Sec. Litig., 600 F. Supp. 2d 510, 531-32 (S.D.N.Y. 2009) (finding that the desire to maintain a high creditrating to raise money that is “desperately needed” or necessary “protect the very survival” of a company is fartoo generalized to allege the proper “concrete and personal” benefit required by the Second Circuit), aff’d subnom. Condra v. PXRE Group Ltd., 2009 WL 4893719 (2d Cir. Dec. 21, 2009); In re Dynex Capital, Inc. Sec.Litig., No. 05 Civ. 1897(HB), 2006 WL 314524, at *5 (S.D.N.Y. Feb. 10, 2006) (holding allegations againstparticular individual must demonstrate culpability based on more than person’s position in corporate hierarchy);Goplen v. 51job, Inc., 453 F. Supp. 2d 759 (S.D.N.Y 2006) (finding generalized allegations of managementaccess to inside information insufficiently particular to state claim); In re eSpeed, Inc. Sec. Litig., 457 F. Supp.2d 266 (S.D.N.Y. 2006) (holding plaintiffs were required to allege that officers lacked reasonable basis for theircautious optimism, even though the electronic bond trading product ultimately failed); In re DRDGOLD Ltd.Sec. Litig., 472 F. Supp. 2d 562, 570 (S.D.N.Y. 2007) (holding a significant stock sale by just one corporateinsider is insufficient to support the inference of fraudulent intent).

The Second Circuit had its first opportunity to consider the impact of Tellabs in ATSI Communications, Inc. v.Shaar Fund, Ltd., 493 F.3d 87 (2d Cir. 2007). The Second Circuit affirmed the dismissal of marketmanipulation claims for failure to plead scienter adequately. The court confirmed the Second Circuit’sjurisprudence requiring a showing either (1) that the defendants had both motive and opportunity to commit thefraud, or (2) facts constituting strong circumstantial evidence of conscious misbehavior or recklessness. Id. at

99. In light of Tellabs, however, the court acknowledged its obligation to consider and weigh competinginferences, and that the inference of scienter would be strong only if it was at least as compelling as anyopposing inference one could draw from the facts. Id. Ultimately, the court found the allegations in the casetoo vague and speculative to meet even the motive and intent requirements, and concluded that there was aplausible, non-culpable reason for the defendants conduct, and so affirmed the district court’s dismissal of thecomplaint. See also South Cherry Street, LLC v. Hennessee Group LLC, 573 F.3d 98, 108-134 (2nd Cir.2009).

The sufficiency of alleging motive as a basis for scienter after Tellabs was addressed in In re Take-TwoInteractive Sec. Litig., 551 F. Supp. 2d 247, 269-70 (S.D.N.Y. 2008). In Take-Two, the plaintiffs alleged thatthe defendants made misstatements concerning compliance with videogame rating requirements in order toimprove profitability and avoid excessive costs. Id. In granting defendants’ motion to dismiss the claims, thecourt noted that “the desire to improve a company’s year-end financial numbers is essentially identical to themotive to maintain the appearance of corporate profitability, which does not give rise to an inference ofscienter.” Id. at 270 (internal quotations omitted). Similarly, in ECA & Local 134 IBEW Joint Pension Trust ofChicago v. JP Morgan Chase Co., 553 F.3d 187, 201-02 (2nd Cir. 2009), the Second Circuit held that theplaintiffs’ motive allegations that JP Morgan sought to inflate its stock price to reduce the cost of its acquisitionof another financial institution did not establish a motive to defraud, rather it established a motive to increaseprofits. The court further stated that “[e]ven if [JP Morgan] was actively engaged in duping other institutionsfor the purpose of gaining at the expense of those institutions, it would not constitute a motive for [JP Morgan]to defraud its own investors.” Id. at 203.

On the other hand, motive was sufficiently pled where a plaintiff alleged that defendants misrepresentedcorporate performance to inflate stock prices while they sold their own shares. See In re LaBranche Sec. Litig.,405 F. Supp. 2d 333, 356-357 (S.D.N.Y. 2005) (finding motive and opportunity supported by significance ofstock price to defendant’s stock-based strategy of acquiring competitors, given the scope, impact and industry-wide trend of acquisitions); Lapin v. Goldman Sachs Group Inc., 506 F. Supp. 2d. 221 (S.D.N.Y. 2006) (findinga strong inference of scienter where defendants had access to information about the conflict of interest in itsanalyst recommendations). Insider trading complaints must allege more than mere benefit; trades must be“unusual” in amount of profit earned, amount of stock traded, portions of stock sold, or number of insidersbefore they will be deemed sufficient to give rise to a strong inference of scienter. See Rothman v. Gregor, 220F.3d 81, 94 (2d Cir. 2000).

District courts within the Second Circuit have had more opportunities to consider the impact of Tellabs. TheSouthern District of New York recognized that the comparative analysis of the strength of the inference is an“addition to the PSLRA jurisprudence.” In re Top Tankers, Inc. Sec. Litig., 528 F. Supp. 2d. 408, 413(S.D.N.Y. 2007) (describing Tellabs as “the only truly relevant case for assessing the viability of the scienterallegations” in the complaint, and dismissing complaint). The district court recognized that equally stronginferences weighed against dismissal. In addition, the court continued to apply the Second Circuit’s “motiveand opportunity” and “strong circumstantial evidence of recklessness standards.” See also In re ComverseTech., Inc. Sec. Litig., 543. F. Supp. 2d 134, 141-42 (E.D.N.Y. 2008) (considering motive and intent as part ofTellabs analysis of scienter allegations); In re Scottish RE Group Sec. Litig., 524 F. Supp. 2d 370 (S.D.N.Y.2007) (finding scienter allegations adequate under Tellabs’ competing inference analysis); In re Openwave Sys.Sec. Litig., 528 F. Supp. 2d. 236 (S.D.N.Y. 2007) (denying motion to dismiss where defendants pointed to nocompeting inferences that could be rationally drawn from the facts alleged in options backdating scheme); In reDynex Capital, Inc. Sec. Litig., No. 05-1897, 2009 WL 3380621, at *12 (S.D.N.Y. Oct. 19, 2009) (findingstrong inference of scienter when a restatement is paired with allegations of direct information and supported bythe fact that the misrepresentations involve the company’s “core operations”).

g. Third Circuit

The Third Circuit in In re Advanta Corp. Securities Litigation (which the First Circuit followed in Greebel), inconsidering the “strong inference” standard after the Reform Act was enacted, dismissed legislative history and

the presidential veto, finding it “ambiguous and even contradictory.” 180 F.3d 525, 531 (3d Cir. 1999). Thecourt instead focused on the “plain language” of the statute, and concluded that Congress’ use of the SecondCircuit language in the Reform Act established a standard “approximately equal in stringency to that of theSecond Circuit.” Id. at 534.

The Third Circuit held in Advanta that the Seventh Circuit’s Sundstrand recklessness standard, “remains asufficient basis for liability.” 180 F.3d at 535. See also GSC Partners CDO Fund v. Washington, 368 F.3d228, 239 (3d Cir. 2004) (quoting In re Advanta, 180 F.3d at 535); In re Alpharma Sec. Litig., 372 F.3d 137,148-49 (3d Cir. 2004). The Advanta court stated that “[r]etaining recklessness not only is consistent with the[PSLRA’s] expressly procedural language, but also promotes the policy objectives of discouraging deliberateignorance and preventing defendants from escaping liability solely because of the difficulty of provingconscious intent to commit fraud.” Id.

The Advanta court stressed that adherence to the Second Circuit’s standard – which had been the most stringentstandard nationwide before the Reform Act – would generally increase the difficulty of pleading scienter, aswas clearly Congress’ intent. However, by adding the “particularity” requirement to the strong inferencestandard, the Reform Act raised the standard higher than that imposed in the Second Circuit. Thus, the courtfound that plaintiffs could indeed plead scienter by alleging facts establishing motive and opportunity, but thoseallegations must be supported by particular facts giving rise to a “strong inference” of scienter. Id. at 532. “Blanket” assertions will not suffice. Id. at 539; In re Bio-Tech. Gen. Corp., No. CIV.A. 02-6048(HAA), 2006WL 3068553 (D.N.J. Oct. 26, 2006) (scienter allegation that accounting principle at issue was “simple” did notalone establish its violation as reckless), aff’d sub nom. In re Savient Pharms., Inc. Sec. Litig., 283 F. App’x887 (3d Cir. 2008). Cf. In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256 (3d Cir. 2006) (holdingcomplaint sufficiently alleged scienter as to two officers who sold a substantial amount of stock just beforeresigning and who boasted of close relationships with customers who had already pled guilty to fraud inconnection with round-tripping scheme; also sufficiently alleged scienter as to auditors because evidence of thecompany’s “financial foul play was hiding in plain sight”); Baker v. MBNA Corp., No. 05-272, 2007 WL2009673, at *7 (D. Del. July 6, 2007) (“[An officer’s] sale of nearly two-thirds of his stock holdings during theClass Period is sufficient to create the requisite inference of scienter.”); Aviva Partners LLC v. Exide Techs.,No. 05-3098 (MLC), 2007 WL 789083, at *16-17 (D.N.J. Mar. 13, 2007) (applying Advanta and finding thatplaintiffs adequately alleged “conscious misbehavior” by detailing specific facts that were known to theindividual defendants at the time the alleged misstatements were made thereby constituting circumstantialevidence of reckless or conscious behavior without alleging that defendants “must have known” that theirstatements were false by virtue of their positions in the company). In insider trading cases, the Third Circuitalso requires that the trades be “unusual.” See id. at 540-41; Oran v. Stafford, 226 F.3d 275, 290 (3d Cir.2000).

The Third Circuit addressed the “strong inference” standard again after Tellabs in Winer Family Trust v. Queen,503 F.3d 319 (3d Cir. 2007). The court modified its existing jurisprudence to allow for competing inferences,as required by Tellabs. Specifically, the court held that an inference of scienter requires careful examination ofall other likely inferences that could explain a defendant’s actions. Id. at 327. The Third Circuit thereforeaffirmed the district court’s decision to grant a motion to dismiss because “[a] reasonable person would notdeem the inference of scienter cogent and at least as compelling as any nonculpable inference.” Id. at 329; seealso Key Equity Investors, Inc. v. Sel-Lab Marketing, Inc., 246 F. App’x 780 (3d Cir. Sept. 6, 2007).

In Institutional Investors Group v. Avaya, Inc., 564 F.3d 242 (3rd Cir. 2009), the Third Circuit noted that theSupreme Court in Tellabs made clear that allegations of scienter need not be irrefutable and that the relevantinquiry is whether all the facts alleged, taken collectively, give rise to a strong inference of scienter. Id. at 269. Accordingly, the court applied a “totality-of-the-circumstances” approach to determining the sufficiency ofplaintiffs’ scienter allegations, rather than looking for the presence or absence of certain types of allegations. Id. Moreover, the court reevaluated Advanta, and held that attempts to establish scienter through proof ofmotive and opportunity alone is no longer tenable in light of Tellabs. Id. at 276. Thus, in light of Tellabs,allegations of motive and opportunity “are to be considered along with all other allegations in the complaint”rather than be “entitled to a special, independent status.” Id. at 277.

h. Fourth Circuit

In examining the pleading standard for scienter pre-Tellabs, the Fourth Circuit noted the absence of anystatutory language addressing particular methods of pleading and the inconclusive legislative history regardingthe adoption of Second Circuit pleading standards. Ottmann v. Hanger Orthopedic Group, Inc., 353 F.3d 338,345 (4th Cir. 2003). The Fourth Circuit opted for a flexible case-specific approach. See, e.g., Phillips v. LCIInt’l, 190 F.3d 609, 620-21 (4th Cir. 1999); Ottmann, 353 F.3d at 345 (citing Phillips, 190 F.3d at 620-21). TheFourth Circuit held that while the Reform Act did not alter the substantive standard for proving scienter insecurities fraud actions, the Reform Act did, however, heighten the standard for pleading scienter by requiringallegations of particular facts raising a “strong inference” of the requisite state of mind. Phillips, 190 F.3d at620.

The Fourth Circuit also articulated the same definition of recklessness as the Third Circuit. Id.; see also Pub.Employees’ Ret. Ass’n of Colo. v. Deloitte & Touche LLP, 551 F.3d 305, 313-14 (4th Cir. 2009). Further, whilefacts demonstrating motive and opportunity to commit fraud may be relevant, the Fourth Circuit concluded thatcourts should not restrict their scienter inquiry by focusing on these specific categories of facts, but shouldinstead examine all the allegations. Philips at 345-46.

The Fourth Circuit considered the post-Tellabs standard in Cozzarelli v. Inspire Pharmaceuticals, 549 F.3d 618(4th Cir. 2008), in which it affirmed the district court’s dismissal of the complaint for failure to establish astrong inference of scienter. Noting that the Tellabs decision required it to “determine whether plaintiffs’inference of scienter is ‘cogent and at least as compelling’ as defendants’ inference of a legitimate businessjudgment,” the court ultimately found that the “most persuasive inference” to be drawn from the “record as awhole” was that defendants “acted with a lawful intent to protect their competitive interests” when theywithheld information from the market. Id. at 628 (internal quotation marks omitted); see also In reBearingPoint, 525 F. Supp. 2d 759, 778 (E.D. Va. 2007) (granting motion to dismiss for failure to pleadscienter adequately); In re aaiPharma Inc. Sec. Litig., 521 F. Supp. 2d 507 (E.D.N.C. 2007) (same).

i. Fifth Circuit

The Fifth Circuit addressed the pre-Tellabs pleading standard in Nathenson v. Zonagen, Inc., 267 F.3d 400 (5thCir. 2001). Before the Reform Act, the Fifth Circuit had adopted the Seventh Circuit’s definition ofrecklessness. Nathenson, 267 F.3d at 408 (citing Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033 (7thCir. 1977)). The Fifth Circuit in Nathenson took the majority view that the Reform Act had not altered thesubstantive scienter requirement, and found that “severe recklessness remains a basis for such liability.” Id.

The court in Nathenson observed that the controversial “motive and opportunity” pleading “is proper only as ananalytical device for assessing the logical strength of the inferences arising from particularized facts pled by aplaintiff to establish the necessary mental state.” Id. at 411. The Reform Act, according to the court, “neithermandated nor prohibited any particular method of establishing a strong inference of scienter.” Id. Like manycircuits, the Fifth Circuit refused to find that the Reform Act prohibited motive and opportunity pleadingaltogether. However, voicing its distaste, the court stated that while “allegations of motive and opportunity maymeaningfully enhance the strength of scienter … it would seem to be a rare set of circumstances indeed wherethose allegations alone are both sufficiently persuasive to give rise to a scienter inference of the necessarystrength and yet at the same time there is no basis for further allegations also supportive of that inference” Id. at412. Thus, while not rejecting motive and opportunity pleading outright, the Fifth Circuit generally rejectspleadings that merely allege motive and opportunity without further allegations to support a strong inference ofscienter. See also Abrams v. Baker Hughes, Inc., 292 F.3d 424, 431 (5th Cir. 2002) (stating that the appropriateanalysis, under Nathenson, is to consider whether all facts and circumstances “taken together” are sufficient tosupport the necessary strong inference of scienter); Goldstein v. MCI WorldCom, 340 F.3d 238, 250-51 (5thCir. 2003) (holding that while allegations of motive and opportunity may meaningfully enhance the strength ofinference of scienter, such allegations without more do not fulfill the Reform Act’s pleading requirements);

Cent. Laborers’ Pension Fund v. Integrated Elec. Servs. Inc., 497 F.3d 546, 555 (5th Cir. 2007) (holding themere fact that officers signed a Sarbanes-Oxley Act Section 302 certification did not establish a stronginference of scienter because “otherwise scienter would be established in every case where there was anaccounting error or an auditing mistake made by a publicly traded company, which would eviscerate thepleading requirements for scienter set forth in the PSLRA”).

In Central Laborers’ Pension Fund, 497 F.3d at 551, the Fifth Circuit acknowledged its post-Tellabs obligationto consider competing inferences at the pleading stage in deciding whether a complaint pleads a stronginference of scienter. In weighing inferences, the Fifth Circuit concluded that neither mere GAAP violationsnor incorrect Sarbanes-Oxley certifications, without more, raised a strong inference of scienter, that the use ofconfidential witnesses to plead scienter required specific details about the witnesses, and that the circumstancesof alleged insider trading must be examined for plausible, nonculpable explanations. See id. at 553-56. InFlaherty & Crumrine Preferred Income Fund, Inc. v. TXU Corp., 565 F.3d 200, 208 (5th Cir. 2009), the FifthCircuit reiterated that while “allegations of motive and opportunity standing alone will not suffice to meet thescienter requirement, motive and opportunity allegations may meaningfully enhance the strength of theinference of scienter.” Thus, the suspect fact that management recommended a dividend increase only daysafter the end of the corporation’s self-tender offer, was insufficient, without more, to establish a stronginference of scienter. Id. at 210; see also In re Cyberonics Inc. Sec. Litig., 523 F. Supp. 2d 547, 554 (S.D. Tex.2007) (“[I]nsider trading can only be a strong enhancement of an inference of scienter, not an inference byitself, if the trading occurs at suspicious times or in suspicious amounts.”), aff’d sub nom. Catogas v.Cyberonics, Inc., 292 F. App’x 311 (5th Cir. 2008).

j. Sixth Circuit

Post-Reform Act cases in the Sixth Circuit interpreting the requirements of pleading scienter include In reComshare Securities Litigation, 183 F.3d 542, 550 (6th Cir. 1999), Helwig v. Vencor, Inc., 251 F.3d 540 (6thCir. 2001) (en banc), as well as PR Diamonds, Inc. v. Chandler, 364 F.3d 671, 681 (6th Cir. 2004) (citingHelwig, 251 F.3d at 550-51). Comshare adopted the First Circuit’s fact-specific approach. Similarly, theHelwig court held that the Reform Act’s requirement of a “strong inference that the defendant acted with therequired state of mind” did not alter the substantive scienter requirement already adhered to by the SixthCircuit. Helwig, 251 F.3d at 551. Thus, in the Sixth Circuit, the required state of mind remains recklessness,defined as “highly unreasonable conduct which is an extreme departure from the standards or ordinary care.” Id. at 550. “[T]he meaning of recklessness … is especially stringent when brought against an outside auditor.” PR Diamonds, 364 F.3d at 693. Specifically, “recklessness on the part of an independent auditor entails amental state so culpable that it approximates an actual intent to aid in the fraud being perpetrated by the auditedcompany.” Id. (internal quotation marks omitted); see also Fidel v. Farley, 392 F.3d 220, 226 (6th Cir. 2004).

The Sixth Circuit requires that the totality of allegations pleaded must give rise to a strong inference of at leastrecklessness. PR Diamonds, 364 F.3d at 683. That requirement is consistent with Tellabs. Moreover, the SixthCircuit had held that plaintiffs were entitled only to the most plausible of competing inferences. See Fidel, 392F.3d at 227. The Sixth Circuit thus has acknowledged that “[f]acts regarding motive and opportunity may berelevant to pleading circumstances from which a strong inference of fraudulent scienter may be inferred, andmay, on occasion, rise to the level of creating a strong inference of reckless or knowing conduct.” Comshare,183 F.3d at 551 (internal quotation marks and citation omitted). As in the First Circuit, factual predicates in theSixth Circuit are judged on a case-by-case basis under the strong inference standard and post-Reform Actheightened particularity requirements.

The Sixth Circuit considered the impact of Tellabs in Frank v. Dana Corp., 547 F.3d 564, 570 (6th Cir. 2008),holding that the governing standard regarding an allegation of scienter is “whether Plaintiffs have madeallegations that support an inference of scienter at least as compelling as competing nonculpable inferences.” District courts from within the circuit that have considered the question focused on the comparative inferenceanalysis prescribed by the Supreme Court. In Ross v. Abercrombie & Fitch Co., 501 F. Supp. 2d 1102, 1106-7(S.D. Ohio 2007), the district court cited both Tellabs and the Sixth Circuit’s decision in Fidel for the

proposition that the scienter inquiry “is inherently comparative” and that the inference need not be irrefutable,or even the most plausible of competing inferences. See id. at 1117 (refusing to dismiss complaint even thoughdefendants raised plausible explanations for the events in the case); see also In re Diebold Sec. Litig., No.5:05CV2873, 2008 WL 3927467 (N.D. Ohio Aug. 22, 2008) (conclusory, generalized allegations of accountingirregularities coupled with defendants’ access to internal financial documents alone are insufficient to raise astrong inference of scienter), aff’d sub nom. Konkol v. Diebold, Inc., 590 F.3d 390 (6th Cir. 2009); In reProquest Sec. Litig., 527 F. Supp. 2d 728 (E.D. Mich. 2007); Nicholson v. N-Viro Int’l Corp., No.3:06CV01669, 2007 WL 2994452, at *4 (N.D. Ohio Oct. 12, 2007).

k. Seventh Circuit

The Seventh Circuit ruled in 2006 on the post-Reform Act pleading standard in Makor Issues & Rights Ltd. v.Tellabs, Inc., 437 F.3d 588 (7th Cir. 2006), which ultimately led to the Supreme Court’s decision in Tellabs. The Seventh Circuit concluded in Tellabs that Congress did not intend to change the substantive scienterstandard in passing the PSLRA, and applied the Seventh Circuit’s pre-Reform Act standard requiring “anextreme departure from the standards of ordinary care . . . which presents a danger of misleading buyers orsellers that is either known to the defendant or is so obvious that the actor must have been aware of it.” Id.(citing Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)). The court also held that inorder to determine whether plaintiff has raised a “strong inference” of scienter under the PSLRA, courts must“examine all of the allegations in the complaint and then [] decide whether collectively they establish such aninference. Notably, the Seventh Circuit appeared to endorse a standard that would allow a complaint to surviveeven upon raising only a “reasonable” inference of scienter, as opposed to a “strong” one. Id. at 2505. Onremand, from the Supreme Court, and in light of the standard articulated by the Court, the Seventh Circuit stillfound that the complaint in Tellabs sufficiently alleged scienter, even under the Supreme Court’s articulatedstandard, and again reversed the district court’s dismissal of the case. Makor Issues & Rights Ltd. v. Tellabs,Inc., 513 F.3d 702 (7th Cir. 2008). On remand, the district court ultimately granted summary judgmentdismissing most of plaintiff’s claims. Makor Issues & Rights, Ltd. v. Tellabs, Inc., 2010 U.S. Dist. LEXIS82444 (N.D. Ill. Aug. 13, 2010) (granting summary judgment to defendants on claims regarding quarterly andannual reports for one year, guidance for the following year, and a statement that end-user demand continued togrow, but denying summary judgment as to whether one particular statement was misleading and gave rise tocontrol person liability).

In the wake of the Supreme Court’s Tellabs decision, the Seventh Circuit considered what weight confidentialwitnesses testimony should receive at the pleading stage in Higginbotham v. Baxter International, Inc., 495F.3d 753 (7th Cir. 2007). The court held that anonymity frustrates courts’ abilities to weigh plaintiffs’favorable inferences from competing inferences. Id. at 757. Plaintiffs must eventually provide defendants withthe identity of persons with relevant information (see Fed. R. Civ. P. 26(a)(1)(A)), so concealing names at thecomplaint stage “does nothing but obstruct the judiciary’s ability to implement the PSLRA.” Higginbotham,495 F.3d at 757. Because Tellabs requires a court to evaluate what a complaint reveals and disregard what itconceals, allegations by “confidential witnesses” usually must be steeply discounted. Id. Thus, in the SeventhCircuit at least, the use of confidential witnesses is not a persuasive tool for pleading a strong inference ofscienter.

The Tellabs decision settles previous disagreement in the District Courts of the Seventh Circuit over thestandard of scienter. Most courts had followed the Second Circuit’s approach. See, e.g., In re Motorola Sec.Litig., No. 03 C 287, 2004 WL 2032769, at *26 (N.D. Ill. Sep. 9, 2004); 766347 Ontario Ltd. v. Zurich CapitalMarkets Inc., 249 F. Supp. 2d 974 (N.D. Ill. 2003); Great Neck Capital Appreciation Inv. P’ship L.P. v.PricewaterhouseCoopers, LLP, 137 F. Supp. 2d 1114 (E.D. Wisc. 2001); In re Next Level Sys., Inc., No. 97 C7362, 2000 WL 15091, at *4 (N.D.Ill. Jan. 6, 2000) (declining to adopt the Silicon Graphics standard, notingthat “[t]he majority of courts agree with the Second Circuit, including those within this district”). A few courtsreached the opposite conclusion, however, and rejected the Second Circuit approach as inconsistent with theReform Act. See Great Neck Capital Appreciation Inv. P’ship L.P. v. PricewaterhouseCoopers, LLP, 137 F.Supp. 2d 1114, 1120 (E.D. Wisc. 2001); Danis v. USN Commc’ns, Inc., 73 F. Supp. 2d 923, 937-38 (N.D. Ill.

1999).

l. Eighth Circuit

The Eighth Circuit interpreted the post Reform Act scienter standard in Florida State Board of Administrationv. Green Tree Financial Corp., 270 F.3d 645 (8th Cir. 2001) and in In re Navarre Corp. Securities Litigation,299 F.3d 735 (8th Cir. 2002). The Eighth Circuit held that since the Reform Act had not changed thesubstantive scienter standard, plaintiffs could still plead under the Sunstrand recklessness standard. Green TreeFin. Corp., 270 F.3d at 653-54.

After surveying the “motive and opportunity” stances taken by the other circuits, and finding the legislativehistory ambiguous, the Eighth Circuit held that: (1) allegations of motive and opportunity are generallyrelevant to a fraud case, and a showing of unusual or heightened motive will often form an important part of acomplaint that meets the Reform Act standard; (2) where circumstantial allegations that establish motive andopportunity also tend to show knowing or reckless misrepresentations, such allegations may meet the ReformAct standard, because they raise a strong inference of scienter, not merely because they establish motive andopportunity; and (3) without allegations of motive and opportunity, averments tending to show scienter wouldhave to be particularly strong in order to meet the Reform Act standard. Id. at 660; see also In re HutchinsonTech., Inc. Sec. Litig., 502 F. Supp. 2d 884, 898 (D. Minn. June 4, 2007) (“[M]otive-and-opportunityallegations must go beyond alleging a general desire to increase stock prices and officer compensation . . . .[they] must show that the particular defendant benefited in some concrete and personal way from the allegedfraud.”), aff’d, 536 F.3d 952 (8th Cir. 2008). The Eighth Circuit made the unique observation that motive andopportunity are not simply “allowed,” but may be substantively necessary to meet the Reform Act standard. While allegations of motive and opportunity may suffice, they will suffice only where they also tend to showknowing and reckless misrepresentations and, therefore, give rise to a strong inference of scienter.

The Eighth Circuit addressed pleading standards under Tellabs in two cases in 2008. In In re Ceridian Corp.Sec. Litig., 542 F.3d 240, 244 (8th Cir. 2008), the Circuit Court noted that Tellabs added “an additional hurdlefor Eighth Circuit plaintiffs to overcome to satisfy [their] pleading requirements” with its mandate that aninference of scienter must be at least as compelling as any opposing inference of fraud. Applying Tellabs’holding, the Circuit Court affirmed the district court’s dismissal of plaintiffs’ claims. In Elam v. Niedorff, 544F.3d 921 (8th Cir. 2008), the Eighth Circuit reached the same conclusion.

In Horizon Asset Mgmt. Inc. v. H&R Block, Inc., 580 F.3d 755, 767 (8th Cir. 2009), the plaintiff argued that thedefendant corporation’s scienter could be imputed from the allegations of the scienter of a corporate officer whowas not a named defendant. The court noted that the appropriate standard for considering the pleading ofcorporate scienter under the PSLRA is an open question in the Eight Circuit. Id. But the court “assume[ed] forthe sake of argument that [the non-defendant officer’s] state of mind can be imputed to the corporation,” andconcluded that the scienter allegations were insufficient to raise a strong inference that the officer acted withscienter, and therefore held that the plaintiff failed to plead scienter adequately with respect to the corporation. Id.

m. Ninth Circuit

The Ninth Circuit interpreted the Reform Act scienter pleading standard in In re Silicon Graphics Inc. Sec.Litig., 183 F.3d 970 (9th Cir. 1999), where it took the most stringent approach of all the circuits to address theissue before the Supreme Court’s decision in Tellabs. See, e.g., Nursing Home Pension Fund v. Oracle Corp.,380 F.3d 1226, 1230 (9th Cir. 2004) (citing Silicon Graphics, 183 F.3d at 475); Ronconi v. Larkin, 253 F.3d423 (9th Cir. 2001); In re Vantive Corp. Sec. Litig., 283 F.3d 1079 (9th Cir. 2002); Gompper v. VISX, Inc., 298F.3d 893 (9th Cir. 2002). The Ninth Circuit expressly rejected the Second Circuit “motive and opportunity”standard, adopting instead a heightened standard requiring “deliberate or conscious recklessness.” SiliconGraphics, 183 F.3d at 974.

In Silicon Graphics, the Ninth Circuit held that plaintiffs must plead “in great detail, facts that constitute strongcircumstantial evidence of deliberately reckless or conscious misconduct.” 183 F.3d at 974. “[M]indful thatnot all courts share [its] view,” the Ninth Circuit attempted in Silicon Graphics to reconcile Congress’ adoptionof the Second Circuit’s “strong inference” language with Congressional refusal to codify Second Circuit caselaw interpreting the pleading standard. Id. at 974, 978-79. The Ninth Circuit is the only circuit to hold that theReform Act raised the scienter standard to one of “deliberate recklessness.” See id. at 979.

Prior to the Reform Act, the Ninth Circuit had also adopted the 7th Circuit’s standard of recklessness inSundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033 (7th Cir. 1977). Afterwards, however, the NinthCircuit “read the PSLRA language that the particular facts must give rise to a ‘strong inference … [of] therequired state of mind’ to mean that the evidence must create a strong inference of, at a minimum, ‘deliberaterecklessness.’” Silicon Graphics, 183 F.3d at 976.

The Silicon Graphics court pointed to legislative history, determining that, because the Joint Committee hadexpressly declined to codify the Second Circuit’s “recklessness” standard, that it must have intended tostrengthen that standard. Thus, plaintiffs “can no longer aver intent in general terms of mere ‘motive andopportunity’ or ‘recklessness,’ but rather, must state specific facts indicating no less than a degree ofrecklessness that strongly suggests actual intent.” Id. at 979.

In explaining its holding, the court added, “We believe that this ‘deliberate recklessness’ standard bestreconciles Congress’ adoption of the Second Circuit’s so-called ‘strong inference standard’ with its expressrefusal to codify that circuit’s two-prong … test.” Id. The court also pointed to the Congressional override ofPresident Clinton’s veto of the Reform Act, which stemmed from his concern that the Act would elevate thestandard above that already required in the Second Circuit. In overriding the veto, the court argued, Congressmeant to show a deliberate intent to raise the pleading standard above that already in existence in the SecondCircuit. Id.

The Silicon Graphics court thus concluded that Congress adopted the Second Circuit’s “strong inference”language “only because it was facially more stringent than the ‘reasonable inference standard’ in othercircuits.” Id. In so holding, the court also found that mere motive and opportunity pleading could not besufficient to survive a motion to dismiss. Id. In fact, the court went even further, stating that plaintiffs “muststate specific facts indicating no less than a degree of recklessness that strongly suggests actual intent.” Id. Noother circuit has adopted this standard.

The Ninth Circuit, under Silicon Graphics and its progeny, examines the totality of circumstances to determinewhether plaintiffs have demonstrated the deliberate recklessness to raise a strong inference of scienter. Id. at979 (examining plaintiff’s allegations regarding internal reports and stock sales); In re Vantive Corp. Sec. Litig.,283 F.3d 1079 (9th Cir. 2002) (examining plaintiffs’ allegations of misrepresentations, accountingmanipulations, stock sales, and corporate transactions). Moreover, in considering all circumstances, “allreasonable inferences to be drawn from the allegations, including inferences unfavorable to the plaintiffs” mustbe considered. Gompper v. VISX, Inc., 298 F.3d 893, 896-97 (9th Cir. 2002) (considering only inferencesfavorable to plaintiffs’ position “would . . . eviscerate the PSLRA’s strong inference requirement by allowingplaintiffs to plead in a vacuum”). In No. 84 Employer-Teamsters Joint Council Pension Trust Fund v. AmericaWest Holding Corp., the Ninth Circuit found that allegations that were individually lacking were sufficient tomeet the stringent pleading standards set forth in the PSLRA when considered collectively. 320 F.3d 920, 945(9th Cir. 2003); see also Oracle, 380 F.3d at 1234. Further, a panel of the Ninth Circuit in dicta has expressedthe view that the Silicon Graphics holding relates only to a pleading requirement, stating that the Reform Act“did not alter the substantive requirements for scienter under Section 10(b).” Howard v. Everex Sys., Inc., 228F.3d 1057, 1064 (9th Cir. 2000). However, one court has extended the Silicon Graphics “deliberaterecklessness” standard past the pleading stage, and to non-private actions. See S.E.C. v. Platforms WirelessInt’l Corp., 559 F. Supp. 2d 1091, 1097 n.3 (S.D. Cal. 2008) (applying “deliberate recklessness” standard to anSEC action at summary judgment stage).

When evaluating the totality of circumstances, the Ninth Circuit has often examined stock trades by insiders. InSilicon Graphics, the court stated that stock trades are only suspicious when “dramatically out of line with priortrading practices at times calculated to maximize the personal benefit from undisclosed inside information.” Silicon Graphics, 183 F.3d at 986; see also Langley Partners, LP v. Tripath Tech., Inc., No. C-05-4194, 2006WL 563053, *5 (N.D. Cal. Mar. 7, 2006) (holding although the timing was suspicious plaintiff’s allegations ofinsider trading did not show scienter without a showing such trading was unusual for defendants); In reNature’s Sunshine Prods. Sec. Litig., 486 F. Supp. 2d 1301, 1311 (D. Utah 2007) (finding plaintiff pledsufficient facts to show scienter where plaintiff pled that the defendant, having never sold stock previously, soldsignificant quantities of stock and received significant profits in great excess of his salary). In the past, greatweight has been given to the percentage of stock sold. See, e.g., Am. W. Holding, 320 F.3d at 939. However,“when stock sales result in a truly astronomical figure, less weight [will be] given to the fact that they mayrepresent a small portion of the defendant’s holdings.” Oracle, 380 F.3d at 1232 (involving sale of $900million worth of stock representing only 2.1% of defendant’s holdings). On the other hand, if a defendantpurchases stock during the class period, that fact will assist to tip the scienter balance in defendants’ favor, allother things being equal. In re Aspeon, Inc. Sec. Litig., 168 F. App’x 836, 838-40 (9th Cir. 2006) (findingcomplaint lacked particularity necessary to raise a strong inference of scienter because allegations did not detailhow information was inaccurate or CEO obstructed audit; CEO’s stock purchase also indicated he knew orbelieved that issued statements were in fact accurate).

In addition, the Northern District of California made several observations about the software industry that mayinform the scienter analysis for high technology companies. In In re Siebel Systems, Inc. Securities Litigation,No. C 04-0983 CRB, 2005 WL 3555718 (N.D. Cal. Dec. 28, 2005), the district court held that the release of animproved version of software to address “kinks” and “bugs” did not mean that the company’s earlier positivestatements about the previous version were false. “If that were the case, the federal securities laws wouldprevent software companies from making any positive statements about new software.” Id. at *4. The CFO’sstatement that there was “little sign of improvement” one month before the end of a quarter of decliningrevenues also failed to support a scienter finding because “[i]t is common knowledge that high tech companiescomplete many deals in the last few days of a quarter in order to meet revenue projections.” Id. at *12.

Post-Tellabs. In Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981 (9th Cir. 2009) the Ninth Circuitdefinitively established its post-Tellabs pleading standard for scienter under the Reform Act. In Zucco, theCourt articulated the two-part test that is now required under Tellabs (a segmented, then a holistic analysis). However, the Court also reiterated the vitality of Silicon Graphics and its progeny by stating that “Tellabs didnot materially alter the particularity requirements for scienter claims established in the court’s previousdecisions, but instead only added an additional ‘holistic’ component to those requirements.” The ultimateholding of Zucco in affirming dismissal with prejudice and its analysis in rejecting plaintiffs’ arguments make ita particularly significant decision for defense counsel. Zucco is especially important in light of other recentNinth Circuit decisions finding that plaintiffs had adequately pled scienter based on less specific factualallegations. See, e.g., Siracusano v. Matrixx Initiatives, Inc., 585 F.3d 1167, 1180-83 (9th Cir. 2009) (reversingdismissal for failure to plead scienter when plaintiffs had alleged that defendant made statements generallyabout the risks of product liability claims but gave no indication that a lawsuit had already been filed and thusthe risk “may already have come to fruition”).

In South Ferry LP #2 v. Killinger, 542 F.3d 776 (9th Cir. 2008), the Ninth Circuit held that “core operations”allegations, that is, allegations regarding management’s role in a company, may be relevant and help satisfy thePSLRA scienter requirement in three circumstances. Id. at 785. First, the allegations may be used along withother allegations, that when read together, create a strong inference of scienter. Id. Second, core operationsallegations may independently satisfy the PSLRA where they are particular and suggest that defendants hadactual exposure to the disputed information. Id. at 786. Finally, core operations allegations may “conceivably”meet the PSLRA where the nature of the relevant fact is of such prominence that it would be “absurd” tosuggest that management was unaware of the matter. Id.; see also In re Countrywide Fin. Corp. Deriv. Litig.,554 F. Supp. 2d 1044 (C.D. Cal. 2008) (finding strong inference of scienter (i) as to outside directors based, inpart, on oversight responsibilities of various board committees and (ii) as to officer defendants, because “theywere involved in the day-to-day operation of the company”); McCasland v. FormFactor Inc., No. C 07-5545

SI, 2009 WL 2086168, at *5-6 (N.D. Cal. July 14, 2009) (holding that plaintiffs failed to meet South Ferry’sstandard because the complaint did not identify any specific information that was either received orcommunicated by any defendant).

The Ninth Circuit affirmed its Zucco ruling in Rubke v. Capitol Bancorp Ltd., 441 F.3d 1156, 1165 (9th Cir.2009), noting that courts “can no longer summarily dismiss a complaint whose individual allegations areinsufficient under the PSLRA” and that it “must perform a second holistic analysis to determine whether thecomplaint contains an inference of scienter that is greater than the sum of its parts.” The Rubke court appliedthe Tellabs/Zucco standard and determined that plaintiffs had failed to demonstrate with particularity thatdefendants made statements or omissions “intentionally or with deliberate recklessness.” Id. at 1166.

Prior to Zucco, District Courts within the Ninth Circuit applied the Tellabs standards with varying results. In Inre Countrywide Financial Corp. Derivative Litigation, 554 F. Supp. 2d 1044, 1050-51 (C.D. Cal. 2008)plaintiffs alleged that the individual defendants, directors and officers of Countrywide, misled the public as tothe type of loans the company was willing to issue. In denying the motion to dismiss, the court found thatscienter had been adequately pled due to the statements of confidential witnesses and the oversightresponsibilities of the board committees. Id. at 1058-63. Specifically, the court found that members of theAudit & Ethics Committee were required to oversee Countrywide’s risk management practices, and therefore astrong inference of scienter was pled where the committee members ignored “red flags” related todelinquencies, negative amortizations, and other signs of non-performance. Id. at 1063. On the other hand, thecourt in In re Impac Mortgage Holdings, Inc. Securities Litigation, 554 F. Supp. 2d 1083 (C.D. Cal. 2008)dismissed the plaintiffs’ claims with prejudice after finding that the claims failed to plead scienter under the“deliberate recklessness” standard. The Impac court noted that even if the individual defendant knew that thecompany was taking on increasingly risky loans or that the company operated in a “do any deal” culture, suchdid not establish deceitfulness in stating publicly that he “anticipated solid loan acquisitions” by the company. Id. at 1100. In In re InfoSonics Securities Litigation, No. 06-cv-1231-BTM, 2007 WL 2301757, at *4-8 (S.D.Cal. Aug. 7, 2007), the court found that plaintiffs’ claims regarding improper accounting for warrants, whicheventually resulted in a restatement, did not meet the heightened pleading standards enunciated in Tellabs. Plaintiffs failed to allege scienter adequately because statements of a confidential witness alleging thatmanagement knew the restatement would be necessary failed to state how the witness knew that managementwas aware the warrants were misclassified. By contrast, allegations regarding misstatements about certainproduct sales withstood the motion to dismiss because management was aware that a series of defective productshipments had derailed the business but continued to make affirmative representations to the public that theproducts were well received and that they were excited about growth opportunities in the U.S. market. See alsoIn re Impax Labs., Inc. Sec. Litig., No. C 04-04802 JW, 2007 U.S. Dist. LEXIS 52356, at *31-32 (N.D. Cal.July 18, 2007) (finding that significant GAAP violations as well as likelihood that high-ranking officers wereaware of wrongdoing established a “strong inference” of scienter); Commc’ns Workers of Am. Plan forEmployees’ Pensions & Death Benefits v. CSK Auto Corp., 525 F. Supp. 2d 1116 (D. Ariz. 2007) (describingTellabs’ equal-inference approach as “a tie goes to the plaintiff”).

n. Tenth Circuit

The Tenth Circuit interpreted the scienter pleading standard in Philadelphia v. Fleming Cos. Inc., 264 F.3d1245 (10th Cir. 2001). Like the First, Second, Third, Sixth, and Eleventh Circuits before it, the Tenth Circuitfound that “plaintiffs can adequately plead scienter by setting forth facts raising a ‘strong inference’ ofintentional or reckless misconduct.” Fleming, 264 F.3d at 1259.

The Tenth Circuit defines recklessness as “conduct that is an extreme departure from the standards of ordinarycare, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is soobvious that the actor must have been aware of it.” Id. However, recognizing that courts in general “have beencautious about imposing liability for securities fraud based on reckless conduct,” the Tenth Circuit has limitedits scope. Id. at 1260. The court reviewed the facts of the case under the Second Circuit’s recklessnessstandard in Novak. Id. (citing Novak v. Kasaks, 216 F.3d 300, 308 (2d Cir. 2000)).

As for motive and opportunity pleading, the court adopted what it called the “middle ground chosen by the Firstand Sixth Circuits, and arguably by the Eleventh Circuit.” Id. at 1261-62. In doing so, the Tenth Circuit heldthat the “totality of the pleadings” was determinative in whether allegations permitted a “strong inference” offraudulent intent. Id.; see also Pirraglia v. Novell, Inc., 339 F.3d 1182, 1187 (10th Cir. 2003). Like those“middle” circuits, the Tenth Circuit found that “[a]llegations of motive and opportunity may be important tothat totality, but typically are not sufficient in themselves to establish a ‘strong inference’ of scienter.” Fleming,264 F.3d at 1261-62; see also Andropolis v. Red Robin Gourmet Burgers, Inc., 505 F. Supp. 2d 662 (D. Colo.2007) (holding that the lack of allegations of insider trading, when combined with the allegations of motive andopportunity shared by all corporate managers to raise stock price, warrant dismissal based on lack of scienter). As such, the Tenth Circuit rejected “defined, formalistic categories such as ‘motive and opportunity’” todetermine whether the plaintiffs’ allegations overall give rise to a strong inference of scienter. Fleming, 264F.3d at 1262. To establish scienter for allegations concerning non-disclosure, plaintiff must demonstrate thatthe defendant knew of the potentially material fact, and knew that failure to reveal the potentially material factwould likely mislead investors. Id.

The Tenth Circuit has yet to revisit the PSLRA pleading standard in the wake of Tellabs. However, at least onedistrict court in the Tenth Circuit has applied Tellabs in a way that substantially – although not completely –mirrors the Circuit’s pre-Tellabs standards. In New Jersey v. Sprint Corp., 531 F. Supp. 2d 1273, 1281 (D.Kan. 2008), the court denied defendants’ motion for judgment on the pleadings – filed by defendants followingthe Tellabs decision – observing that the Tenth Circuit’s Pirraglia standard for pleading scienter is substantiallysimilar to the standard adopted by the Court in Tellabs. The court, however, noted that Pirraglia left open thepossibility that an inference of scienter could be deemed sufficiently “strong” to survive a motion to dismisseven if an innocent inference tips the scales ever so slightly. Id. This result would be impermissible underTellabs. Id.

When the securities fraud claim is brought against an outside auditor, several courts within the Tenth Circuithave defined recklessness “as requir[ing] more than a misapplication of accounting principles. [Plaintiffs] mustprove that the accounting the accounting practices were so deficient that the audit amounted to no audit at all, oran egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments whichwere made were such that no reasonable accountant would have made the same decisions if confronted with thesame facts.” In re Imergent Sec. Litig., No. 2:05-CV-204, 2009 WL 3731965, at *7 (D. Utah Nov. 2, 2009)(citations omitted).

o. Eleventh Circuit

The Eleventh Circuit first interpreted the effect of the Reform Act on the scienter pleading standard in Bryant v.Avado Brands, Inc., 187 F.3d 1271, 1283-84 (11th Cir. 1999). Explicitly rejecting the Ninth Circuit’s holdingin Silicon Graphics, the Eleventh Circuit held that severe recklessness still sufficed to plead scienter in asecurities fraud case. Bryant, 187 F.3d at 1283; see also Phillips v. Scientific-Atlanta, Inc., 374 F.3d 1015,1018-19 (11th Cir. 2004).

Prior to the Reform Act, the Eleventh Circuit had adopted the “recklessness” standard articulated in SundstrandCorp. v. Sun Chemical Corp., 553 F.2d 1033 (7th Cir. 1977). Bryant, 187 F.3d at 1282, n.18. In Bryant, thecourt found that the Reform Act had not substantively raised the necessary level of scienter, but merelyincorporated the reckless behavior standard already in general use by the federal courts. Id. at 1284. The courtrejected the Silicon Graphics view as inconsistent with the plain language of the statute. Id. The court furthersuggested that had Congress “desired to require some other state of mind, that is, other than the reckless state ofmind then uniformly held sufficient by the federal courts … [it] would have done so in explicit terms.” Id. at1284.

However, the court also refuted the contention that the Reform Act had codified the Second Circuit test, notingthat the Act made “no express mention of the motive and opportunity test.” Id. at 1285. The court interpreted

the Reform Act’s language to mean that the plaintiff must state with particularity facts leading to a stronginference of “severe recklessness.” Therefore, allegations of motive and opportunity (without more), whilerelevant, could not be sufficient to show a “strong inference” of scienter. Id. at 1285-86. The court wasparticularly persuaded by the fact that only two circuits, the Second and Ninth, had allowed motive andopportunity pleading at the time the Reform Act was enacted. Id. at 1286. Thus, the court found that it was“certainly not so well-established that it was codified sub silentio.” Id.

The Eleventh Circuit aligned itself with the Sixth Circuit’s holding in In re Comshare Securities Litigation, 183F.3d 542, 550 (6th Cir. 1999), but when the Sixth Circuit revisited the issue in Helwig, it contended that theEleventh Circuit had interpreted its Comshare decision in an “unduly rigid” way. The Sixth Circuit had leftopen the possibility that, under some fact patterns, motive and opportunity could be sufficient to plead scienter. Helwig, 251 F.3d at 550.

The Eleventh Circuit recently addressed the impact of Tellabs in Mizzaro v. Home Depot, Inc., 544 F.3d 1230,1238 (11th Cir. 2008). The court highlighted that though the PSLRA “raised the pleading standard for scienter,it did not change the substantive intent requirements.” Id. (emphasis in original). Reiterating the“recklessness” standard outlined in Bryant, the court outlined a “stringent” scienter standard: to withstand amotion to dismiss, plaintiff “must (in addition to pleading all of the other elements of a § 10(b) claim) pleadwith particularity facts giving rise to a strong inference that the defendants either intended to defraud investorsor were severely reckless when they made the allegedly materially false or incomplete statements.” Id. (internalquotation marks omitted). A court must take into account “all of the facts alleged,” which is an “inherentlycomparative” exercise. Id. (citing Tellabs). The court emphasized that the test under Tellabs is different fromthe summary judgment standard, as “it asks what a reasonable person would think, not what a reasonable personcould think.” Id. at 1239 (emphasis in original). The court rejected plaintiffs’ “must have known” theory,among other reasons, because the fraud was not complex in nature, the amount of the fraud was speculative,and the type of fraud alleged would be difficult for senior management to detect. Id. at 1251.

p. DC Circuit

The D.C. Circuit first interpreted the post-Reform Act scienter pleading standard in Rockies Fund, Inc. v.S.E.C., 428 F.3d 1088 (D.C. Cir. 2005). This case provided no background regarding the court’s decisionmaking process in adopting the pleading standard, but rather simply reiterated its pre-Reform Act standardfound in S.E.C. v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992). The court in Rockies Fund held that in orderto plead a strong inference of scienter, a plaintiff is required to show that a defendant acted with “extremerecklessness.” 428 F.3d at 1093; see also Liberty Prop. Trust v. Republic Props. Corp., 577 F.3d 335, 342(D.C. Cir. 2009) (“Either intentional wrongdoing or ‘extreme recklessness’ satisfies the standard.”). Extremerecklessness is defined by the D.C. Circuit as an “extreme departure from the standards of ordinary care …which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obviousthat the actor must have been aware of it. In other words, extreme recklessness requires a stronger showingthan simple recklessness but does not rise to the level of specific intent.” Rockies Fund, Inc., 428 F.3d at 1093;see also Belizan v. Hershon, 495 F.3d 686 (D.C. Cir. 2007) (applying Tellabs to securities fraud allegations).

At least one district court in the D.C. Circuit has rejected the “core operations” theory, holding that ageneralized assertion that the defendants’ corporate positions exposed them to confidential information and thusthey “should have known” of false statements, does not warrant an inference of scienter in the absence ofdetails regarding what this information entailed, when the defendants received it, or how it related to the allegedfraud. Stevens v. InPhonic, Inc., 662 F. Supp. 2d 105, 121 (D.D.C. 2009).

q. Corporate Scienter

While establishing scienter against an individual is accomplished by pleading and proving the requisite mentalstate of the individual, establishing scienter for a corporation can be more complex. Courts agree that a

corporation acts with scienter if the authorized corporate agent making a false statement acted with scienter. See, e.g., Southland Sec. Corp. v. INSpire Ins. Solutions Inc., 365 F.3d 353, 366 (5th Cir. 2004) (explaining thatcorporate scienter is established by looking “to the state of mind of the individual corporate official or officialswho make or issue the statement”); In re Cabletron Sys., Inc., 311 F.3d 11, 40 (1st Cir. 2002) (“The scienteralleged against the company’s agents is enough to plead scienter for the company.”). The more difficultquestion is whether a plaintiff, under a “collective scienter” theory, can plead and prove corporate scienter whenthe person responsible for the misstatement was not aware of the truth but some other corporate employee was,or when no single corporate employee knew the truth but the aggregate knowledge of several employees wouldhave revealed it.

Most courts have expressly or implicitly rejected the collective scienter approach, requiring proof that theperson responsible for the misstatement had scienter. See Garfield v. NDC Health Corp., 466 F.3d 1255, 1263-67 (11th Cir. 2006) (holding that scienter was not pleaded where complaint did not allege specifically thatofficers who signed certifications to financial statements required by SOX were presented with reasons to doubtthe financial statements, even though a “management level employee” allegedly notified outside auditors ofrevenue recognition problems); In re Tyson Foods, Inc. Sec. Litig., 155 F. App’x 53, 57 (3rd Cir. 2005)(“Having concluded that there is no primary liability on the part of any of the individual officers, the DistrictCourt properly held that Tyson Foods could not itself be primarily liable under the facts of this case.”);Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424, 1435 (9th Cir.1995) (“there is no case law supporting anindependent ‘collective scienter’ theory,” i.e., the theory “that a corporation’s scienter could be different fromthat of an individual director or officer”); Teachers’ Retirement System v. Hunter, 477 F.3d 162, 184 (4th Cir.2007) (“[I]f the defendant is a corporation, the plaintiff must allege facts that support a strong inference ofscienter with respect to at least one authorized agent of the corporation, since corporate liability derives fromthe actions of its agents.”); Southland, 365 F.3d at 366 (stating that a court must look to the state of mind of theindividuals “who make or issue the statement (or order or approve it or its making or issuance, or who furnishinformation or language for inclusion therein, or the like) rather than generally to the collective knowledge ofall the corporation’s officers and employees acquired in the course of their employment.”); Phillips v.Scientific-Atlanta, Inc., 374 F.3d 1015, 1018 (11th Cir. 2004) (stating in dictum that “the most plausible reading[of the PSLRA] in light of congressional intent is that a plaintiff, to proceed beyond the pleading stage, mustallege facts sufficiently demonstrating each defendant’s state of mind regarding his or her violations.”); see alsoIn re Medtronic Inc., Sec. Litig., 618 F. Supp. 2d 1016, 1035 (D. Minn. 2009) (“While the Eighth Circuit hasnot directly addressed the issue of ‘collective scienter,’ … the Court will not apply [the doctrine], requiringinstead that the Plaintiffs establish corporate scienter by adequately alleging the scienter of individual corporateofficers.”); Zavolta v. Lord, Abbett & Co. LLC, 2010 U.S. Dist. LEXIS 16491 (D.N.J. 2010) (questioningwhether Third Circuit would recognize concept of corporate scienter without identifying responsibleindividuals); City of Roseville Empl. Ret. Sys. v. Horizon Lines, Inc., 686 F. Supp. 2d 404 (D. Del. 2010)(scienter of low-level employees could not be attributed to high level employees or to corporation).

Some circuit courts have indicated that, at least at the pleading stage, a plaintiff may allege scienter on the partof a corporate defendant without pleading scienter as to any particular employee. For example, in City ofMonroe Employees Retirement Sys. v. Bridgestone Corp., 399 F.3d 651, 690 (6th Cir. 2005), the Sixth Circuitpermitted a securities class action against a corporation to proceed even though the complaint failed to allegethat the corporate agent whose scienter was imputed to the corporation “played any role in drafting, reviewing,or approving” the allegedly false representations or “that he was, as a matter of practice, or by job description,typically involved in the creation of such documents.” In affirming the dismissal of the claims against thecorporate agent, the court acknowledged that “it might seem incongruous to reach this conclusion after relyingin part on [his] knowledge … as a basis for [the corporation’s] scienter.” Id. at 690 n.34.

In Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702, 710 (7th Cir. 2008), the Seventh Circuit in dictanoted that “it is possible to draw a strong inference of corporate scienter without being able to name theindividuals who concocted and disseminated the fraud.” The court gave the following as a hypotheticalexample of such a situation: “Suppose General Motors announced that it had sold one million SUVs in 2006,and the actual number was zero. There would a strong inference of corporate scienter, since so dramatic anannouncement would have been approved by corporate officials sufficiently knowledgeable about the company

to know that the announcement was false.” Id. Thus, the Seventh Circuit has indicated that at the pleadingstage, some fraudulent statements may be so flagrant as to support allegations of corporate scienter even whenthe knowledge of individual agents cannot be determined.

The Second Circuit in Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital, Inc., 531 F.3d 190,195 (2nd Cir. 2008), distinguished between “pleading rules and liability rules,” and explained that in pleadingscienter “it is possible to raise the required inference with regard to a corporate defendant without doing so withregard to a specific individual defendant.” Thus, for pleading purposes, a plaintiff need only plead facts that“create a strong inference that someone whose intent could be imputed to the corporation acted with therequisite scienter,” without actually having to identify that someone. However, to succeed on the merits, aplaintiff must “prove that an agent of the corporation committed a culpable act with the requisite scienter, andthat the act (and accompanying mental state) are attributable to the corporation.” Id.; cf. Defer LP v. RaymondJames Fin., Inc., 654 F. Supp. 2d 204, 218-19 (S.D.N.Y. 2009) (refusing to aggregate the knowledge of two ormore separate corporate entities to infer collective corporate scienter on the basis that they share the sameparent and nothing more). But see In re Worldcom, Inc., Sec. Litig., 352 F. Supp. 2d 472, 497 (S.D.N.Y. 2005)(“[T]o carry their burden of showing that a corporate defendant acted with scienter, plaintiffs in securities fraudcases need not prove that any one individual employee of a corporate defendant also acted with scienter. Proofof a corporation’s collective knowledge and intent is sufficient.”); In re MBIA, Inc. Sec. Litig., 700 F. Supp. 2d566 (E.D.N.Y. 2010 (corporate scienter adequately alleged via claims of confidential witnesses about unnamedofficers).

More recently, the Ninth Circuit in Glazer Capital Mgmt., LP v. Magistri, 549 F.3d 745 (9th Cir. 2008),revisited its decision in Nordstrom, which at least one district court had interpreted as rejecting collectivescienter. See In re Apple Computers, Inc., 243 F. Supp. 2d 1012, 1023 (N.D. Cal. 2002) (“A corporation isdeemed to have the requisite scienter for fraud only if the individual corporate officer making the statement hasthe requisite level of scienter at the time that he or she makes the statement. We have squarely rejected theconcept of ‘collective scienter’ in attributing scienter to an officer and, through him, to the corporation.”). Citing the Seventh Circuit’s decision in Makor, the court explained that “Nordstrom does not foreclose thepossibility that, in certain circumstances, some form of collective scienter pleading might be appropriate.” Glazer, 549 F.3d at 744. Ultimately, however, the court did not decide whether such circumstances werepresent “because the facts of this case are different than the hypothetical posed in Makor.” Id. at 745. Nonetheless, the Ninth Circuit left open the possibility that “there could be circumstances in which a company’spublic statements were so important and so dramatically false that they would create a strong inference that atleast some corporate officials knew of the falsity upon publication.” Id.

13. Damages Under Section 10(b)

The private cause of action under Rule 10b-5 is implied. Therefore, until the Reform Act, courts had nostatutory guidance to determine the appropriate measure of damages. Because the primary basis for implyingthis private cause of action is a tort theory, courts predominantly used tort concepts to shape the measure ofrecovery under Rule 10b-5. See Kardon v. Nat’l Gypsum Co., 69 F. Supp. 512, 513 (E.D. Pa. 1946) (relying onthe tort principle that “[t]he disregard of the command of a statute is a wrongful act and a tort”). The result wasuncertainty concerning the method to calculate damages because factors other than the information in disputecan impact stock price.

There has been a “relative paucity of decisions dealing with damages in Rule 10b-5 cases.” Miller v. Asensio &Co., Inc. 364 F.3d 223, 228 (4th Cir. 2004); see also 3 Alan R. Bromberg & Lewis D. Lowenfels, Bromberg andLowenfels on Securities Fraud & Commodities Fraud § 9.1 (2d ed. 1999) (“Few 10b-5 cases have reached therelief stage.”). In Asensio, for instance, the Fourth Circuit analyzed a question of first impression: whether ajury’s finding of liability under Rule 10b-5 in a private securities case required an award of damages. Asensio,364 F.3d at 225. The Court concluded that a jury could properly determine that defendant’s fraud constitutedsubstantial cause of plaintiff’s loss, and yet find that plaintiff failed to prove the amount of plaintiff’s loss solelycaused by defendant’s fraud. Id. at 235. In Rocker Management, LLC v. Lernout & Hauspie Speech Products

N.V., No. 00-5965 (PGS), 2007 WL 2814653, at *14 (D.N.J. Sept. 24, 2007), the court held that to measureactual loss for damages purposes, the court must decide (1) whether “the gains and losses of [Plaintiff’s] shortsales should be netted” or whether “a transactional approach” should be used, considering “each saleindividually,” and allowing “plaintiff to recover on all losses without any offset for gains,” and (2) “the periodof time in which [Plaintiff’s] short sales will be netted or considered on a transactional basis.”

a. Pre-Reform Act Damage Theories

Like a plaintiff in a common law case where a contract was allegedly induced by fraud, a plaintiff who proved aviolation of Rule 10b-5 in a pre-Reform Act case had the choice of undoing the bargain or holding thedefendant to the bargain and requiring the defendant to pay damages. Sackett v. Beaman, 399 F.2d 884, 891(9th Cir. 1968); Estate Counseling Service, Inc. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 303 F.2d 527,531 (10th Cir. 1962). Of the two alternative Pre-Reform Act measures of damages for Rule 10b-5 violations –the injury measure (also known as the “out-of-pocket” measure) and the restitution measure – the former is thepredominant measure of damages post-Reform Act.

Out-of-Pocket Measure of Damages. The out-of-pocket measure, which looks to the plaintiff’s loss, is thetraditional measure of damages under Rule 10b-5. Affiliated Ute Citizens of Utah v. United States, 406 U.S.128, 154-55 (1972). The damages are “the difference between the fair value of all that the [plaintiff] receivedand the fair value of what he would have received had there been no fraudulent conduct.” Asensio, 364 F.3d at225 (citing Affiliated Ute, 406 U.S. at 155). The guiding philosophy of the out-of-pocket measure is “not whatthe plaintiff might have gained if the false facts had been true, but rather what he has actually lost by beingdeceived into the purchase.” Barr v. Matria Healthcare, Inc., 324 F. Supp. 2d 1369, 1376 (N.D. Ga. 2004)(quoting Wool v. Tandem Computers, Inc., 818 F.2d 1433, 1437 n.2 (9th Cir. 1987)). This rule is particularlyappropriate where plaintiff’s basic claim is that, due to defendant’s fraud, he paid an inflated price for hisstock. See, e.g., G & M, Inc. v. Newbern, 488 F.2d 742, 745 (9th Cir. 1973).

The most crucial factor, and the one which causes the most difficulty in calculating out-of-pocket damages, isdetermining the “actual” or “fair” value of the stock.

Actual Value. Under the out-of-pocket rule, the court measures the actual value of the stock on the day of thesales transaction and excludes that portion of the price decline that is the result of forces unrelated to themisrepresentation. See, e.g., In re Executive Telecard, Ltd. Sec. Litig., 979 F. Supp. 1021, 1025 (S.D.N.Y.1997); Harmsen v. Smith, 693 F.2d 932, 946 (9th Cir. 1982).

The out-of-pocket rule reflects what courts perceive to be the reality of the securities marketplace – that anyinvestor must assume a risk of fluctuation in stock value. Huddleston v. Herman & MacLean, 640 F.2d 534,549 (5th Cir. 1981), rev’d in part on other grounds, 459 U.S. 375 (1983). This approach prevents a plaintifffrom shifting the usual risks involved in any securities transaction to the defendant. One factor considered bythe court in determining actual value is the price of the stock on the date of purchase. Actual value equals the“real value,” Sackett v. Beaman, 399 F.2d 884, 891 (9th Cir. 1968), or the “prices at which [the buyer] wouldhave purchased the stock in an unmanipulated market.” Sarlie v. E.L. Bruce Co., 265 F. Supp. 371, 375(S.D.N.Y. 1967).

The inflation in price caused by the misrepresentation may be measured by the change in price after the releaseof corrective information. Goldberg v. Household Bank, F.S.B., 890 F.2d 965, 967 (7th Cir. 1989); Wool, 818F.2d at 1437; Blackie v. Barrack, 524 F.2d 891, 909 n.25 (9th Cir. 1975). The court may rely on other methodsof determining actual value on the date of purchase, including expert testimony on actual value derived fromcapitalization of earnings techniques or testimony of book value. In re Home Theater Sec. Litig., No. SA CV95 818 GLT EEX, 1997 WL 820968, at *3 (C.D. Cal. Sept. 2, 1997) (citing Blackie, 524 F.2d at 909 n.25).

Face-To-Face Misrepresentation. The out-of-pocket rule is not appropriate for a plaintiff who claims that the

defendant’s misrepresentations about a publicly traded security were made to the plaintiff personally, ratherthan to the public. In this situation, because the plaintiff paid the market, or, in other words, “fair” price, theplaintiff would recover little or nothing under the out-of-pocket rule. Silverberg v. Paine, Webber, Jackson &Curtis, Inc., 710 F.2d 678, 687 (11th Cir. 1983). Under such circumstances, the applicable measure of damageswill generally be a restitutionary measure.

b. Post-Reform Act Damage Calculations

The Reform Act modified the “traditional” out-of-pocket rule. One of the stated purposes of the Reform Actwas to provide statutory guidance regarding the calculation of damages in securities fraud cases. See S. Rep.104-98 at 19 (1995), reprinted in 1995 USCCAN 679, 698; In re Mego Fin. Corp. Sec. Litig., 213 F.3d 454, 461n.3 (9th Cir. 2000). The Reform Act attempts to address the uncertainty of damage calculations by adopting the90-day “look back” or “bounce back” period. This “bounce back” period seeks to limit damages to thoselosses caused by the defendant’s fraud and not by other market conditions. Therefore, damages under Section10(b) are limited to the difference between the price paid or received by the plaintiff and the mean trading priceduring the earlier of (1) the 90 days after a disclosure is made correcting the false statement in question, or (2)the date on which the plaintiff sells or repurchases the security. 15 U.S.C. § 78u-4(e). One reason for the90-day period was that Congress felt that “[c]alculating damages based on the date the corrective informationis disclosed may substantially overestimate plaintiff’s actual damages.” S. Rep. 104-98, at 20 (1995), reprintedin 1995 USCCAN 679, 699; see also Mego, 213 F.3d at 461.

1) Basic Effect

The Reform Act “essentially caps a plaintiff’s damages to those recoverable under the rescissory measure. Thus, if the mean trading price of a security during the 90-day period following the correction is greater thanthe price at which the plaintiff purchased his stock, the plaintiff would recover nothing under the PSLRA’slimitation on damages.” Mego, 213 F.3d at 461.

2) Effect On “Largest Financial Interest” Standard

At least one court has found that damage calculations under the Reform Act has no effect in determining whichplaintiff has the largest financial interest to qualify as the lead plaintiff. “[T]he determination of financialinterest does not equate to damages … [and the] lead plaintiff provision in the PSLRA does not use the term‘damages,’ but instead, ‘largest financial interest.’” In re Ribozyme Pharms., Inc. Sec. Litig., 192 F.R.D. 656,661-62 (D. Colo. 2000). The court considers factors such as “(1) the number of shares the movant purchasedduring the class period; (2) the total net funds expended by the plaintiffs during the class period; and (3) theapproximate losses suffered by the plaintiffs.” In re Peregrine Sys. Sec. Litig., No. 02cv870-J (RBB), 2002 WL32769239, at *4 (S.D.Cal. Oct. 11, 2002) (citation omitted). These factors look to “relatively objectiveindicators … rather than to the ultimate question of damages.” Id. (citation omitted).

c. Burden Of Proof

A plaintiff in a Rule 10b-5 cause of action has the burden of proving damages. Harmsen v. Smith, 693 F.2d932, 945 (9th Cir. 1982); Feldman v. Pioneer Petroleum, Inc., 813 F.2d 296, 302 (10th Cir. 1987); Pelletier v.Stuart-James Co., 863 F.2d 1550, 1558 (11th Cir. 1989).


Section 804 of the Sarbanes-Oxley Act of 2002, detailed below, amends the federal statute of limitationsapplicable to securities claims. Section 804 provides that the statute of limitations is the earlier of two yearsafter discovery of the facts constituting a violation of the securities laws or five years after such a violationoccurs. See Sarbanes-Oxley Act § 804(b). The Sarbanes-Oxley Act extends the statute of limitationsestablished by the 1991 Supreme Court decision in Lampf.

a. The Lampf Standard

In Lampf, the Supreme Court adopted a uniform federal statute of limitations for litigation instituted pursuant toSection 10(b) and Rule 10b-5. Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 354 (1991). Under the Lampf standard, Section 10(b) and Rule 10b-5 actions were required to be commenced within oneyear after discovery of the facts constituting the violation and, in no event, more than three years after theoccurrence of the violation. Id. Lampf resolved the split in the circuits as to whether a uniform federal statuteor applicable state laws should govern the limitations period for Section 10(b) and Rule 10b-5 claims. See,e.g., In re Data Access Sys. Sec. Litig., 843 F.2d 1537 (3d Cir. 1988) (en banc). The Lampf Court held thatstate borrowing principles should not apply where the claim asserted is implied under a statute which containsan express cause of action with its own time limitation. Id. at 359.

The Supreme Court in Lampf established a uniform federal limitations period in actions filed under section10(b), and applied the rule in Lampf itself and in all cases then pending under section 10(b). Congresspromptly responded to Lampf by passing section 27A of the Exchange Act, which became effective December19, 1991. 15 U.S.C. § 78aa-1 (section 27A). Through section 27A, Congress repudiated the Supreme Court’sdecision to apply Lampf retroactively. However, in Plaut v. Spendthrift Farm, Inc., 514 U.S. 211 (1995), theSupreme Court ruled that Section 27A(b), to the extent it requires federal courts to reopen final judgmentsentered before its enactment, violated the separation of powers doctrine. Accordingly, under Plaut, Section27A could not be applied to reinstate a claim where the disposition qualifies as a final judgment. Plaut, 514U.S. at 240.

b. Period Extended By Sarbanes-Oxley Act

Under the Sarbanes-Oxley Act, claims must be brought the earlier of two years after discovery of the factsconstituting such a violation or five years after such violation. Sarbanes-Oxley Act § 804(b). Section 804 ofthe Sarbanes-Oxley Act applies to claims of “fraud, manipulation, or contrivance in contravention of aregulatory requirement concerning the securities laws,” as defined in Section 3(a)(47) of the SecuritiesExchange Act of 1934. Id. But see In re Exxon Mobil Corp. Sec. Litig., 500 F.3d 189, 197 (3d Cir. 2007)(finding that Section 804 of the Sarbanes-Oxley Act does not extend the statute of limitations for claimsbrought under Section 14(a) as these claims do not require scienter and therefore do not involve “fraud, deceit,manipulation or contrivance”). Section 804 applies to all private rights of action brought on or after the date ofenactment, irrespective of when the alleged conduct occurred. The statute does not alter the law regardingwhen inquiry notice is triggered. See, e.g., In re Enter. Mortg. Acceptance Co., LLC, Sec. Litig., 295 F. Supp.2d 307, 311 (S.D.N.Y. 2003), aff’d, 391 F.3d 401 (2d Cir. 2004).

Section 804 amends a general statute of limitations that applies to all federal civil suits. See 28 U.S.C. § 1658(2002). This in effect replaces the prior statute of limitations announced in Lampf.

c. Concerns Raised By The Extended Limitations Period

Several problematic issues arose with the new statute of limitations period under Sarbanes-Oxley. First,although Sarbanes-Oxley clearly did not apply to pending claims, the answer as to whether the Act revivedtime-barred claims was less clear. The legislative history contains no evidence suggesting Congress intended to

revive time-barred claims. Almost all courts considering this issue decided that the extended limitations perioddid not apply retroactively. See Swack v. Credit Suisse First Boston, No. CIV. A. 02-11943-DPW, 2004 WL2203482, at *5 (D. Mass. Sept. 21, 2004) (collecting cases); Foss v. Bear, Stearns & Co., Inc., 394 F.3d 540,542 (7th Cir. 2005); In re Enterprise Mortgage Acceptance Co., LLC Sec. Litig., 391 F.3d 401 (2d Cir. 2004)(holding that Congress did not provide or intend for retroactive application of the Sarbanes-Oxley statute oflimitations); In re ADC Telecomm., Inc. Sec. Litig., 409 F.3d 974 (8th Cir. 2005); Tello v. Dean WitterReynolds, Inc., 410 F.3d 1275 (11th Cir. 2005); Livid Holdings Ltd. v. Salomon Smith Barney, Inc., 403 F.3d1050 (9th Cir. 2005); Lieberman v. Cambridge Partners, LLC, 432 F.3d 482 (3d Cir. 2005); Margolies v.Deason, 464 F.3d 547 (5th Cir. 2006); In re Polaroid Corp. Sec. Litig., 465 F. Supp. 2d 232, 243 (S.D.N.Y.2006) (holding that claims which expired before the passage of Sarbanes-Oxley cannot be revived); see also Inre Apple Computer, Inc., No. C 06-4128 JF, 2007 WL 4170566 (N.D. Cal. Nov. 19, 2007) (holding that the fiveyear statute of limitations under 28 U.S.C. §1658(b) begins to run on the date the option grant is made,therefore claims based on a combination of recent financial statements and time-barred options backdating,should be dismissed); In re Tyco Int’l, Ltd., No. 02-1335-B, 2007 WL 1703023, at *4 (D.N.H. June 11, 2007)(noting that the Sarbanes-Oxley Act does not revive expired claims). But see Roberts v. Dean Witter Reynolds,Inc., No. 8:02-CV-2115-T-26 (EAJ), 2003 WL 1936116, at *3-4 (M.D. Fla. Mar. 31, 2003) (relying onlegislative history to find intent to make the statute retroactive). As the Third Circuit has noted, “analyticallydistinct” from the issue decided by the above courts is the question whether claims that had accrued but not yetexpired were to be given the benefit of Section 804. Lieberman, 432 F.3d at 488. This remains undecided. Id.

Second, “while Section 804(b) applies only to proceedings ‘commenced on or after’ July 30, 2002, the issue ofwhat constitutes a new proceeding where plaintiff filed actions both before or after Sarbanes’ enactment” is stillunclear (In re Adelphia Commc’ns Corp. Sec. & Derivative Litig., No. 03 MD 1529 (LMM), 2005 WL1679540, *2 (S.D.N.Y. July 18, 2005)). In Adelphia, the court held that the extended Statute of Limitations didnot apply where a first action was filed before the enactment of Sarbanes-Oxley and a second duplicative actionwas filed after the date of enactment. Id. at *3. Addressing the same question, the court in Quaak v. Dexia, 357F. Supp. 2d 330, 334-36 (D. Mass. 2005), held that a consolidated complaint filed after the date of enactmentagainst a new defendant constituted a new “proceeding” within the meaning of Section 804(b).

Third, the Sarbanes-Oxley Act left open the question whether claims arising under Sections 11 and 12 of theSecurities Exchange Act of 1934 which “sound in fraud” but do not actually require proof of fraud will also besubject to the longer statute of limitations period. See, e.g., In re WorldCom, Inc. Sec. Litig., 294 F. Supp. 2d431, 440-44 (S.D.N.Y. 2003) (stating that because Sarbanes-Oxley only applies to claims involving fraud,deceit, manipulation or contrivance, the extended statute of limitations does not apply to Section 11 and 12(a)(2) claims which do not sound in fraud); Ato Ram, II, Ltd. V. SMC Multimedia Corp., No. 03 CIV. 5569 HB,2004 WL 744792, at *5 (S.D.N.Y. Apr. 7, 2004) (holding that Sarbanes-Oxley did not extend the statute oflimitations for Section 11 violations). But see Grippo v. Perazzo, 357 F.3d 1218, 1224 (11th Cir. 2004)(applying Lampf limitations period to both section 10(b) and section 12 claims); In re Enron Corp. Sec.,Derivative & ERISA Litig., 310 F. Supp. 2d 819, 844 (S.D. Tex. 2004) (stating that the extended statute oflimitations applies to Section 12(a)(2) claims).

d. “Inquiry Notice” v. “Discovery”

Prior to the Supreme Court’s 2010 decision in Merck v. Reynolds (see 4) below), most courts held that the one-year limitations period announced in Lampf and, presumably, the two-year statute of limitations in theSarbanes-Oxley Act, begins to run when the plaintiff has “inquiry notice” of the facts underlying the allegedclaims. Whirlpool Fin. Corp. v. GN Holdings, Inc., 67 F.3d 605 (7th Cir. 1995) (ruling that action is time-barred because information alleged to be necessary to uncover the fraud was publicly available more than oneyear prior to suit); Berry v. Valence Tech., Inc., 175 F.3d 699, 703 (9th Cir. 1999) (“Every circuit to haveaddressed the issue since Lampf has held that inquiry notice is the appropriate standard.”) (citing Sterlin v.Biomune Sys., 154 F.3d 1191, 1201 (10th Cir. 1998)). The Ninth Circuit affirmed the “inquiry notice” standardfor triggering the statute of limitations. Betz v. Trainer Wortham & Co., 504 F.3d 1017, 1024-1026 (9th Cir.2007) (noting that (a) when there is “sufficient suspicion of fraud to cause a reasonable investor to investigate

the matter further,” inquiry notice exists; and (b) where inquiry notice is found to exist, the court must then askwhether the plaintiff “exercised reasonable diligence in investigating the facts underlying the alleged fraud.”);accord Alaska Elec. Fund v. Pharmacia Corp., 554 F.3d 342, 347 (3rd Cir. 2009).

“A plaintiff in a federal securities case will be deemed to have discovered fraud for purposes of triggering thestatute of limitations when a reasonable investor of ordinary intelligence would have discovered the existenceof the fraud.” Dodds v. Cigna Sec., Inc., 12 F.3d 346, 350 (2d Cir. 1993); see also Rothman v. Gregor, 220F.3d 81, 96 (2d Cir. 2000) (“Discovery of facts for the purpose of this statute of limitations includesconstructive or inquiry notice, as well as actual notice.”) (internal quotation marks omitted). “Inquiry notice istriggered by evidence of the possibility of fraud, not full exposition of the scam itself.” Grippo v. Perazzo, 357F.3d 1218, 1244 (11th Cir. 2004) (quoting Theoharous v. Fong, 256 F.3d 1219, 1228 (11th Cir. 2001))(emphasis in original). “If the investor makes no inquiry once the duty arises, knowledge will be imputed as ofthe date the duty arose. However, if the investor makes some inquiry once the duty arises, [the court] willimpute knowledge of what an investor in the exercise of reasonable diligence should have discovered.” In reWorldCom, Inc. Sec. Litig., 294 F. Supp. 2d 431, 444 (S.D.N.Y. 2003) (citation omitted). Where the relevantinformation is under the exclusive control of the defendants and would not have been available to a potentialplaintiff without the aid of the legal process, the plaintiff cannot be found to have had inquiry notice of fraud. In re Motorola Sec. Litig., 505 F. Supp. 2d (N.D. Ill. 2007); see also In re Brocade Commc’ns Sys., Inc. Deriv.Litig., 616 F. Supp. 2d 1018, 1035-36 (N.D. Cal. 2009) (refusing to impute the knowledge of defendant officersand directors to the company for purposes of accrual because “it would create absurd results in that companieswould be limited in their ability to seek relief from the fraudulent misdeeds of their officers and directors, eventhough others within the company or the shareholders were reasonably unaware of what was occurring.”).

The circumstances giving rise to the duty to inquire are referred to as “storm warnings,” and must be triggeredby information that “relates directly to the misrepresentations and omissions” the plaintiffs allege against thedefendants. Levitt v. Bear Stearns & Co., 340 F.3d 94, 101 (2d Cir. 2003). Moreover, storm warnings mustindicate that defendants acted with scienter. Alaska Elec. Fund, 554 F.3d at 348 (“[F]or investors to be oninquiry notice of §10(b) claims, there must be some indication that defendants did not, in fact, hold the viewsexpressed.”). A plaintiff “is charged with knowledge of publicly available news articles and analysts’ reports,to the extent they constitute ‘storm warnings’ sufficient to trigger inquiry notice.” Adams v. Intralinks, Inc.,No. 03 CIV. 5384 (SAS), 2004 WL 1627313, at *5 (S.D.N.Y. July 20, 2004) (citation omitted); Mathews v.Kidder, Peabody & Co., Inc., 260 F.3d 239, 252 (3rd Cir. 2001) (plaintiffs are “presumed to have readprospectuses, quarterly reports, and other information relating to their investments.”). However, the EleventhCircuit has remarked that to qualify as putting plaintiffs on inquiry notice, national articles must be explicit;mere general skepticism expressed in a press article about corporate conduct is insufficient to trigger inquirynotice. There must be some reasonable nexus between the allegations made in the article and the nature of theactions subsequently brought. Tello v. Dean Witter Reynolds, Inc., 410 F.3d 1275, 1289-94 (11th Cir. 2005). The allegations need not be company-specific, however. “[W]hile company-specific information of the kindcontemplated in Lentell contemplates a storm warning, information that is not so company-specific may alsosuffice for a court to find that the circumstances would suggest to an investor of ordinary intelligence thatprobability that she has been defrauded.” Staehr v. Hartford Fin. Servs. Group, Inc., 460 F. Supp. 2d 329 (D.Conn. 2006) (citing Lentell v. Merrill Lynch & Co., 396 F.3d 161, 169 (2d Cir. 2005)); see also DeBenedictis v.Merrill Lynch & Co., 492 F.3d 209 (3d Cir. 2007) (finding inquiry notice from publications that were notcompany-specific).

These storm warnings do not necessarily dissipate in response to a defendant’s later reassuring statements. LCCapital Partners, LP v. Frontier Ins. Group, Inc., 318 F.3d 148 (2d Cir. 2003); see also In re Merck & Co., Inc.Sec., Derivative & “ERISA” Litig., 483 F. Supp. 2d 407, 421 (D.N.J. 2007) (after FDA warning letter andextensive media coverage put plaintiff on inquiry notice, company reassurances were unreliable). But seeBallard v. Tyco Int’l, Ltd., MDL No. 02-MD-1335-PB, Civil No. 04-CV-1336-PB, 2005 U.S. Dist. LEXIS14523, at *30 (D.N.H. July 11, 2005); In re Alcatel Sec. Litig., 82 F. Supp. 2d 513 (S.D.N.Y. 2005). In bothcases, the court held that defendant’s “persistent denial” or “words of comfort” mitigated storm warnings to thepoint where plaintiff’s claim was found not to be time barred. See also Lapin v. Goldman Sachs Group, Inc.,506 F. Supp. 2d 221 (S.D.N.Y. 2006) (finding plaintiff may not be considered to be on inquiry notice despite

existence of storm warnings when investors are “being fed reassuring statements” by management).

The determination of inquiry notice is fact-intensive. See, e.g., Alaska Elec. Fund, 554 F.3d at 350 (“Thetotality of the evidence in the public realm . . . did not indicate a possibility of fraud or even hint at anymalfeasance”); Staehr v. Hartford Fin. Servs. Group, Inc., 547 F.3d 406, 435 (9th Cir. 2008) (holding that filingsuit did not trigger inquiry notice where reasonable investor of ordinary intelligence would not have knownabout a lawsuit “filed in an unlikely venue . . . that received no publicity whatever” and did not result in apublished or “broadly disseminated” opinion during the relevant time period); In re Merck & Co., Inc. Sec.Deriv. & ERISA Litig., 543 F.3d 150 (3rd Cir. 2008) (appellate court reversed and remanded district court’sdismissal of plaintiffs’ claims, holding that investors were not necessarily put on inquiry notice by the variousarticles and press releases dealing with the safety and FDA approval of Vioxx); Benak v. Alliance CapitalMgmt., LP, 435 F.3d 396 (3d Cir. 2006) (holding mutual fund investors are held to a lower standard of inquirynotice because they may be unaware of where their investments are placed); La Grasta v. First Union Sec., Inc.,358 F.3d 840, 847, 850 (11th Cir. 2004) (holding that a decline in stock price alone is not enough to putinvestors on inquiry notice when stock had history of volatility); Caprin v. Simon Transp. Serv., Inc., 99 F.App’x 150, 156-57 (10th Cir. 2004) (stating that plaintiff was on inquiry notice of the company’s fraudulentactivity in light of the dramatic decline in stock price and press release projecting loss); Menowitz v. Brown, 991F.2d 36, 41-42 (2d Cir. 1993) (holding that inquiry notice was provided by SEC filings); Swack v. Credit SuisseFirst Boston, 383 F. Supp. 2d 223, 234-36 (D. Mass. 2004) (finding that extensive reports about conflicts ofinterest were not significant enough to trigger the limitations period until the facts were revealed in agovernment investigation); In re Dynegy, Inc. Sec. Litig., 339 F. Supp. 2d 804 (S.D. Tex. 2004). But seeNewman v. Warnaco Group, Inc., 335 F.3d 187 (2d Cir. 2003) (holding that SEC filing of restated earnings didnot put the plaintiffs on inquiry notice because the report attributed the restatement to a “benign” accountingchange and failed to disclose the presence of serious inventory problems); Domenikos v. Roth, No. 05-CV-2080, 2007 WL 221418, at *3 (S.D.N.Y. Jan. 26, 2006) (holding that the similarity of the allegations in anotherclass action case against the same defendants and the proximity of the time periods at issue were sufficient toput the plaintiffs on inquiry notice); Shah v. Stanley, No. 03 CIV. 8761 (RJH), 2004 WL 2346716, at *9-13(S.D.N.Y. Oct. 19, 2004), aff’d, 435 F.3d 244 (2d Cir. 2006) (finding that suit was time barred because aninvestor in a security firm had inquiry notice about conflicts of interest when articles critical of the securityfirm’s practices were published); In re WorldCom, Inc. Sec. Litig., 294 F. Supp. 2d 431 (S.D.N.Y. 2003)(finding that SEC subpoena by itself does not trigger inquiry notice); In re Tyson Foods Consol. S’holder Litig.,919 A.2d 563, 591 (Del. Ch. 2007) (holding even though proxy statements contained the grant date and optionsprice of “spring-loaded” options, investors were not on inquiry notice because investors’ duty to exercisereasonable diligence does not include an obligation to sift through a proxy statement).

In 2010, the Supreme Court clarified the meaning of “discovery” for purposes of applying Section 10(b)’sstatute of limitations. Merck & Co., Inc. v. Reynolds, 130 S.Ct. 1784. The district court had held that acomplaint was time-barred because plaintiffs were on “inquiry notice” no later than 2001 that patients takingMerck’s pharmaceutical Vioxx had a higher incidence of heart attacks than patients taking naproxen. At thattime, Merck claimed the difference was due to the positive effect of naproxen in reducing heart attacks, not anynegative effect of Vioxx. The Third Circuit reversed, holding that the “storm warnings” in 2001 did not suggestMerck knew that its naproxen explanation was false so as to put plaintiffs on inquiry notice. The SupremeCourt affirmed. Noting the circuit split on when “discovery” occurs, the Court rejected the use of an “inquirynotice” standard because the point at which a reasonable investigation would begin is not necessarily the sameas the point at which “the facts constituting the violation” would be discovered. Accordingly, the Court heldthat the statute begins to run only when a plaintiff actually discovers, or when a reasonably diligent plaintiffwould have discovered, the “facts constituting the violation,” including the requisite element of scienter.

e. Equitable Tolling

Under Lampf, the one-year/three-year limitations period was not subject to the doctrine of equitable tolling. The one-year period began after discovery of the facts constituting the violation, which made tollingunnecessary, and the three-year limit was a period of repose that is inconsistent with tolling. Lampf, Pleva,

Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350 (1991). However, courts in Ballard and Wyser-PratteManagement Co., Inc. v. Telxon Corp., 413 F.3d 553 (6th Cir. 2005) held that the legal tolling of the statute ofrepose period while a class action is pending was permissible under Section 10(b). In Wyser-Pratte, the SixthCircuit held that class action tolling did not apply to a defendant not named in the class action complaint. 413F.3d at 566-69. A plaintiff who chooses to file an independent action without waiting for a determination onthe class certification issue may not rely on the American Pipe tolling doctrine.

There may be equitable tolling under the Sarbanes-Oxley Act under exceptional circumstances. See In reParmalat Sec. Litig., 493 F. Supp. 2d 723, 730 (S.D.N.Y. 2007). But see In re Mercury Interactive Corp. Sec.Litig., No. C 05-3395 JF, 2007 WL 2209278, at *5 (N.D. Cal. July 30, 2007) (“The five-year period of repose isnot subject to tolling.”); In re Ditech Networks, Inc. Derivative Litig., No. 06-5157, 2007 WL 2070300, at *8(N.D. Cal. July 17, 2007) (noting skepticism of a continuing wrong theory that would revive a time-barredclaim based on the filing of a subsequent financial statement that failed to correct a prior statement). The courtin Parmalat applied the two-year extended statute of limitations under the Sarbanes-Oxley Act to the plaintiffs’fraud claims. Id. at 730. To invoke equitable tolling, a plaintiff must show that “(1) it has pursued its rightsdiligently and (2) some extraordinary circumstance stood in its way.” Id. (citing Pace v. DiGuglielmo, 544 U.S.408, 418 (2005)). Because a court order prevented the plaintiffs in Parmalat from pursuing relief, the courtheld that the statute of limitations was equitably tolled. Id. at 731-32.

B. Section 11 Of The 1933 Act

Section 11(a) of the Securities Act of 1933, 15 U.S.C. § 7k, provides that:

In case any part of the registration statement, when such part became effective, contained anuntrue statement of a material fact or omitted to state a material fact required to be statedtherein or necessary to make the statements therein not misleading, any person acquiringsuch security (unless it is proven that at the time of such acquisition he knew of such untruthor omission) may, either at law or in equity, in any court of competent jurisdiction, sue[designated persons connected with the registration statement].


a. Liability Limited To Registration Statement Or Prospectus

The scope of liability under Section 11 applies to alleged misstatements contained in prospectuses orregistration statements. Aftermarket statements, which include “roadshow” presentations, analyst reports, andstatements to institutional investors during conference calls, are generally outside the reach of Section 11. In reStac Elecs. Sec. Litig., 89 F.3d 1399, 1405 (9th Cir. 1996); Castlerock Mgmt., Ltd. v. Ultralife Batteries, Inc.,68 F. Supp. 2d 480, 484 (D.N.J. 1999); see also In re Levi Strauss & Co. Sec. Litig., 527 F. Supp. 2d 965 (N.D.Cal 2007) (noting that since plaintiffs must establish that they purchased shares “either (1) directly in the publicoffering for which the misleading registration statement was filed or (2) traceable to that public offering,”Section 11 liability is not available for Rule 144A private offerings.).

b. Material Misstatement Or Omission

To state a claim under Section 11, the registration statement must contain a misrepresentation of material fact oromit either a fact required by law to be included or a fact necessary to make statements contained in theregistration statement not misleading. 15 U.S.C. § 77k. The alleged misstatement must be false or misleadingas of the date the registration statement becomes effective. Id.

1) Materiality

A plaintiff must allege and prove that the alleged misstatement was of a material fact. Herman & McLean v.Huddleston, 459 U.S. 375, 382 (1983) (“If a plaintiff purchased a security issued pursuant to a registrationstatement, he need only show a material misstatement or omission to establish his prima facie case”). TheSecurities and Exchange Commission has defined the term “material” as “those matters to which there is asubstantial likelihood that a reasonable investor would attach importance in determining whether to purchasethe security registered.” 17 C.F.R. § 230.405; see Sedighim v. Donaldson, Lufkin & Jenrette, Inc., 167 F. Supp.2d 639, 647 (S.D.N.Y. 2001). The same standard for materiality applies to both Section 10(b) and Section 11claims. See In re Global Crossing, Ltd. Sec. Litig., 322 F. Supp. 2d 319, 348 (S.D.N.Y. 2004) (citing Kronfeldv. Trans World Airlines, Inc., 832 F.2d 726, 731 (2d Cir. 1987)).

Materiality is a mixed question of law and fact. Therefore, it is “ordinarily an issue left to the factfinder and …not typically a matter for Rule 12(b)(6) dismissal.” In re Adams Golf, Inc. Sec. Litig., 381 F.3d 267, 274 (3dCir. 2004). To determine whether a misstatement is material, courts consider the certainty of the information,its availability in the public domain, and the need for the information in light of cautionary statements beingmade. Klein v. Gen. Nutrition Co., 186 F.3d 338, 342 (3d Cir. 1999). Even if a material fact is disclosed,“where the method of presentation obscures or distorts the significance of material facts, a violation of Section11 will be found.” Greenapple v. Detroit Edison Co., 618 F.2d 198, 205 (2d Cir. 1980).

When assessing whether an alleged misstatement or omission is material, a court may not employ hindsight. Instead, a court must consider whether the omission was material on the date the registration statement wasissued. In re Unicapital Corp. Sec. Litig., 149 F. Supp. 2d 1353, 1363 (S.D. Fla. 2001). If the allegedomissions are so obviously unimportant to investors that reasonable minds could not differ on the question ofmateriality, then the court may rule such omissions immaterial as a matter of law. Klein v. Gen. Nutrition Co.,186 F.3d 338, 342-343 (3d Cir. 1999); In re Livent, Inc. Noteholders Sec. Litig., 151 F. Supp. 2d 371, 408(S.D.N.Y. 2001). Cf. Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 166 (2d Cir. 1980) (noting that informationmust be “reasonably certain to have a substantial effect on the market price of the security”).

2) Misrepresentation Or Omission

The complaint must set forth a misrepresentation of an existing material fact or an omission of an existingmaterial fact necessary in order to make the statements not misleading. See In re Int’l Business Machines Corp.Sec. Litig., 163 F.3d 102, 106-07 (2d Cir. 1998); In re Westinghouse Sec. Litig., 90 F.3d 696 (3d Cir. 1996); Inre Trump Casino Sec. Litig., 7 F.3d 357 (3d Cir. 1993). Courts should evaluate an alleged misrepresentation oromission in the complete context in which it was conveyed. See I. Meyer Pincus & Assocs. v. Oppenheimer &Co. Inc., 936 F.2d 759, 763 (2d Cir. 1991). For instance, a particular misrepresentation or omission that issignificant to a reasonable investor in one document or circumstance may not influence a reasonable investor inanother. Trump, 7 F.3d at 369.

Section 11 does not impose liability for the mere omission of a material fact unless that fact is either required bylaw to be included in the registration statement or must be included in order to make other facts included in thestatement not misleading. See, e.g., In re SeaChange Intern., Inc., No. CIV. A. 02-12116-DPW, 2004 WL240317, at *8 (D. Mass. Feb. 6, 2004) (“While a company that chooses to reveal material information, eventhough it had no duty to do so, ‘must disclose the whole truth,’ it need not disclose everything it knows; rather,the company is required only to make additional disclosures to keep the information from being materiallymisleading.”) (quotation omitted); In re Adams Golf, Inc. Sec. Litig., 381 F.3d 267, 279 (3d Cir. 2004) (statingthat defendants had no duty to disclose general industry-wide trends easily discernible from available publicinformation); Parnes v. Gateway 2000, Inc., 122 F.3d 539, 546 (8th Cir. 1997) (holding that a failure to discloseinformation in the public domain is immaterial and does not amount to securities fraud); Cooperman v.Individual, Inc., 171 F.3d 43, 49 (1st Cir. 1999) (“The mere possession of material non-public information does

not create a duty [under Section 11] to disclose it.”).

3) Statements That “Bespeak Caution”

“Certain alleged misrepresentations in a stock offering are immaterial as a matter of law because it cannot besaid that any reasonable investor would consider them important in light of adequate cautionary language setout in the same offering.” In re Globalstar Sec. Litig., No. 01 CIV. 1748 (SHS), 2003 WL 22953163, at *10(S.D.N.Y. Dec. 15, 2003) (quoting Halperin v. ebanker USA.com, Inc., 295 F.3d 352, 357 (2d Cir. 2002), aff’d,40 F. App’x 624 (2d Cir. 2002); additionally, the Reform Act’s safe harbor provision applies to a defendant’sprospectus. Id. at *10). Thus, a registration statement or prospectus will be found to “bespeak caution” when itis “balanced by extensive cautionary language” which is prominent and specific and which “warn[s] investorsof exactly the risk plaintiffs claim was not disclosed.” Globalstar, 2003 WL 22953163, at *10 (citationomitted). However, defendants cannot seek protection of the doctrine if they fail to disclose a currently existingfact critical to appreciating the magnitude of the risks described. Id. at *11.

There is Second Circuit precedent stating that the “bespeaks caution” doctrine applies only to “forward-looking,prospective” representations or omissions. Rubin v. MF Global, Ltd., 634 F. Supp. 2d 459, 467 (S.D.N.Y.,2009) (citing P. Stolz Family P’ship L.P. v. Daum, 355 F.3d 92, 96-97 (2d. Cir. 2004); Heller v. GoldinRestructuring Fund, L.P., 590 F. Supp. 2d 603, 617 (S.D.N.Y. 2008); Scantek Med., Inc. v. Sabella, 583 F.Supp. 2d 477, 496 (S.D.N.Y. 2008). However, the Rubin court cautioned that plaintiffs could not “evadeapplication of the ‘bespeaks caution’ doctrine through pleading that fixates on present or historical facts” whenplaintiff’s claims really amounted to an allegation regarding current facts. Rubin, 634 F. Supp. 2d at 472(emphasis added).

c. Plaintiff’s Standing To Assert Claim

To possess standing, a plaintiff must allege and prove the purchase of a security that was issued pursuant to thespecific registration statement containing an alleged material misstatement. Herman & MacLean v.Huddleston, 459 U.S. 375, 381-82 (1983); Hertzberg v. Dignity Partners, Inc., 191 F.3d 1076, 1079 (9th Cir.1999). Section 11 does not apply to previously traded shares or shares that a plaintiff merely alleges were likelyissued during the questioned offering. See, e.g., Kirkwood v. Taylor, 590 F. Supp. 1375, 1378-83 (D. Minn.1984), aff’d, 760 F.2d 272 (8th Cir. 1985). In the context of a merger, Section 11 standing is not limited tothose shareholders eligible to vote on the merger, but extends to all shareholders who acquired shares throughthe merger. In re Cendant Corp. Litig., 60 F. Supp. 2d 354, 365 (D.N.J. 1999). However, as detailed below, asplit of authority exists on the issue of aftermarket purchasers.

1) Split Authority Over “Tracing”

Tracing Prohibited. The Supreme Court has acknowledged in dicta that Section 11 claims are limited topurchasers who bought their shares in the allegedly defective offering itself. Gustafson v. Alloyd Co. Inc., 513U.S. 561, 571-72 (1995). Many courts have followed the reasoning of Gustafson and held that a plaintiff’sability to “trace” his purchase back to the defective offering is insufficient to bring a claim under Section 11. Only investors who purchased shares in a public offering have standing to sue. See, e.g., Brosious v. Children’sPlace Retail Stores, 189 F.R.D. 138, 144 (D.N.J. 1999); Lilley v. Charren, 936 F. Supp. 708, 715-16 (N.D. Cal1996) (stating that shares purchased in the secondary market, even if those shares were registered and first soldin an offering, may not form the basis for liability under Section 11); Stack v. Lobo, 903 F. Supp. 1361, 1375-76(N.D. Cal. 1995) (“Although Gustafson only addressed the applicability of Section 12(2) to secondarytransactions, it applies with equal force to Section 11”).

Tracing Permitted. A recent trend in Section 11 cases permits aftermarket purchasers to trace back to thedefective offering. Most courts that have expressly considered the issue have reasoned that the SupremeCourt’s holding in Gustafson is limited to Section 12(a)(2) claims, or that Gustafson’s holding did not directlyaddress “traceability” at all. “Tracing may be established either through proof of a direct chain of title from theoriginal offering to the ultimate owner ... or through proof that the owner bought her shares in a marketcontaining only shares issued pursuant to the allegedly defective registration statement.” In re Initial Pub.Offering Sec. Litig., 227 F.R.D. 65, 117-18 (S.D.N.Y. 2004) (citation omitted). However, tracing is difficult toprove. “Even where the open market is predominantly or overwhelmingly composed of registered shares,plaintiffs are not entitled to a presumption of traceability.” Id.

The Second, Fifth, Eighth, Ninth, and Tenth Circuits are the only circuits that have addressed the standing ofaftermarket purchasers under Section 11. Both Joseph v. Wiles, 223 F.3d 1155 (10th Cir. 2000) and Hertzbergv. Dignity Partners, Inc., 191 F.3d 1076, 1080 (9th Cir. 1999) hold that anyone purchasing a security issued ortraceable to a false or misleading registration statement has standing, “regardless of whether he bought in theinitial offering, a week later, or a month after that.” Hertzberg, 191 F.3d at 1080. The Eighth Circuit in Lee v.Ernst & Young, LLP held that plaintiffs who are “aftermarket purchasers” can establish standing by tracing. 294 F.3d 969, 974-75 (8th Cir. 2002) (citing both Joseph and Hertzberg). The Fifth Circuit held in Krim v.pcOrder.com, Inc, 402 F.3d 489, 495 (5th Cir. 2005), that “there is no reason to categorically excludeaftermarket purchasers, so long as the security was indeed issued under that registration statement and notanother.” The Second Circuit held in DeMaria v. Andersen, 318 F.3d 170 (2d Cir. 2003), that aftermarketpurchasers who can trace their shares to an allegedly misleading registration statement have standing to sue. Id.at 178. Although the district courts remain divided, many allow tracing to establish Section 11 standing. See,e.g. Danis v. USN Commc’ns, Inc., 73 F. Supp. 2d 923, 931 (N.D. Ill. 1999) (citing Hertzberg); Cooperman v.Individual, Inc., No. CIV. A. 96-12272-DPW, 1998 WL 953726 (D. Mass. May 27, 1998), aff’d, 171 F.3d 43(1st Cir. 1999) (acknowledging that district courts “have split” on the issue of Section 11 standing by allowing“tracing” to an IPO).

2) No Privity Requirement

A plaintiff need not allege that he was in privity with the defendant in order to state a Section 11 claim. Hertzberg v. Dignity Partners, Inc., 191 F.3d 1076, 1081 (9th Cir. 1999) (distinguishing Section 11 claims fromSection 12 claims, in which privity is required).

d. Limited Class Of Defendants

In addition to the issuer, Section 11(a) limits the class of persons who may be sued under Section 11 to thefollowing:

1) every person who signed the registration statement;

2) every person who was a director, or person performing a similar function, or partner in the issuer at thetime of the filing of the part of the registration statement with respect to which his liability is asserted;

3) every person who, with his consent, is named in the registration statement as being or about to become adirector, person performing similar functions, or partner;

4) every accountant, engineer, or appraiser, or any person whose profession gives authority to a statementmade by him, who has with his consent been named as having prepared or certified any part of theregistration statement, or as having prepared or certified any report or valuation which is used inconnection with the registration statement, with respect to the statement in such registration statement,report or valuation, which purports to have been prepared or certified by him;

5) every underwriter with respect to such security.

e. Reliance

Ordinarily, a plaintiff need not allege reliance on the alleged misrepresentation or omission to state a claimunder Section 11. Metz v. United Counties Bancorp, 61 F. Supp. 2d 364, 377 (D.N.J. 1999). However, Section11(a) requires a showing of actual, not presumed, reliance if the stock was purchased after the issuance of atwelve-month earnings statement. Section 11(a) provides that, if plaintiff “acquired the security after the issuerhas made generally available to its security holders an earning statement covering a period of at least twelvemonths beginning after the effective date of the registration statement, then the right of recovery under thissubsection shall be conditioned on proof that such person acquired the security relying upon such untruestatement in the registration statement or relying upon the registration statement and not knowing of suchomission, but such reliance may be established without proof of the reading of the registration statement bysuch person.” 15 U.S.C. § 77k(a). The reliance requirement may be satisfied by an allegation of indirectreliance. Rudnick v. Franchard Corp., 237 F. Supp. 871, 873 (S.D.N.Y. 1965). Additionally, in a case whereinvestors bound themselves to an investment before the filing of a registration statement (though one wouldeventually be filed), the 11th Circuit held that it would be illogical to allow the investors the Section 11presumption of reliance, as they would be relying on a document that did not exist at the time they made theirinvestment. APA Excelsior III L.P. v. Premiere Techs., 476 F.3d 1261, 1273 (11th Cir. 2007).

f. Causation

Causation is not an essential element of a prima facie case under Section 11. However, the absence of losscausation is an affirmative defense to a Section 11 claim. See 15 U.S.C. §77k(e); In re Adams Golf, Inc. Sec.Litig., 381 F.3d 267, 277 (3d Cir. 2004); Miller v. Apropos Tech., Inc., No. 01 C 8406, 2003 WL 1733558, at *8(N.D.Ill. Mar. 31, 2003); In re Worlds of Wonder Sec. Litig., 814 F. Supp. 850, 866-67 (N.D. Cal. 1993)(reasoning that securities declined in value due to market forces and not because defendant’s financialstatements may have been in error), aff’d in relevant part, 35 F.3d 1407 (9th Cir. 1994).

g. Statute Of Limitations

The Sarbanes-Oxley Act left open the question whether Section 11 claims that “sound in fraud” will be subjectto the longer statute of limitations period. Section 804 of Sarbanes-Oxley lengthened the statute of limitationsfor private causes of action alleging securities fraud. SEE 28 U.S.C. § 1658 (“Section 804”). In In re GlobalCrossing, Ltd. Sec. Litig., 313 F. Supp. 2d 189 (S.D.N.Y. 2003), the court held that a Section 11 cause of actionbased on negligence is not a claim for “fraud, deceit, manipulation, or contrivance,” thus not subject to theextended statute of limitations. 313 F. Supp. 2d at 196-97. In In re WorldCom, Inc. Sec. Litig., the court alsostated that the extended statute of limitations does not apply to Section 11 and 12(a)(2) claims because they donot sound in fraud. 294 F. Supp. 2d 431, 440-44 (S.D.N.Y. 2003). In WorldCom, the plaintiffs tried to seekclarification on whether Section 804 can ever apply to Section 11 or 12(a)(2) claims, but the court refused torender an advisory opinion on this issue. 308 F. Supp. 2d at 233; see also Lawrence E. Jaffe Pension Plan v.Household Int’l, Inc., No. 02 C5 893, 2004 WL 574665, at *13 (N.D. Ill. Mar. 22, 2004) (holding that theextended statute of limitations under the Sarbanes-Oxley Act does not apply to Section 11 claims).

2. Defenses To Liability Under Section 11

a. Plaintiff’s Knowledge

Recovery is not permitted under Section 11 if, at the time of the challenged security transaction, plaintiff knewthe true facts concerning the alleged misrepresentation or omission. 15 U.S.C. § 77k(a).

b. Due Diligence Defense

With the exception of the issuer, defendants may avoid Section 11 liability by demonstrating that they actedreasonably in connection with the portions of the registration statement for which they were responsible. Thisdefense is known as the “due diligence defense.” 15 U.S.C. § 77k(b); Weinberger v. Jackson, No. C-89-2301-CAL, 1990 WL 260676 (N.D. Cal. Oct. 11, 1990); In re Software Toolworks, Inc. Sec. Litig., 789 F. Supp. 1489(N.D. Cal. 1992), aff’d in part, rev’d in part, 38 F.3d 1078 (9th Cir. 1994); Glassman v. Computervision Corp.,90 F.3d 617, 626-28 (1st Cir. 1996); In re Initial Pub. Offering Sec. Litig., 241 F. Supp. 2d 281 (S.D.N.Y.2003). The due diligence defense is discussed in further detail below.

c. Reliance On Counsel Defense

Reliance on counsel can constitute due diligence under circumstances where counsel has properly “expertised”a portion of an offering document or where a client has delegated due diligence to his counsel who hassuccessfully carried it out. Moreover, in some circumstances, reliance on counsel can also constitute anindependent defense to charges of securities fraud. The scope of this independent defense is not well defined.

d. The Good Faith Or Due Care Defense

The defense of reliance on counsel is known as the good faith or due care defense and can negate the elementsof scienter and negligence, respectively. Draney v. Wilson, Morton, Assaf & McElligott, 592 F. Supp. 9, 11 (D.Ariz. 1984).

A defendant must show that it: (1) made a complete disclosure to counsel; (2) requested advice as to legality ofthe contemplated action; (3) received advice that the action would be legal; and (4) relied in good faith on thatadvice. Id.; S.E.C. v. Savoy Indus., Inc., 665 F.2d 1310, 1314 n.28 (D.C. Cir. 1981).

Reliance as to factual matters does not sustain the defense. See Escott v. BarChris Constr. Corp., 283 F. Supp.643, 697 (S.D.N.Y. 1968). Indeed, inappropriate reliance on counsel in nonlegal matters can negate thedefense as to legal matters. Draney, 592 F. Supp. at 11 (holding that reliance on counsel regarding economicfeasibility destroyed counsel’s independent judgment where counsel was to be paid a percentage of theproceeds).

In any event, reliance on counsel’s advice that disclosures in an offering document are complete and legallysufficient is insufficient to sustain a due diligence defense. To hold otherwise would tacitly permit the“expertising” of the entire offering document, a concept rejected in BarChris. Reliance on counsel, however,can be treated as a component of a due diligence defense. Longstreth, Reliance on Counsel as a Defense toSecurities Laws Violations, 37 Bus. Law. 1185, 1193 (1982); see also Feit v. Leasco Data Processing Corp.,332 F. Supp. 544, 582-83 (E.D.N.Y. 1971). See generally Hawes & Sherrard, Reliance on Advice of Counsel asa Defense in Corporate and Securities Cases, 62 Va. L. Rev. 1, 110-23 (1976).

The reliance on counsel defense also impacts the availability of the attorney-client privilege, which may be heldto have been waived as to the advice relied upon and other advice on the same subject matter. See Apex Mun.Fund v. N-Group Sec., 841 F. Supp. 1423, 1431 (S.D. Tex. 1993).

e. “Negative Causation” Defense

Damages may be reduced if the defendant proves that any portion “represents other than the depreciation invalue of such security resulting from [the allegedly untrue] part of the registration statement, with respect towhich his liability is asserted.” 15 U.S.C. § 77k(e); Goldkrantz v. Griffin, No. 97 CIV. 9075 (DLC), 1999 WL

191540, at *3 (S.D.N.Y. Apr. 6, 1999), aff’d, 201 F.3d 431 (2d Cir. 1999); Beecher v. Able, 435 F. Supp. 397,407 (S.D.N.Y. 1975) (holding that a decline in market price resulting from general economic problems cannotbe charged to defendants).

In In re Metropolitan Sec. Litig., 2010 U.S. Dist. LEXIS 4209 (E.D. Wash. Jan. 20, 2010), the court held in acase against accounting firms that the standards governing loss causation under Section 10(b) are equallyapplicable to the defense of negative causation under Section 11.

If a plaintiff establishes a prima facie case under Section 11, causation is presumed and, pursuant to Section11(e), defendants have the burden to show that “other factors” caused the decline in the value of the stock forwhich plaintiff seeks to recover. See In re Adams Golf, Inc. Sec. Litig., 381 F.3d 267, 277 (3d Cir. 2004)(“While a defendant may be able to prove this ‘negative causation’ theory, an affirmative defense may not beused to dismiss a plaintiff’s complaint under Rule 12(b)(6).”); In re Worlds of Wonder Sec. Litig., 35 F.3d 1407,1421-23 (9th Cir. 1994) (characterizing the defendant’s burden to prove its loss causation defense as a “heavyburden” and reversing the district court’s grant of summary judgment in favor of accountants). In Akerman v.Oryx Commc’ns, Inc., 810 F.2d 336 (2d Cir. 1987), the court held that a Section 11 defendant was not liable forthe price decline prior to disclosure of errors in the registration statement. Regarding the post-disclosure pricedecline, the court held that defendants met their “negative causation” burden because (1) the misstatement was“barely material” and (2) ”the public failed to react adversely” to the disclosure. Id. at 343; see also Collins v.Signetics Corp., 605 F.2d 110, 114-16 (3d Cir. 1979) (allowing the defendants to establish negative causationdefense through expert testimony regarding economic and political factors that affected price decline),overruled in part on other grounds in In re Craftmatic Sec. Litig., 890 F.2d 628, 635-36 (3d Cir. 1989);McMahan & Co. v. Wherehouse Ent’mt, Inc., 65 F.3d 1044, 1048 (2d Cir. 1995) (ordering the district court, onremand, to allow defendants the opportunity to prove negative causation); In re Executive Telecard, Ltd. Sec.Litig., 979 F. Supp. 1021, 1025 (S.D.N.Y. 1997) (stating that negative causation principles of Section 11 requireelimination of the portion of the price decline resulting from forces unrelated to the wrong).

The defendant’s burden is not “insurmountable” and summary judgment has been granted in appropriate cases. In re Fortune Sys. Sec. Litig., 680 F. Supp. 1360, 1364 (N.D. Cal. 1987); see also Madden v. Deloitte &Touche, 118 F. App’x 150 (9th Cir. 2004) (affirming district court’s grant of summary judgment on plaintiffs’Section 11 claim because undisputed expert testimony established no loss causation); Ross v. Warner, No. 77CIV. 243 (CHT), 1980 U.S. Dist. LEXIS 15622, at *26 (S.D.N.Y. Dec. 12, 1980) (finding summary judgmenton Section 11 claims appropriate in “light of the minimal materiality of [defendant’s] nondisclosure and themarket’s failure to react in any discernible way to the revelations”).

In Hildes v. Arthur Andersen, 2010 U.S. Dist. LEXIS 72086 (S.D. Cal. July 19, 2010), the court granted amotion to dismiss, holding that the negative causation defense barred a Section 11 claim as a matter of lawbecause plaintiff had entered into a binding commitment to exchange stock in a merger before the falsestatement was made in a prospectus.

3. Damages Under Section 11

Section 11(e) limits the damages available to a plaintiff.

a. Measure Of Damages

Damages “shall represent the difference between the amount paid for the security (not exceeding the price atwhich the security was offered to the public) and (1) the value thereof as of the time such suit was brought, or(2) the price at which such security shall have been disposed of in the market before suit, or (3) the price atwhich such security shall have been disposed of after suit but before judgment” if less than the differencebetween the purchase price and the value of the security at the time of suit. 15 U.S.C. § 77k(e). This list ofdamage theories is exclusive and precludes recovery on other theories. McMahan & Co. v. Wherehouse Ent’mt,

Inc., 65 F.3d 1044, 1048 (2d Cir. 1995); Goldkrantz v. Griffin, No. 97 CIV. 9075 (DLC), 1999 WL 191540, at*3 (S.D.N.Y. Apr. 6, 1999).

If a plaintiff disposes of a security at a greater price than the offering price, the plaintiff cannot recoverdamages. Securities Release No. 33-45, 11 F.R. 10947 (1933), reprinted in 1 Fed. Sec. L. Rep. (CCH) ¶ 4655,at 4089 (1982); see Metz v. United Counties Bancorp, 61 F. Supp. 2d 364, 377-78 (D.N.J. 1999); Grossman v.Waste Mgmt., Inc., 589 F. Supp. 395, 415-17 (N.D. Ill. 1984).

If a plaintiff holds her shares, the price of the shares goes up after the suit is filed, and the plaintiff disposes ofthe shares at the higher price, the defendant gets the benefit of the increase in value after the suit was filed. However, if the market price of the shares goes down, and the plaintiff disposes of the shares after the suit wasfiled, the plaintiff still only receives the difference between the purchase price and the value of the shares at thetime the suit was filed. A defendant is thereby unaffected by post-suit sales in a falling market and benefitsfrom post-suit sales in a rising market. Thus, a plaintiff who wants to ensure being made whole should not holdonto the security after filing suit. L. Loss, Fundamentals of Security Regulations 1039 (1983).

15 U.S.C. § 77k(g) limits the amount a plaintiff may recover to “the price at which the security was offered tothe public.” This provision primarily applies to those plaintiffs who purchased shares in the open market ratherthan in the course of the distribution. Loss, supra, at 1039. In Grossman, Faber & Miller, P.A. v. CableFunding Corp., No. 4720, 1974 WL 470, at *11 (D. Del. Dec. 16, 1974), the court held that, when a plaintiffstates a claim under Section 11, damages are limited by the provisions of Section 11, even though hisallegations also state a claim under Section 12. However, the court noted that, when liability is premised on theadditional element of intentional deception, or its legal equivalent under Section 10(b), “there would appear tobe no reason to restrict a plaintiff’s recovery to the limitations of Section 11.” Id.; accord McMahan & Co. v.Wherehouse Ent’mt, Inc., 65 F.3d 1044 (2d Cir. 1995) (stating that while damages under the Securities Act areexpressly limited and therefore preclude benefit of the bargain damages under Section 11, plaintiffs couldrecover those damages under the Securities Exchange Act).

Where multiple Section 11 actions are brought with respect to the same set of facts, the filing date of the firstaction should control as the date for measuring the value of the securities under Section 11(e). This rulediscourages date-shopping in future cases and limits multiplicity of identical suits. Beecher v. Able, 435 F.Supp. 397, 402 (S.D.N.Y. 1975).

Courts look at the “value” of the security at the time suit is brought. In re AFC Enters., Inc. Sec. Litig., No.1:03-CV-817-TWT, 2004 U.S. Dist. LEXIS 26088, at *1380 (N.D. Ga. Dec. 28, 2004) (holding that anamended complaint containing the initial assertions of a Section 11 claim “relates back” to the originalcomplaint for the purpose of determining the date by which Section 11 damages are measured). Section 11(e)uses “value” and not “market price.” Id. In Beecher, the court stated that the realistic value of a security maybe something other than the market price where the public is either misinformed or uninformed about importantfactors relating to the issuer’s well-being. The court in Beecher added 9 1/2 points to the market price as ameasure of the “fair value.” 435 F. Supp. at 406; see also Goldkrantz v. Griffin, No. 97 CIV. 9075 (DLC), 1999WL 191540, at *3 (S.D.N.Y. Apr. 6, 1999), aff’d, 201 F.3d 431 (2d Cir. 1999) (stating that, although stockprice is the “usual starting point” for determining value under Section 11(e), the presence or absence of stockprice movement immediately after disclosure is not per se dispositive under Section 11(e)). However, adistinction between the market price and the value of a security is “an unusual and rare situation.” In reFortune Sys. Sec. Litig., 680 F. Supp. 1360, 1370 (N.D. Cal. 1987).

b. Underwriter’s Liability Limited

An underwriter defendant can be liable only to the extent of “the total price at which the securities underwrittenby him and distributed to the public were offered to the public,” unless the underwriter received a special,disproportionate benefit from the offering beyond that received by other underwriters. 15 U.S.C. § 77k(e); see,e.g., In re Itel Sec. Litig., 89 F.R.D. 104, 111 (N.D. Cal. 1981); In re Gap Stores Sec. Litig., 79 F.R.D. 283

(N.D. Cal. 1978); see also Special Situations Fund, III, L.P. v. Cocchiola, Civ. No. 02-3099 (WHW), 2007 WL2261557, at *10 (D.N.J. Aug. 3, 2007) (holding that “section 11(e) of the Securities Act does not limit theliability of an underwriter to the shares that particular underwriter personally distributed to the public”).

c. Outside Director’s Liability Limited

The Reform Act limits the liability of outside directors in Section 11 actions to their proportionate liability. 15U.S.C. § 77k(f)(2)(A). However, as noted by the Southern District of New York, the relevant case lawdemonstrates a lack of uniform understanding as to precisely who counts as an outside director, an uncertaintyunaided by the SEC who has yet to provide a definition. In re WorldCom, Inc. Sec. Litig., No. 02 CIV.3288DLC, 2005 WL 638268, at *10 (S.D.N.Y. Dec. 15, 2004).

d. Attorney’s Fees And Costs

A court may award attorney’s fees and costs under Section 11(e) if it finds that the losing party asserted a claimor defense without merit or brought in bad faith. 15 U.S.C. § 77k(e); Aizuss v. Commonwealth Equity Trust,847 F. Supp. 1482 (E.D. Cal. 1993); Sharp v. I.S., Inc., 685 F. Supp. 688 (S.D. Ill. 1988), abrogated in part onother grounds as recognized by Berson v. Hardiman, No. 97 C 3583, 1999 WL 754703, at *6 n.9 (N.D. Ill.Sept. 13, 1999); Zissu v. Bear, Stearns & Co., 627 F. Supp. 687, 694 (S.D.N.Y. 1986); Johnson v. Yerger, 612F.2d 953, 959 (5th Cir. 1980). In order for a claim or defense to be without merit under Section 11(e), it mustborder on frivolity. Layman v. Combs, 994 F.2d 1344 (9th Cir. 1992). A mere failure to present sufficientevidence to support a claim will not in itself warrant a determination of frivolity. Aid Auto Stores, Inc. v.Cannon, 525 F.2d 468, 471 (2d Cir. 1975).

Specific Finding Required. Section 11(e) requires the court to make a specific finding of lack of merit beforefees may be awarded. 15 U.S.C. § 77k(e). Courts have interpreted the attorney’s fee provisions to provide thecourt with discretion to award fees in a broader range of cases than it would under general equitable powers. Weil v. Investment/Indicators, Research & Mgmt., Inc., 647 F.2d 18, 22 (9th Cir. 1981); see also Katz v. AmosTreat & Co., 411 F.2d 1046 (2d Cir. 1969); Reube v. Pharmacodynamics, Inc., 348 F. Supp. 900 (E.D. Pa.1972).

Posting of Security. 15 U.S.C. § 77k(e) also authorizes the court to require a party to post security, in advanceof trial, sufficient to cover the costs and attorney’s fees of the opposing party. The standard for determiningwhether a party should be required to post such a security is whether “the defendants [have] show[n] thatplaintiff has commenced … suit in bad faith or that . . . [the] claim borders on the frivolous.” Weil, 647 F.2d at22 (alteration in original) (citations omitted). The decision need not be based on a formal, factual finding thatthe claim or defense is obviously without merit. Id.

e. Interest On Damages

Although Section 11 does not discuss a plaintiff’s ability to obtain interest, the court in Beecher v. Able, 435 F.Supp. 397, 410 (S.D.N.Y. 1975), used its discretion to award interest from the time of sale or the time of suit,whichever is earlier.

4. Contribution And Indemnity

Indemnity is usually unavailable under the 1933 Act. Laventhol, Krekstein, Horwath & Horwath v. Horwitch,637 F.2d 672, 676 (9th Cir. 1980). As the court recognized in Laventhol, “[i]n extending liability tounderwriters and those who prepared misleading statements, the purpose of the [1933] Act is regulatory ratherthan compensatory, and permitting indemnity would undermine the statutory purpose of assuring diligent

performance of duty and deterring negligence.” Id.

Section 11(f) provides a right of contribution:

Except as provided in paragraph (2) [which limits the liability of outside directors] all or any one or more of thepersons specified in subsection (a) of this section shall be jointly and severally liable, and every person whobecomes liable to make any payment under this section may recover contribution as in cases of contract fromany person who, if sued separately, would have been liable to make the same payment, unless the person whohas become liable was, and the other was not, guilty of fraudulent misrepresentation. 15 U.S.C. § 77k(f)(1).

5. Applicability Of The Heightened Pleading Requirements Of Rule 9(b) And TheReform Act

A split of authority exists on whether 1933 Securities Act claims are subject to the Rule 9(b) heightenedpleading standard when grounded in fraud rather than negligence. The majority holds that the particularityrequirements of Rule 9(b) apply only to those Section 11 claims that are “grounded in fraud.” See, e.g., Rubkev. Capitol Bancrop Ltd., 551 F.3d 1156 (9th Cir. 2009) (holding that plaintiffs cannot argue that certain factsmeet the particularized pleading requirements of Section 10(b) while backing away from those same allegationsto argue that Section 11 claims are not based on fraud); Wagner v. First Horizon Pharm. Corp., 464 F.3d 1273,1277 (11th Cir. 2002) (holding that Rule 9(b) applies when the misrepresentation justifying relief under theSecurities Act is also alleged to support a claim for fraud under the Exchange Act and Rule 10(b)-5); Rombachv. Chang, 355 F.3d 164, 171 (2d Cir. 2004) (“while a plaintiff need allege no more than negligence to proceedunder Section 11 …, claims that do rely upon averments of fraud are subject to the test of Rule 9(b)”); Shapirov. UJB Fin. Corp., 964 F.2d 272, 287-89 (3d Cir. 1992); Melder v. Morris, 27 F.3d 1097, 100 n.6 (5th Cir.1994); Sears v. Likens, 912 F.2d 889, 893 (7th Cir. 1990); In re Daou Sys., Inc., 411 F. 3d 1006, 1027-1028(9th Cir. 2005); accord Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1223 (1st Cir. 1996) (noting in dicta thatthe requirements of Rule 9(b) would apply to Section 11 and Section 12 claims where the plaintiff alleges one“unified course of fraudulent conduct”), superseded in part by statute as stated in Greebel v. FTP Software,Inc., 194 F.3d 185, 196-97 (1st Cir. 1999).

The Third Circuit determined that Rule 9(b)’s particularity requirements may be triggered by a Section 11 or12(a)(2) claim grounded in fraud even though either claim may be pled without alleging fraud. See Shapiro, 964F.2d at 287-89, cited with approval in Schwartz, 124 F.3d at 1251-52. Shapiro held that Rule 9(b) applies if thecomplaint does not allege negligence. Shapiro, 964 F.2d at 287-89; see also Schwartz v. Celestial Seasonings,Inc., 124 F.3d 1246, 1252 (10th Cir. 1997) (“assuming without deciding” that the approach set out by the ThirdCircuit in Shapiro applies).

The Fifth Circuit held that the district court abused its discretion in dismissing a Section 11 claim withprejudice for failure to satisfy Rule 9(b)’s particularity requirement. See Lone Star Ladies Inv. Club v.Schlotzsky’s Inc., 238 F.3d 363 (5th Cir. 2001) (noting that while Rule 9(b) applies to claims grounded in fraud,failure to comply does not warrant dismissal with prejudice).

However, the District Court for Utah found Shapiro inapposite in Spiegel v. Tenfold Corp., 192 F. Supp. 2d1261, 1267-68 (D. Utah 2002), because the complaint in Speigel did not allege negligence for both the Sections11 and 12(a) claims. It held that Rule 8 applies to complaints that do assert negligence grounds. Spiegel, 192F. Supp. 2d at 1268; see also In re Majesco Sec. Litig., No. CIV A 05CV-3557 WL 2846281, at *2 (D.N.J.Sept. 19, 2006) (citing In re Suprema Specialities, Inc. Sec. Litig., 438 F.3d 256 (3d Cir. 2005) in holding that9(b)’s heightened pleading requirements did not apply to Section 11 claim where negligence allegations insupport of the Section 11 claim were pled separately and distinctly from fraud allegations in support of Section10(b) claim).

The Eighth Circuit held that the particularity requirement of Rule 9(b) does not apply because proof of fraudand scienter are not prerequisites to establishing liability under Section 11. See In re NationsMart Corp. Sec.

Litig., 130 F.3d 309, 315 (8th Cir. 1997).

A distinct but related question is whether the heightened pleading requirements of the Reform Act apply toSection 11 claims. Most courts that have considered this question have determined that the heightened pleadingrequirements of 15 U.S.C. § 78u-4(b) do not apply to Section 11 claims. See In re Initial Pub. Offering Sec.Litig., 241 F. Supp. 2d 281 (S.D.N.Y. 2003) (holding that the language in 15 U.S.C. § 78u-4(b)(1) referring to“any private action arising under this chapter” does not apply to 1933 Act claims) (emphasis in original);Giarraputo v. UNUMProvident Corp., No. CIV. 99-301-PC, 2000 WL 1701294, at *9 (D. Me. Nov. 8, 2000)(“[T]he PSLRA does not place a parallel provision to § 78u-4(b) in the Securities Act.”); In re BankAmericaCorp. Sec. Litig., 78 F. Supp. 2d 976, 1000 (E.D. Mo. 1999) (“The strict pleading requirements for the PSLRAand Rule 9(b) do not apply to claims pursuant to [Sections 11 and 12(a)(2)].”). But see In re Seachange Int’l,Inc., No. CIV. A.02-12116-DPW, 2004 WL 240317, at *3 (D. Mass. Feb. 6, 2004) (“Section 78u-4(b)(1) doesaway with the need to determine whether a complaint ‘sounds in fraud’ and imposes a heightened pleadingrequirement on all § 11 and § 12(a)(2) claims arising out of alleged misrepresentations or omissions.”).

6. Due Diligence – Defense Or Duty

“Due diligence” represents a variety of related concepts. First, “due diligence” refers to an affirmative defenseto various federal securities claims. Second, it refers to an affirmative duty to verify the accuracy of disclosuresconcerning securities. Finally, “due diligence” refers to the standard investigation conducted in connection withevery issuance of securities. All three of these meanings come into play when analyzing a Section 11 claim.

Although Sections 11 and 12(2) do not expressly mention “due diligence” and are structured to provide adefense based on reasonable investigation or care, due diligence is sometimes viewed as an affirmative duty. Even if not a legally-imposed duty, the concept of due diligence as a common sense duty arises from the interrorem effect of Section 11 and Section 12(2) liability. See Douglas and Bates, The Federal Securities Act of1933, 43 Yale L. J. 171, 173 (1933).

a. The Statutes

Sections 11 and 12(2) both provide that a defendant who sustains the burden of proof as to his exercise of duediligence shall not be liable. Thus, the statutes structure due diligence as a defense to charges of materialmisstatements and not as an affirmative duty.

b. The SEC’s View

The SEC’s view of the “defense versus duty” issue is not clear. In requesting the NASD to establish duediligence standards, the SEC noted that, “[a]lthough there is no express provision in the [1933] Act requiring anunderwriter to conduct a due diligence investigation, in order to establish a defense under the civil liabilityprovisions of Section 11 of the Act, an underwriter must exercise reasonable care in verifying the statements inthe prospectus.” SEC Release Nos. 33-5275 & 34-9671, Fed. Sec. L. Rep. (CCH) ¶ 4506B at 4054, SpecialEdition No. 434 (July 26, 1972). Although this statement can be read as recognizing due diligence to be solely adefense rather than a duty, other SEC comments suggest that perhaps the statement simply recognized that noduty was expressly mandated. Fortenbaugh, Underwriter’s Due Diligence, 14 Rev. of Sec. Reg. 799, 802(1981). For example, the SEC observed that “the primary function of Section 11 may not be the compensationof investors ... rather that section may have been designed by Congress to assure adherence to high standards ofconduct through the ‘in terrorem’ nature of the liabilities.” Release No. 33-5275 at 4055.

In Charles E. Bailey & Co., the SEC observed that the underwriter “owed a duty to the investing public toexercise a degree of care reasonable under the circumstances to assure the substantial accuracy ofrepresentations made in the prospectus and other sales literature.” 35 S.E.C. 33, 41 (1953); see also In re

Rooney, Pace Inc. & Randolph K. Pace, 39 S.E.C. 804 (1987); In re Hamilton Grant & Co. and Mark G. Ross,38 S.E.C. 1030 (1987); accord Richmond Corp., 41 S.E.C. 398, 406 (1963) (“[A]n underwriter impliedlyrepresents that he has made such an investigation in accordance with professional standards.”).

c. The FINRA View

Although FINRA does not have an official statement on this issue, most of its members apparently adhere to the“strict interpretation of the Securities Act of 1933, [which] holds that due diligence is only a defense, and not anaffirmative obligation.” Macklin and Hensley, “Background and Purpose of Seminars,” NASD Special Report— Due Diligence Seminars at 1.

d. Judicial Views

Several courts have commented on this issue directly or indirectly. For example, ruling on the typicality of adefendant underwriter class, the court referred to due diligence in dicta as a “responsibility to insure theaccuracy of the offering materials.” In re Consumers Power Co. Sec. Litig., 105 F.R.D. 583, 612 (E.D. Mich.1985). Describing due diligence as a “responsibility” in a discussion of typical defenses highlights the blurringof the line between duty and defense.

In Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F.2d 341, 370-71 (2d Cir. 1973), holding that theunderwriter violated Section 14(e) of the Exchange Act (material misstatement with regard to an exchangeoffer), the court explained that the underwriter had an “obligation” and was “duty-bound” to exercise Section11-type due diligence to verify the accuracy of the registration statement. Thus, the court relied on the viewthat an investigation was a duty in order to read a due diligence obligation into Section 14(e).

In discussing the due diligence standard, the court in In re WorldCom, Inc. Sec. Litig., 346 F. Supp. 2d 628(S.D.N.Y. 2004) stated that “Section 11 provides an affirmative defense of ‘due diligence.’” Id. at 659. However, the court also emphasized that “[u]nderwriters must exercise a high degree of care in investigationand independent verification of the company’s representations.” Id. at 662.

7. The Due Diligence Defense

For an extensive discussion of the due diligence defense and tips for conducting effective due diligence, seeAlderman, “Due Diligence in the Post-Enron Era: A Litigator’s Practical Tips on Mitigating Underwritten Risk,Course Handbook No. B-1746 (PLI 2009). While the diligence that must be exercised to take advantage of thisdefense generally depends on the totality of the circumstances, the applicability of the due diligence defensevaries with the type of defendant, its relationship to the issuer, its access to information, and the type of securityand offering. S.E.C. Rule 176, 17 C.F.R. § 230.176.

a. No Issuer Defense

The due diligence defense is not available to issuers. Section 11 imposes almost absolute liability on issuersbecause issuers are liable without regard for any action taken to prevent or avoid any material misstatementcontained in the registration statement. Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983); Krim v.pcOrder.com, Inc., 402 F.3d 489, 495 (2005).

b. Due Diligence Defenses For Non-Issuer Defendants

Although the phrase “due diligence” does not appear in the Securities Act, two affirmative defenses availableunder Section 11(b) are collectively known as the “due diligence” defense. In re WorldCom, Inc. Sec. Litig.,346 F. Supp. 2d 628, 662 (S.D.N.Y. 2004). The first relates to “non-expertised” portions of the registrationstatement and the second to “expertised” portions.

1) “Non-Expertised” Portions

For portions of the registration statement not made on the authority of an expert, “a defendant will not be liableupon a showing that he had, after reasonable investigation, reasonable ground to believe and did believe, at thetime such part of the registration statement became effective, that the statements therein were true and that therewas no omission to state a material fact required to be stated therein or necessary to make the statements thereinnot misleading.” WorldCom, 346 F. Supp. 2d at 662 (citing 15 U.S.C. § 77k(b)(3)(A)) (emphasis in original);In re Enron Corp. Sec., Deriv. & “ERISA” Litig., 540 F. Supp. 2d 800, at n. 16 (S. D. Tex. 2007). This isunderstood as “a negligence standard.” Id. (citation omitted).

2) “Expertised” Portions

For “expertised” portions, a non-expert defendant “will not be liable if he demonstrates that he had noreasonable ground to believe and did not believe, at the time such part of the registration statement becameeffective, that the statements therein were untrue or that there was an omission to state a material fact requiredto be stated therein or necessary to make the statements therein not misleading.” WorldCom, 346 F. Supp. 2d at663 (citing 15 U.S.C. § 77k(b)(3)(C)) (emphasis in original). Courts have labeled this the “reliance defense.” Id. At least one court has stated that “just as underwriters’ reliance on audited financial statements may not beblind, directors also may not fend off liability by claiming reliance where ‘red flags’ regarding the reliability ofan audited financial statement, or any other expertised statement, emerge.” In re WorldCom, Inc. Sec. Litig.,No. 02 Civ. 3288DLC, 2005 WL 638268, at *8 (S.D.N.Y. Mar. 21, 2005). When a “red flag” emerges, adefendant has an affirmative “obligation to inquire until satisfied as to the integrity of the” underlyingexpertised statement. Id. at 11.

For an expert defendant, “[t]he expert must prove that he had, after reasonable investigation, reasonable

ground to believe and did believe, at the time such part of the registration statement became effective, that thestatements therein were true and that there was no omission to state a material fact required to be stated thereinor necessary to make the statements therein not misleading.” WorldCom, 346 F. Supp. 2d at 663 (citing 15U.S.C. § 77k(b)(3)(B)). This is known as the “due diligence defense.” Id.

Section 11(a)(4) does not clearly define the term “expert,” but rather “lists the professions that give a personauthority to make a statement, which on consent can be included in a registration statement.” In re WorldCom,Inc. Sec. Litig., 346 F. Supp. 2d at 664; see 15 U.S.C. § 77k(a)(4) (making liable “every accountant, engineer,or appraiser or any person whose profession gives authority to a statement made by him” and “who has with hisconsent been named as having prepared or certified any part of the registration statement, or as having preparedor certified any report or valuation which is used in connection with the registration statement . . .” 15 U.S.C. §77k(a)(4).

Accountants are experts with regard to portions of the registration statement they certified in their capacity asindependent accountants. McNamara v. Bre-X Minerals Ltd., 197 F. Supp. 2d 622, 695 (E.D. Tex. 2001);Cashman v. Coopers & Lybrand, 877 F. Supp. 425, 434 (N.D. Ill. 1995). The duty to disclose only applieswhere a representation or certification is given. Pahmer v. Greenberg, 926 F. Supp. 287, 307 (E.D.N.Y. 1996),aff’d sub nom. Shapiro v. Cantor, 123 F.3d 717 (2d Cir. 1997).

Unaudited financial statements are not “expertised” for purposes of Section 11. Escott v. BarChris Constr.Corp., 283 F. Supp. 643, 684 (S.D.N.Y. 1968); see also In re WorldCom, Inc. Sec. Litig., No. 02 Civ.3288DLC, 2005 WL 638268 (S.D.N.Y. Mar. 21, 2005); 17 C.F.R. §§ 230.436(c)-(d); S.E.C. Rel. No. 33-6173,1979 WL 170299 (Dec. 28, 1979) (discussing adoption of Sections 230.436(c) & (d), which exclude anaccountant from Section 11 liability arising from a report of a review of unaudited interim financialinformation); S.E.C. Rel. No. 33-6127, 1979 WL 169953 (S.E.C. Rel. No. 33-6127) (Sept. 20, 1979)(discussing rules ultimately adopted by Rel. No. 33-6173).

Comfort letters do not “expertise” any portion of the registration statement that is otherwise “non-expertised.” However, a comfort letter can have significant value as a component in establishing that due diligence wasexercised. See Phillips v. Kidder, Peabody & Co., 933 F. Supp. 303, 323 (S.D.N.Y. 1996), aff’d, 108 F.3d 1370(2d Cir. 1997) (finding that due diligence was supported by comfort letter from accountants). However, while acomfort letter will be important in assessing the reasonableness of the underwriters’ investigation, “it isinsufficient by itself to establish the defense.” WorldCom, 346 F. Supp. 2d at 683.

Lawyers are generally not considered Section 11 “experts” and their participation in, or drafting of, theregistration statement does not serve to “expertise” the entire registration statement. In re Flight Transp. Corp.Sec. Litig., 593 F. Supp. 612, 616 (D. Minn. 1984); Escott v. BarChris Constr. Corp., 283 F. Supp. 643, 683(S.D.N.Y. 1968). However, an attorney may be rendered an expert within the meaning of Section 11(a)(4) if heor she expressly consents to the inclusion of, or reference to, his or her opinion in the registration statement. See, e.g., Schneider v. Traweek, 1990 WL 169856, at *11 (C.D. Cal. 1990) (holding that plaintiffs had stated aSection 11 claim against a law firm that had drafted and signed allegedly misleading tax opinions that wereincluded in a prospectus with the firm’s consent); In re American Continental Corporation, 794 F. Supp. 1424,1453 (D. Ariz. 1992) (attorney whose opinion letter was filed pursuant to S.E.C. Regulation S-K, Item 601(b)(5) deemed an expert within meaning of Section 11). Moreover, some courts point to a footnote in Herman &MacLean v. Huddleston, 459 U.S. 375, 387 n. 22 (1983), in which the Court refers to lawyers “not acting as‘experts’” as leaving open the possibility that under narrow circumstances lawyers can be Section 11 “experts.” See, e.g., In re New York City Shoes Sec. Litig, 1988 WL 80125, at *2 (E.D. Pa. July 8, 1988)

An expert is relieved of liability if the “expertised” portion reproduced in the prospectus was not a fair copy,extract, or representation of the expert report or valuation submitted. 15 U.S.C. § 77k(b)(3).

3) “Official” Portions

For portions of the registration statement purporting to be a statement of an official or an official publicdocument, a defendant escapes liability if, at the time of effectiveness, “he had no reasonable ground to believeand did not believe” that a material misstatement or omission existed. Any defendant, except the issuer, isrelieved of liability with regard to an “official” portion if the “official” portion was not a fair copy or extract ofthe public official document. 15 U.S.C. § 77k(b)(3)(D).

c. Scope of Due Diligence Defenses

The essence of the Section 11 due diligence defense is that a defendant must have had (1) a reasonable basis forthe truthfulness of statements; (2) an actual belief in the truthfulness of statements made; and (3) the subjectiveand objective belief must survive reasonable investigation.

1) Section 11(c)

For due diligence purposes, the standard of reasonableness is defined in Section 11(c) as: “that required of aprudent man in the management of his own property.” 15 U.S.C. § 77k(c).

2) “Standard Of The Street”

Because what is “reasonable” is a matter of degree and judgment and may vary with the circumstances of eachcase, reasonableness has been described as a “standard of the street.” Escott, 283 F. Supp. at 697. In otherwords, reasonableness is likely to be determined based on commonly accepted industry or commercialstandards of due diligence. Mann, Fleischer, and Sommer, “Legal Aspects of Due Diligence,” Special Report,NASD Due Diligence Seminars, at 6.

3) Financial Industry Regulatory Authority (FINRA) Delineations Of“Reasonableness”

FINRA’s predecessor, NASD (National Association of Securities Dealers), had no general rule or policystatement concerning due diligence. It refrained from adopting a list of recommended due diligence stepsbecause this would unduly restrict an exercise that must be flexible to be effective, might result in liability foreven reasonable variances, and would transform a litigation defense into an affirmative duty. Since theconsolidation of NASD and the NYSE into FINRA in July 2007, it has not directly addressed due diligencerelated to publicly-traded securities.

4) SEC Rule 176

Rule 176 provides a list of “relevant circumstances” in determining whether a person’s conduct is reasonableunder Section 11(c). The list includes the type of issuer, the security, the type of person, the office held if theperson is an officer, the presence or absence of another relationship to the issuer if the person is a director,reasonable reliance on others, the role of the underwriter, the type of underwriting arrangement, and whetherthe person had any responsibility for a document incorporated by reference into the registration statement. 17C.F.R. § 230.176; S.E.C. Release Nos. 7606A, 40632A, 33-7606A, 34-40632A, IC - 23519A), 1998 WL792508, at *92 (Nov. 17, 1998).

d. Due Diligence Defense For Underwriters

Several courts have emphasized underwriters’ duty to conduct rigorous due diligence if they are to have thebenefit of the defense. As the Southern District of New York has observed, “[u]nderwriters function as ‘thefirst line of defense’ with respect to material misrepresentations and omissions in registration statements.” In reWorldCom, Inc. Sec. Litig., 346 F. Supp. 2d 628, 662 (S.D.N.Y. 2004). Thus, “courts must be particularlyscrupulous in examining their conduct.” Id. at 672 (citations omitted).

“It is the task of the underwriter to go behind the publicly available information and, using its direct access tothe issuing company, to conduct a searching inquiry as to any portions of a registration statement that are notmade on the authority of an expert.” In re WorldCom, Inc. Sec. Litig., No. 02 CIV. 3288 (DLC), 2005 WL408137, at *3 (S.D.N.Y. Feb. 22, 2005) (citing WorldCom, 346 F. Supp. 2d at 677-78). Even for expertisedportions, “an underwriter defendant must show that it had no reasonable ground to believe and did not believethat the statements within the registration statement that were made on an expert’s authority were untrue.” Id.(citing WorldCom, 346 F. Supp. 2d at 673).

The due diligence defense has been utilized successfully by underwriters to obtain summary judgment in somecases where underwriters “have demonstrated extensive due diligence.” WorldCom, 346 F. Supp. 2d at 676;see, e.g., Weinberger v. Jackson, No. C-89-2301-CAL, 1990 WL 260676 (N.D. Cal. Oct. 11, 1990) (holdingunderwriters’ due diligence included following-up on “negative or questionable” information); In re SoftwareToolworks, Inc. Sec. Litig., 789 F. Supp. 1489, 1496 (N.D. Cal. 1992), aff’d in part, rev’d in part, 38 F.3d 1078(9th Cir. 1994), amended, 50 F.3d 615 (9th Cir. 1995) (underwriters “only need to reasonably attempt to verifyand believe the accuracy of the information in the prospectus”); Phillips v. Kidder, Peabody & Co., 933 F.Supp. 303 (S.D.N.Y. 1996), aff’d, 108 F.3d 1370 (2d Cir. 1997); In re Int’l Rectifier Sec. Litig., No. CV 91-3357-RMT, 1997 WL 529600 (C.D. Cal. Mar. 31, 1997); Picard Chem. Inc. Profit Sharing Plan v. Perrigo Co.,No. 1:95-CV-141, 1:95-CV-290, 1998 WL 513091 (W.D. Mich. June 15, 1998); In re Worlds of Wonder Sec.Litig., 814 F. Supp. 850 (N.D. Cal. 1993), aff’d in part, rev’d in part, 35 F. 3d 1407 (9th Cir. 1994), cert.denied, 516 U.S. 858 (1995).

1) Reliance On Management Representations

In Escott v. BarChris Construction Corp., the court held that “in order to make the underwriters’ participationin this enterprise of any value to the investors, the underwriters must make some reasonable attempt to verifythe data submitted to them. They may not rely solely on the company’s officers or on the company’s counsel. A prudent man in the management of his own property would not rely on them.” 283 F. Supp. 643, 679(S.D.N.Y. 1968). In Feit v. Leasco Data Processing Equip. Corp., the court similarly concluded that theunderwriters “are expected to exercise a high degree of care in investigation and independent verification of thecompany’s representations. Tacit reliance on management’s assertions is unacceptable; the underwriters mustplay devil’s advocate.” 332 F. Supp. 544, 582 (E.D.N.Y. 1971). However, in In re Software Toolworks, Inc.Securities Litigation, the court explained that underwriters may rely on management’s representations whendoing so is reasonable under the circumstances. 789 F. Supp. 1489, 1496 (N.D. Cal. 1992), aff’d in part, rev’din part, 38 F.3d 1078 (9th Cir. 1994), amended, 50 F.3d 615 (9th Cir. 1995). “It is not unreasonable . . . to relyon management’s representations with regard to information that is solely in the possession of the issuer andcannot be reasonably verified by third parties. Underwriters cannot be expected to ferret out everything thatmanagement knows about the company; they only need to reasonably attempt to verify and believe the accuracyof the information in the prospectus.” Software Toolworks, 789 F. Supp. at 1496. On appeal, the Ninth Circuitaffirmed summary judgment on the underwriters’ due diligence defense for statements concerning thecompany’s sales practices and its description of revenue, but the court reversed summary judgment on theprojected quarterly results. Software Toolworks, 38 F.3d at 1078. In reversing that part of the summaryjudgment ruling, the court held that, because there was evidence that the underwriters participated in drafting aletter to the SEC that purportedly fraudulently stated the company’s anticipated revenue, “[a] reasonable

factfinder could infer that, as members of the drafting group, the Underwriters had access to all information thatwas available and deliberately chose to conceal the truth.” Id. at 1087.

2) Reliance On Accountant Representations

As the WorldCom court held, “reliance on audited financial statements may not be blind.” In re WorldCom,Inc. Sec. Litig., 346 F. Supp. 2d 628, 672 (S.D.N.Y. 2004). Rather, any “information that strips a defendant ofhis confidence in the accuracy of those portions of a registration statement premised on audited financialstatements” should be treated as a “red flag” such that “mere reliance on an audit will not be sufficient to wardoff liability.” Id. at 672. Thus, where the issuer’s expense to revenue ratio in its 10-K was significantly lowerthan that of its two closest competitors in an extremely competitive market, the WorldCom court held that therewas a question of fact that the underwriter defendants had a duty to investigate the discrepancy and deniedsummary judgment. Id. at 679. In Phillips v. Kidder, Peabody & Co., however, the court granted summaryjudgment on due diligence and cautionary language grounds, holding that the underwriter’s investigations werereasonable in relying on an accountant’s representation that internal accounting controls were adequate and onan analyst report regarding the future growth potential in the company’s industry. 933 F. Supp. 303 (S.D.N.Y.1996), aff’d, 108 F.3d 1370 (2d Cir. 1997).

3) Factors In Determining “Reasonableness”

The court in In re International Rectifier Securities Litigation relied on the following factors in deciding thereasonableness of an underwriter’s due diligence:

(1) the underwriter’s familiarity with the issuer’s finances, management, and operations; (2) theunderwriter’s knowledge of the issuer’s industry; (3) whether the underwriter interviewed the issuer’semployees; (4) whether the underwriter interviewed or confirmed issuer data with the issuer’s customersor other third parties; and (5) whether the underwriter obtained written verification from the issuer and itsaccountants that information contained in the prospectus was accurate.

No. CV 91-3357-RMT, 1997 WL 529600 (C.D. Cal. Mar. 31, 1997); see also Weinberger v. Jackson, No.C-89-2301-CAL, 1990 WL 260676 (N.D. Cal. Oct. 11, 1990).

4) Considerations For Due Diligence

Although no definitive list of due diligence methods or inquiries has been deemed practical, lists of items forconsideration have been developed for underwriters and broker/dealers. These lists can act as guides for othersas well. See William F. Alderman, Due Diligence In The Securities Litigation Reform Era: Practical TipsFrom Litigators On The Effective Conduct, Documentation And Defense Of Underwriter Investigation, 1265PLI/Corp 413 (2001); “Legal Aspects of Due Diligence,” NASD Special Report – Due Diligence Seminars 12-14, 44; Competitive Assocs., supra. These include, for instance, the following:

(a) The Issuing Entity

Review the partnership agreement or corporate charter, transfer records, by-laws, and minutes.

(b) Business and Industry

Review the business’ manner of distribution, its sources of supply, its competitive position, its marketor other studies, reports relating to its industry or competitors, and its licenses, patents, andtrademarks.

(c) Management, Counsel, and Auditors

Conduct personal interviews and independent inquiries concerning the background and competenceof management and the experience of counsel and independent auditors.

(d) Financial Statements

Review audited and unaudited financial statements, budgets, forecasts, and internal audit controls.

(e) Properties

Examine the physical plant and properties, as well as title and title insurance policies.

(f) Material Contracts

Review documents evidencing material purchases and commitments, contracts supporting thebacklog of orders, documents evidencing transactions with insiders, and corporate minutes toconfirm that contracts have been properly authorized. Contact the company’s major customers,suppliers, and distributors. Review relationships with banks, creditors, and suppliers

(g) Employees

Examine employment contracts, salaries, and employee benefit plans, and review union contracts andlabor disputes.

(h) Litigation and Administrative Proceedings

Review pending and possible unasserted claims. An opinion of counsel may be desirable.

(i) Use of Proceeds

Determine how the proceeds of the issue will actually be used.

(j) Prior Filings

Review filings made with the SEC, state regulatory authorities, and any stock exchanges.

(k) Investigate “Red Flags”

If any “red flags” arise in the course of due diligence, discuss immediately with the appropriateperson(s), including company management, attorneys, and/or accountants. The court in In reWorldCom, Inc. Sec. Litig., No. 02 Civ. 3288DLC, 2005 WL 638268, at *8 (S.D.N.Y. Mar. 21, 2005)states that what constitutes a “red flag” is a “fact intensive inquiry that depends upon thecircumstances surrounding a particular issuer, the alleged misstatements, and the role of the Section11 defendant.”

5) Non-Managing Underwriters

The underwriter’s due diligence is central to the system of self-regulation. “Self-regulation is the mainspring ofthe federal securities laws. No greater reliance in our self-regulatory system is placed on any single participantin the issuance of securities than upon the underwriter.” Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480F.2d 341, 370 (2d Cir. 1973); see also S.E.C. Release No. 33-6335, 1981 WL 31062, (Aug. 6, 1981).

All members of the underwriting syndicate are held to the “same high standard of diligence.” In re ConsumersPower Co. Sec. Litig., 105 F.R.D. 583 (E.D. Mich. 1985); accord In re Activision Sec. Litig., 621 F. Supp. 415,434 (N.D. Cal. 1985). “[T]he underwriting syndicate members sink or swim with the lead underwriter in theusual case.” Consumers Power Co., 105 F.R.D. at 612. In BarChris Construction, the court held that syndicatemembers, not having made a reasonable investigation of their own, were bound by the deficiencies of the leadunderwriters’ investigation. 283 F. Supp. at 697. In a footnote, the court stated: “In view of this conclusion, itbecomes unnecessary to decide whether the underwriters other than Drexel would have been protected if Drexelhad established that as lead underwriter, it made a reasonable investigation.” Id. at 697 n.26. In CompetitiveAssociates, Inc. v. International Health Sciences, Inc., on the other hand, the court held that the leadunderwriter’s sufficient due diligence “inured to the benefit of all of the underwriters.” No. 72 CIV. 1848-CLB,1975 WL 349, at *19 (S.D.N.Y. Jan. 22, 1975).

[Fed. Sec. L. Rep. (CCH) ¶ 4506B, at 4053, Special Edition No. 434 (July 26, 1972)] In its Release No. 33-5275, the SEC sets forth the diligence standard applicable to syndicate members relying on the leadunderwriter’s investigation:

The [participating underwriter] may appoint the [managing underwriter] as his agent to do theinvestigation, [but] it is important to understand that the delegation to the manager and the subsequentreliance on his investigation must be reasonable in light of all the circumstances. This means that theparticipant may relieve himself of the task of actually verifying the representations in the registrationstatement, but that he must satisfy himself that the managing underwriter makes the kind of investigation

the participant would have performed if he were the manager. He should assure himself that themanager’s program of investigation and actual investigative performance are adequate. The participant’schecks on the manager are vital since they may provide additional assurance of verification of thestatements in the registration statement.

Id.

6) Counsel For The Underwriters

Underwriters often rely to a considerable extent on their counsel to perform due diligence tasks and to build therecord that appropriate steps were taken both by the underwriters and their counsel. See generally William F.Alderman, Due Diligence In The Securities Litigation Reform Era: Practical Tips From Litigators On TheEffective Conduct, Documentation And Defense Of Underwriter Investigation, 1265 PLI/Corp 416 (2001).

e. Officers And Directors Of The Issuer

Some officers may be heavily involved in the process of drafting the registration statement or in conducting duediligence. Since a corporation acts only through its personnel, they may face a very strict standard. See S.E.C.Rule 176 (listing as a “relevant circumstance” in determining due diligence the “office held when the person isan officer”).

Directors and other officers normally receive at least one reasonably final draft of the prospectus and are askedto comment on it. They are also routinely asked to complete a questionnaire providing information aboutthemselves and stating that they are satisfied with the disclosure in the prospectus. Important considerationsinclude: (1) whether the questionnaire is sufficient to document the review performed by officers and directors;(2) whether, from an evidentiary point of view, a “long-form” questionnaire that goes into detail and covers abroad array of issues is better than a “short-form” version; and (3) whether officers should keep notes of whatthey were asked and what was said by underwriters and their counsel while performing their own duediligence. In Escott v. BarChris Construction Corp., the court required corporate insiders to verify the factscontained in the registration statement. 283 F. Supp. 643 (S.D.N.Y. 1968).

Outside directors may be held to a lower standard than insiders based on their limited access to information. See Weinberger v. Jackson, No. C-89-2301-CAL, 1990 WL 260676 (N.D. Cal. Oct. 11, 1990); Laven v.Flanagan, 695 F. Supp. 800, 812 (D.N.J. 1988); S.E.C. Rule 176(e) (noting the relevance of the “presence orabsence of another relationship to the issuer when the person is a director”); Circumstances Affecting theDetermination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief under Section11 of the Securities Act, S.E.C. Release No. 33-6335, 1981 WL 31062 (Aug. 6, 1981). On proposing Rule 176,the SEC observed that “[t]he case law makes clear that a director who has another relationship with the issuerinvolving expertise, knowledge or responsibility with respect to any matter giving rise to the omission ormisstatement will be held to a higher standard of investigation and belief than an outside director with nospecial knowledge or additional responsibility.” Id.; see also Feit v. Leasco Data Processing Equip. Corp., 332F. Supp. 544, 578 (E.D.N.Y. 1971); BarChris Construction, 283 F. Supp. at 688-91.

f. Counsel For The Issuer

Like the officers who are most heavily involved in preparation of the prospectus, counsel for the issuer isnormally central to the process of collecting information and drafting. The amount of due diligence thatissuer’s counsel must do for the offering depends on the extent of historical contact with the issuer. If counselhas been recently retained, a major effort will be necessary. Even if counsel has enjoyed a long relationshipwith the issuer, counsel must update information and make particularized inquiries. Whether joint

representation of inside and outside directors is appropriate when different standards are to be applied to outsidedirectors than to insiders must be addressed on a case-by-case basis depending on the appearance of actualconflicts and other factors. At least one court has recognized that even “independent” directors may bebeholden to the defendant directors who appointed them. Id.

g. Accountants And Other Experts

Clearly, the presence of accountants and other experts helps to discharge or reduce the due diligenceresponsibilities of the other participants in the transaction. Experts must meet a high standard with respect tothe portions of any prospectus or registration statement they are “expertising.” The extent to which they bearresponsibility for other aspects of these documents is unclear. For example, what about a patent lawyer who isexpertising a portion of the “patents” section? See Escott v. BarChris Constr. Corp., 283 F. Supp. 643, 683-84(S.D.N.Y. 1968) (noting that a cross-reference in an “expertised” footnote to another portion of the registrationstatement did not cause that other portion to become “expertised”); accord Seiffer v. Topsy’s Int’l, Inc., 487 F.Supp. 653, 679 (D. Kan. 1980). This subject has received considerable attention in the context of tax opinionsgiven in tax shelter offerings. See ABA Formal Opinion 346 (January 29, 1982) (setting standards forattorneys’ tax shelter opinion letters); 31 C.F.R. § 10.33 (Practice Before the Internal Revenue Service, TaxShelter Opinions); Daily Tax Report (BNA) at J-10 (Feb. 22, 1984) (setting standards for attorneys’ tax shelteropinion letters)); see also Sax, Lawyer Responsibility in Tax Shelter Opinions, 34 Tax Law. 5 (1980).

8. Documenting Due Diligence

Whether due diligence should be documented and to what extent depends on the particular case and should bedictated by how much the documentation will likely help or hurt the ultimate success of the defense. A detailedmemorandum or checklist may be helpful in carrying out due diligence, but the risk is great that, with hindsight,a plaintiff may discover an item not on the list, or an item for which the investigation was not carried out, notcompleted, or insufficiently or inaccurately documented. Thus, the detailed checklist presents the risk that itwould be found insufficient (because of an omission) or not complied with (a listed item was neglected, poorlydocumented, or intentionally ignored). Either way, the detailed plan approach is risky. Moreover, ifexperienced personnel are performing due diligence, a detailed plan would seem unnecessary and might inhibitthe flexibility needed to adjust as discoveries are made during the investigation. See William F. Alderman, DueDiligence In The Securities Litigation Reform Era: Practical Tips From Litigators On The Effective Conduct,Documentation And Defense Of Underwriter Investigation, 1265 PLI/Corp 416 at 446-52 (2001) (discussingdue diligence considerations in the emerging technology sector).

9. The Timing Of Due Diligence

Traditionally, due diligence is accomplished in the time between the initial discussions between issuer andunderwriter and the effective date of the registration statement. In large part, the due diligence investigation isfocused on the drafting process and the bulk of the investigation is often completed before the preliminaryprospectus is filed with the SEC and disseminated. Due diligence continues, however, during the period ofSEC staff comment through the time the registration statement is declared effective by the SEC, and the failureto consider new information up to the effective date can constitute a lack of due diligence. See Glassman v.Computervision Corp., 90 F.3d 617, 629 (1st Cir. 1996).

With respect to qualified issuers, timing of due diligence has been affected by the institution of the integrateddisclosure system by which some issuers are permitted to incorporate filings required under the SecuritiesExchange Act of 1934 into their registration statements. The integrated disclosure system can drasticallyreduce the drafting time and the post-filing waiting period to less than one week. Moreover, market realitiessometimes permit only a brief “window” for an offering, which makes speed of the essence. See Nicholas, TheIntegrated Disclosure System and Its Impact Upon Underwriters’ Due Diligence, 11 Sec. Reg. L. J. 3 (1983);

S.E.C. Release No. 33-6499 (Nov. 17, 1983); Shelf Registration, S.E.C. Release No. 33-6499, 1983 WL408321 (Nov. 17, 1983). Issues of ongoing due diligence are also presented by the use of “shelf registrations.” See, e.g., Ketels, S.E.C. Rule 415, The New Experimental Procedures for Shelf Registration, 10 Sec. Reg. L. J.318 (1983).

10. Drafting Offering Documents

a. Risk Factors

Offering documents should contain a complete disclosure of the particular risks involved in the investment,especially given the availability of the “bespeaks caution” doctrine and statutory Safe Harbor provisions. See Inre NationsMart Corp. Sec. Litig., 130 F.3d 309 (8th Cir. 1997); Phillips v. Kidder, Peabody & Co., 933 F.Supp. 303 (S.D.N.Y. 1996), aff’d, 108 F.3d 1370 (2d Cir. 1997) (ruling on summary judgment based in part oncautionary language in Prospectus). See Alderman, “A Litigator’s Perspective on Disclosing Risks and BadNews,” Course Handbook No. B-1767 (PLI 2009).

b. Forward-Looking Information

The SEC encourages issuers to disclose forward-looking information. See, e.g., Regulation S-K, Item 303(a),Instruction 7, 17 C.F.R. § 229.303(a).

Certain forward-looking information must be disclosed because failure to do so would cause the informationthat is disclosed to be misleading. This point is explicitly covered by Regulation S-K, Item 303(a)(3)(ii),which states that:

[i]f the registrant knows of events that will cause a material change in the relationship between costs andrevenues (such as known future increases in costs of labor or materials or price increases or inventoryadjustments), the change in the relationship shall be disclosed.

The SEC has indicated an intention to enforce rigorously the disclosure rules for forward-looking information. In In the Matter of Caterpillar, Inc., the SEC instituted proceedings against Caterpillar because its Form 10-Kand Form 10-Q allegedly failed to disclose that its 1989 earnings were directly linked to its Braziliansubsidiary, which had exceptionally high earnings due to hyperinflation. Release No. 34-30532, 51 S.E.C.Docket 147 (Mar. 31, 1992). Caterpillar also failed to disclose that its 1990 earnings were very difficult topredict because sweeping economic reforms were to be instituted in Brazil. The SEC found that Caterpillar hadfailed to discuss in its 10-K “the uncertainties surrounding [the subsidiary’s] earnings and possible materialfuture impact on Caterpillar’s overall financial condition and results of operations....” The Release reiterates atest first set forth in a 1989 MD&A Release to explain when disclosure of prospective information is required:

Where a trend, demand, commitment, event or uncertainty is known, management must make twoassessments: (1) is the known trend, demand, commitment, event or uncertainty likely to come tofruition? If management determines that it is not reasonably likely to occur, no disclosure is required; (2)if management cannot make that determination, it must evaluate objectively the consequences of theknown trend, demand, commitment, event or uncertainty, on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the registrant’sfinancial condition or results of operations is not reasonably likely to occur.

S.E.C. Release No. 6835, 43 S.E.C. Docket 1330 (May 18, 1989). Plaintiffs will often try to use the languagein Caterpillar to impose on defendants a duty to disclose forward-looking information.

However, Item 303 does not give rise to a private cause of action and its standard for disclosure differs from

that under Rule 10b-5. See In re Cypress Semiconductor Sec. Litig., No. C-92-2008-RMW, 1992 WL 394927,at *4 (N.D. Cal. Sept. 23, 1992); In re VeriFone Sec. Litig., 784 F. Supp. 1471 (N.D. Cal. 1992), aff’d, 11 F.3d865 (9th Cir. 1993); Alfus v. Pyramid Tech. Corp., 764 F. Supp. 598, 608 (N.D. Cal. 1991).

c. Safe Harbor

Registrants that disclose forward-looking information can, in many cases, take advantage of the “safe harbor”provisions contained in Rule 175 under the 1933 Act and Rule 3b-6 under the 1934 Act. Caterpillar makes theSEC’s Safe Harbor rules especially crucial. See, e.g., Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1121 (1stCir. 1996), superseded in part by statute as stated in Greebel v. FTP Software, Inc., 194 F.3d 185, 196-97 (1stCir. 1999); Roots P’ship v. Lands’ End, Inc., 965 F.2d 1411, 1417 (7th Cir. 1992); Wielgos v. CommonwealthEdison Co., 892 F.2d 509, 514-15 (7th Cir. 1989). In substance, these Safe Harbor rules provide that definedtypes of forward-looking statements will not be deemed “fraudulent” unless plaintiffs can show that thestatements were made or reaffirmed without a reasonable basis or other than in good faith. Safe Harbor Rulefor Projections, S.E.C. Release No. 33-6084, 1979 WL 181199 (June 25, 1979) (commenting upon adoptingRule 175). See generally Marx v. Computer Scis. Corp., 507 F.2d 485 (9th Cir. 1974) (holding forward-lookingstatements made with reasonable basis are not actionable). In Release No. 33-6084, the SEC announced itsauthority for promulgating Rule 175 as follows:

The Commission is adopting the rules pursuant to its authority under Section 19(a) of the Securities Actof 1933 [and inter alia] Sections 3(b) and 23(a)(1) of the Securities Exchange Act of 1934 . . . In additionto the definitional authority provided therein, Section 19(a) of the Securities Act [and inter alia] Section23(a)(1) of the Exchange Act . . . provide that no liability under these acts “shall apply to any act done oromitted in good faith in conformity,” with any rule or regulation of the Commission notwithstanding thatsuch rule or regulation may later be amended, rescinded, or determined invalid.

In addition, the Safe Harbor provisions of Section 27A of the Securities Act and Section 21E of the ExchangeAct may provide limited protection for certain forward-looking statements. These sections provide that certainissuers, persons acting on their behalf, “outside reviewers,” and underwriters (with respect to informationobtained from issuers) shall not be liable with respect to certain forward-looking statements. Forward-lookingstatements may, for example, fail to support liability if (1) they are accompanied by “meaningful cautionarystatements identifying important factors that could cause actual results to differ materially from those in theforward-looking statement;” (2) are immaterial; or (3) if plaintiff fails to prove that the statement was madewith actual knowledge that it was false or misleading. Id.

Despite the protection afforded by the Safe Harbor rules, issuers probably should not include forward-lookinginformation that they are not required to include. Including such information may needlessly expose allparticipants in a public offering to greater liability risks, as plaintiffs routinely try to use Item 303 to expand10b-5 liability, albeit unsuccessfully. See, e.g., Oran v. Stafford, 226 F.3d 275, 286 n.6, 288 (3d Cir. 2000); Inre VeriFone Sec. Litig., 784 F. Supp. 1471, 1483 (N.D. Cal. 1992), aff’d, 11 F.3d 865 (9th Cir. 1993).

11. Professional Malpractice

Professional malpractice claims are sometimes brought together with Section 11 claims.

a. Elements Of Cause Of Action For Professional Malpractice

Actionable legal or accounting malpractice is composed of the same basic elements as other kinds of actionablenegligence: (1) duty; (2) breach of duty; (3) proximate cause; and (4) damage. See generally Howard M.Garfield and Thomas Weathers, A Survey Of Accountant Malpractice: Breach Of Contract Or Tort?, 526PLI/Lit 271 (1995); Sukoff v Lemkin, 202 Cal. App. 3d 740 (1988).

b. To Whom Is The Duty Owed?

Attorneys and accountants who perform work in connection with a public offering usually are retained by theissuer or the underwriters. However, plaintiffs are usually investors who lack privity with these professionals. Therefore, a critical question in malpractice claims raised in public offering litigation is whether a duty of careruns from the professional to persons who foreseeably rely on the professional’s work.

1) Privity

Many jurisdictions require that a plaintiff be in privity or in a relationship that is “the practical equivalent ofprivity” before the plaintiff can state a claim for professional malpractice. See, e.g., Credit Alliance Corp. v.Arthur Andersen & Co., 483 N.E.2d 110, 118-20 (N.Y. 1985), modified on other grounds, 66 N.Y.2d 812 (N.Y.1985); Bily v. Arthur Young & Co., 3 Cal. 4th 370 (1992); FDIC v. Shraeder & York, 991 F.2d 216, 223 (5thCir. 1993); Great American Ins. Co. v. Dover, Dixon Horned, PLLC, 456 F.3d 909, 912 (8th Cir. 2006).

Other jurisdictions, however, have permitted malpractice actions in the absence of privity. Blu-J, Inc. v.Kemper C.P.A. Group, 916 F.2d 637, 640 (11th Cir. 1990) (explaining Florida adopted Restatement (Second)of Torts § 522 (1976) rule); Lucas v. Hamm, 56 Cal. 2d 583 (1961); Merit Ins. Co. v. Colao, 603 F.2d 654, 659(7th Cir. 1979) (holding, under Illinois law, malpractice action could be maintained against accountant in theabsence of privity). See generally Ronald E. Mallen, Legal Malpractice 156 (1981). However, the trend is torequire privity or a similar relationship. Bily, 3 Cal. 4th at 384-389; Credit Alliance v. Arthur Andersen & Co.,483 N.E. 2d 110 (N.Y. Ct. App. 1985), modified on other grounds, 66 N.Y. 2d 812 (1985); Morin v. Trupin,809 F. Supp. 1081, 1093 (S.D.N.Y. 1993); Pell v. Weinstein, 759 F. Supp. 1107, 1119 (M.D. Pa. 1991), aff’d,961 F.2d 1568 (3d Cir. 1992).

2) Accountant Liability

In Credit Alliance, the New York Court of Appeals announced three prerequisites for accountant liability tononcontracting parties: (1) the accountant must have been aware that the financial reports were to be used for aparticular purpose; (2) in the furtherance of which a known party was intended to rely; and (3) there must beconduct on the part of the accountants linking them to that party which evinces the accountant’s understandingof that party’s reliance. 483 N.E. 2d at 118-20; see also Ahmed v. Trupin, 809 F. Supp. 1100 (S.D.N.Y. 1993)(extending Credit Alliance test from accountants to lawyers); First Fed. Sav. & Loan Ass’n of Pittsburg v.Oppenheim, Appel, Dixon & Co., 629 F. Supp. 427, 433 (S.D.N.Y. 1986) (denying motion to dismiss whereaccountant communicated directly with plaintiff); Equitable Life Assurance Soc. v. Alexander Grant & Co., 627F. Supp. 1023, 1032 (S.D.N.Y. 1985) (no “unmistakable relationship” was pleaded); Westpac Banking Corp. v.Deschamps, 484 N.E.2d 1351 (1985) (holding plaintiff had not alleged an accountant-third party relationship“approaching privity”).

The California Supreme Court has held that an accountant “owes no general duty of care regarding the conductof an audit to persons other than the client.” Bily, 3 Cal. 4th at 376. Thus, an accountant’s liability for generalnegligence in the conduct of an audit of its client’s financial statements “is confined to the client, i.e., the personwho contracts for or engages the audit services.” Id. at 406. This decision overruled two lower court decisionsthat made accountants liable to third parties, such as investors and lenders, who reasonably and foreseeablyrelied on audited financial statements. The Bily court ruled, however, that an accountant could be held liable(1) to nonclients for negligent misrepresentation if the accountant knows that the audit is being prepared for thespecific benefit of that party; and (2) to reasonably foreseeable third persons for intentional fraud in thepreparation and dissemination of an audit report. Id. at 413; see also B.L.M. v. Sabo & Deitsch, 55 Cal. App.4th 823, 839 (Cal. Ct. App. 1997) (following Bily, the court declined to extend professional liability under a

negligent misrepresentation theory to individuals who are not clients of the attorney).

C. Section 12 Of the 1933 Act


Section 12 of the Securities Act of 1933, 15 U.S.C. § 771, provides that:

Any person who –

1) offers or sells a security in violation of Section 77e of this title; or

2) offers or sells a security (whether or not exempted by the provisions of Section 77c of this title, other thanparagraph (2) of subsection of such untruth or omission), and who shall not sustain the burden of proofthat he did not know, and in the exercise of reasonable care could not have known, of such untruth oromission,

shall be liable . . . to the person purchasing such security from him . . . to recover theconsideration paid for such security with interest thereon, less the amount of any incomereceived thereon, upon the tender of such security, or for damages if he no longer owns thesecurity.

A plaintiff may bring a Section 12 claim under either Section 12(a)(1) or 12(a)(2). Section 12(a)(1) provides acivil remedy for those who are sold a security without an effective registration statement or prospectus, inviolation of Section 5 of the Securities Act, 15 U.S.C. § 77e. Section 12(a)(2) provides a civil remedy forpurchasers who are sold a security in a public offering “by means of a prospectus or oral communication” thatcontained a material misstatement or omission. The elements of a claim under each section are discussed infra. Claims under section 12(a)(1) and 12(a)(2) both require that the transaction involve a “sale” of a “security” andthat the defendant is a “seller.”

a. Definition Of Security

The challenged transaction must involve a “security” as defined by Section 2(a)(1), formerly 2(1), of the 1933Act. What exactly fits into this definition has often been debated. See Landreth Timber Co. v. Landreth, 471U.S. 681 (1985) (finding that 100 percent of stock represented a security as defined under Section 2(a)(1) --distinguishing “sale of business” doctrine -- because “when an instrument is both called stock and bearscommon stocks’ usual characteristics, a purchaser may justifiably assume that the federal securities lawsapply”); United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975) (“In searching for the meaning and scopeof the word ‘security’ in the [Acts], form should be disregarded for substance and the emphasis should be oneconomic reality.”); Tcherepnin v. Knight, 389 U.S. 332, 336 (1967). Cf. Reves v. Ernst & Young, 494 U.S. 56(1990), aff’d, 507 U.S. 170 (1993) (“Congress’ purpose in enacting the securities laws was to regulateinvestments, in whatever form they are made and by whatever name they are called”). Thus, there is no liabilityif the transaction did not involve a security. In Developer’s Mortgage Co. v. TransOhio Savings Bank, 706 F.Supp. 570, 574-76 (S.D. Ohio 1989), the court held that the mere fact that the instrument in question bears alabel which is listed in the definition of security in Section 2(1) of the 1933 Act does not, ipso facto, make theinstrument a security within the meaning of the Act. The critical determination is whether the instrumentpossesses the characteristics typically associated with securities. Id. at 574.

b. Definition Of “Sale” Of Securities

Section 12(a)(3) of the Securities Act defines “sale” or “sell” to include “every contract of sale or disposition of

a security . . . for value,” and the terms “offer to sell,” “offer for sale,” or “offer” to include “every attempt oroffer to dispose of, or solicitation of an offer to buy, a security . . . for value.” Pinter v. Dahl, 486 U.S. 622,643 (1988) (citing 15 U.S.C. § 77(b)(3) (emphasis added)). Both the SEC and federal courts have held that, fora “sale” or “solicitation” of securities “for value” to occur under the Securities Act, a plaintiff must part withsome “tangible and definable consideration” in return for an interest in the security. Int’l Bhd. of Teamsters v.Daniel, 439 U.S. 551, 560 (1979).

1) Stock And Stock Options

Courts, commentators and the SEC agree that grants of stock and stock options under employee benefits planstypically do not involve a purchase or sale of a security subject to the Securities Act’s registrationrequirements. See Bauman v. Bish, 571 F. Supp. 1054, 1064 (N.D. W. Va. 1983) (finding no offer, sale, orpurchase of securities absent the “furnishing of ‘value’ by participating employees”); Employee Benefits Plans,Securities Act Release No. 33-6188, 19 S.E.C. Docket 465, 1980 WL 29482, at *15 (Feb. 1, 1980) (“S.E.C.Release No. 6188”) (“[T]here is no ‘sale’ in the 1933 Act sense to employees, since such persons do notindividually bargain to contribute cash or other tangible or definable consideration to such plans.”); Childers v.Nw. Airlines, Inc., 688 F. Supp. 1357, 1363 (D. Minn. 1988) (finding no “‘purchase’ of a security sinceparticipating employees did not furnish value”). An employee’s “labor” does not qualify as “value” forpurposes of the Securities Act. Int’l Bhd. of Teamsters, 439 U.S. at 560.

2) Affirmative Investment Decision

Similarly, there can be no liability for a “sale” or “solicitation” under the Securities Act absent an “affirmativeinvestment decision” by a plaintiff to invest in a security. See Bauman, 571 F. Supp. at 1064 (“It is the opinionof the court that no offer, sale or purchase occurs . . . as contemplated by the securities laws . . . [when] there isno affirmative investment decision.”); S.E.C. Release No. 33-6188, 1980 WL 29482, at *2 (“[A] sale . . .occurs where there is both an investment decision and the furnishing of value by participating employees . . .the staff does not believe a sale occurs when an existing plan is converted . . . except where employees aregiven a choice in the matter and therefore have the opportunity to make an investment decision.”); see alsoIsquith by Isquith v. Caremark Int’l, Inc., 136 F.3d 531, 532-34 (7th Cir. 1998) (dismissing complaint allegingsecurities fraud in connection with corporation’s spin-off of a subsidiary because there was “no purchase or saleof securities” absent a voluntary “investment decision” to buy or sell securities); In re Cendant Corp. Sec.Litig., 76 F. Supp. 2d 539, 544-45 (D.N.J. 1999) (affirming dismissal of employee stock option holders’ Section10(b) claim because “no purchase or sale” had taken place, as the plan was “both compulsory andnoncontributory”).

c. Defendant Must Be A “Seller” Of Securities

Sections 12(a)(1) and 12(a)(2) expressly limit liability to a person who “offers or sells a security.” Plaintiff,therefore, must allege that defendant is a “seller” within the meaning of Sections 12(a)(1) and (2). Dietrich v.Bauer, 76 F. Supp. 2d 312, 330 (S.D.N.Y. 1999) (“[I]t is not enough . . . simply to allege that [one] acquiredsecurities through [the] defendant, or that [the] defendant made [the] sale of securities possible; . . . defendant[must be the] title-holder of [the] securities prior to sale, or . . . acting as agent, [must have] successfullysolicited [the] plaintiff’s purchase . . . from [the] title-holder.”). As discussed below, despite the seeminglyclear language of Section 12 and the rescissory measure of damages prescribed by the statute, many courts haveexpanded the universe of possible Section 12 defendants beyond persons in privity with plaintiff.

Although the courts generally apply the same analysis to determine whether a defendant is a seller under bothSections 12(a)(1) and 12(a)(2), (for example, Hill York Corp. v. American International Franchises, Inc., 448

F.2d 680, 692 n.17 (5th Cir. 1971), disagreed with on other grounds in Pinter v. Dahl, 486 U.S. 622, 649 n.25(1988)), some courts have questioned whether the concept of “seller” under Section 12(a)(2) should be broaderthan under Section 12(a)(1) because Section 12(a)(1) does not provide a reasonable care defense. See, e.g.,Pharo v. Smith, 621 F.2d 656, 665-66, aff’d in part, 625 F.2d 1226 (5th Cir. 1980), disagreed with on othergrounds in Pinter, 486 U.S. at 649-50.

d. Supreme Court Definition of “Seller”

In Pinter v. Dahl, 486 U.S. 622 (1988), the Supreme Court held that the term “seller” as used in Section 12includes any person who solicits the sale of securities. It is not limited to the person who passes title. Anonowner of securities must solicit the purchaser, motivated at least in part by a desire to serve his ownfinancial interests or those of the securities owner, in order to qualify as a “seller.” Id. at 647. Only if thesoliciting person is motivated by such financial interests can it be fully said that the buyer purchased thesecurity from him such that he can be aligned with the owner in a rescission action.

1) Privity

Pinter v. Dahl, 486 U.S. 622 (1988), expressly rejected the doctrine of strict privity in a Section 12(a)(1)action. Although the Supreme Court did not take a position on the scope of “seller” for the purposes of aSection 12(a)(2) action, most circuits now hold that the Pinter definition of “seller” applies to Section 12(a)(2).

The Second Circuit, in holding that the language of Sections 12(a)(1) and 12(a)(2) is identical in meaning,applied the Supreme Court’s analysis in Pinter and held that the term “seller” must “include the person whosuccessfully solicits the purchase, motivated at least in part by a desire to serve his own financial interests orthose of the securities owner.” Capri v. Murphy, 856 F.2d 473, 478 (2d Cir. 1988) (citing Pinter v. Dahl, 486U.S. 622 (1988)); see also Moore v. Kayport Package Exp., Inc., 885 F.2d 531, 537 (9th Cir. 1989) (holdingthat Pinter provides the standard for determining liability as a “seller” under Section 12(a)(2) as well as underSection 12(a)(1)); Maher v. Durango Metals, Inc., 144 F.3d 1302 (10th Cir. 1998).

The Capri court found defendants, who prepared and circulated the allegedly misleading prospectus, liable eventhough they did not directly communicate with the plaintiffs. Other courts, however, have required that the“soliciting seller” have “direct” or “personal” contact with a plaintiff. See Craftmatic Sec. Litig. v. Kraftsow,890 F.2d 628, 636 (3d Cir. 1989) (“The purchaser must demonstrate direct and active participation in thesolicitation of the immediate sale to hold the issuer liable as a Section 12[(a)](2) seller.”); In re NewbridgeNetworks Sec. Litig., 767 F. Supp. 275, 281 (D.D.C. 1991) (dismissing Section 12(a)(2) claim because “absentany allegation of direct contact of any kind between defendants and plaintiff-purchasers . . . defendants are notstatutory sellers”); Cent. Laborers Pension Fund v. Merix Corp., No. CV04-826-MD, 2005 WL 2244072, at *8(D. Or. Sept. 15, 2005) (holding the signing of a prospectus by itself does not qualify as soliciting a sale ofsecurities sufficient to render an individual a seller for purposes of Section 12(a)(2)).

In Wilson v. Saintine Exploration & Drilling Corp., 872 F.2d 1124 (2d Cir. 1989), the court held that a law firmthat prepared and distributed a private placement memorandum containing a material misstatement was notliable under Section 12(a)(2) or Pinter v. Dahl because the law firm did not actively solicit an offer or salemotivated by financial gain. Id. at 1127; see also Commercial Union Assurance Co. v. Milken, 17 F.3d 608,616 (2d Cir. 1994) (“Since appellants did not purchase the interests directly from [defendants], defendants willbe liable under Section 12[(a)](2) only if they ‘solicited’ the sale.”); Moore v. Kayport Package Express, Inc.,885 F.2d 531, 537 (9th Cir. 1989) (holding that allegations that accountant and lawyer defendants merelyprovided professional services were insufficient to impose Section 12(a)(2) liability); Shaw v. Digital Equip.Corp., 82 F.3d 1194, 1215-16 (1st Cir. 1996) (finding Section 12(a)(2) liability improper in a public offeringconducted pursuant to a firm commitment underwriting where plaintiff made “bald and factually unsupported”statements that defendants “solicited” purchasers of securities by preparing the registration statement and

prospectus, and participating in other “activities necessary to effect the sale of the . . . securities to the investingpublic”), superseded in part by statute as stated in Greebel v. FTP Software, Inc., 194 F.3d 185, 196-97 (1stCir. 1999); In re Stratosphere Corp. Sec. Litig., 1 F. Supp. 2d 1096 (D. Nev. 1998) (holding that mereinvolvement in the preparation of a registration statement is insufficient to state a claim under Section 12).

2) Supreme Court Rejects “Substantial Factor” Test

The Court in Pinter rejected the “substantial factor test,” which provides that a nontransferor seller is one whoseparticipation in the buy-sell transaction is a substantial factor in causing the transaction to take place, as theappropriate standard for assessing Section 12(a)(1) liability. The Court found that Congress did not intend toimpose rescission based on strict liability on a person only remotely related to the transaction. Id. Rather thanproperly focusing on the defendant’s relationship with the plaintiff-purchaser, as urged by the “purchase from”requirement of Section 12, the “substantial factor test” focused on the defendant’s degree of involvement in thetransaction and surrounding circumstances. Id.

3) In Pari Delicto

The Pinter Court also extended the in pari delicto defense to a Section 12(a)(1) private rescission actionfollowing Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299 (1985), which applied the defenseunder Section 10(b) and Rule 10b-5. Dahl, an investor in oil leases owned by Pinter, an oil and gas driller,urged eleven other individuals, including friends and relatives, to invest in the same deal. The elevenindividuals relied entirely on Dahl’s representations in deciding whether to invest. However, Dahl did notreceive any commissions or other compensation for his role. After the leases turned out to be worthless, Dahland the other investors sued Pinter. Pinter counterclaimed that Dahl had fraudulently misrepresented his ownand the other investors’ investment experience and sophistication. Based on this and other alleged involvementon the part of Dahl, Pinter argued that he and Dahl were in pari delicto. Because the district court’s findingswere inadequate to determine whether Dahl should be subjected to the in pari delicto defense, the case wasremanded for adjudication of that question. The Court provided guidance, however, that the in pari delictodefense applies where: (1) as a direct result of the plaintiff’s own action, the plaintiff “bears at leastsubstantially equal responsibility for the underlying illegality” and (2) the “plaintiff’s role in the offering or saleof nonexempted, unregistered securities is more as a promoter rather than as an investor.” See Pinter, 486 U.S.at 635-36, 639; see also Silva Run Worldwide, Ltd v. Gaming Lottery Corp., No. 96 CIV 3231, 1998 WL167330, at *10 (S.D.N.Y. Apr. 8, 1998).

The first prong of the test is satisfied if the plaintiff is at least equally responsible for the actions that render thesale of the unregistered securities illegal. However, a purchaser’s knowledge that the securities are unregisteredcannot by itself constitute equal culpability. One relevant consideration is the extent to which the plaintiff andthe defendant cooperated in developing and implementing the distribution scheme. A plaintiff found to haveinduced the issuer not to register should be precluded from obtaining Section 12(a)(1) rescission.

The second prong of the test, whether a plaintiff is primarily an investor or primarily a promoter, depends uponmany factors. These factors include, but are not limited to: (1) the extent of the plaintiff’s financialinvolvement compared to that of third parties solicited by the plaintiff; (2) the incidental nature of the plaintiff’spromotional activities; (3) the benefits received by the plaintiff from his promotional activities; and (4) theextent of the plaintiff’s involvement in the planning stages of the offering. Pinter, 486 U.S. at 639.

For post-Pinter cases in the Section 12(a)(1) context, see M. K. Stull, Who May Be Liable in Civil Actions,Under § 12(a)(1) of the Securities Act of 1933 (15 U.S.C.A. §77l(a)(1)) for Selling or Offering Securities forSale in Violation of Registration or Prospectus Provisions of the Act – Post-Pinter Cases, 105 ALR Fed. 725,729 (1991).

e. Officers And Directors Of A Corporate Seller

Officers and directors of a corporate seller are not “sellers” for purposes of Section 12(a)(1) solely by virtue oftheir positions within the company. See Royal Am. Managers, Inc. v. IRC Holding Corp., 885 F.2d 1011, 1017(2d Cir. 1989).

2. Section 12(a)(1)


To state a claim under Section 12(a)(1), plaintiff must plead: (1) a sale or offer to sell securities by thedefendant; (2) the absence of a registration statement; and (3) the use of the mails or facilities of interstatecommerce in connection with the sale or offer. See Ellison v. Am. Image Motor Co., Inc., 36 F. Supp. 2d 628,638 (S.D.N.Y. 1999).

b. Exempt Security

One defense to a Section 12(a)(1) claim exists when the challenged transaction involves a security that wasexempt from the registration provisions of Section 5 or under the subsections of Section 3(a) of the 1933 Act,15 U.S.C. § 77c. See S.E.C. v. Life Partners Inc., 87 F.3d 536, 538 (D.C. Cir. 1996) (holding that, if viaticalsettlements are insurance contracts, they are altogether exempt from coverage under the federal securitieslaws). Such a security is always exempt from registration, both when issued and later when traded.

c. Exempt Transaction

Another Section 12(a)(1) defense exists when the challenged transaction is exempted under Section 4 of the1933 Act, 15 U.S.C. Section 77d. These exemptions include: (1) transactions that do not involve an issuer,underwriter, or dealer under Section 4(1); (2) private offerings under Section 4(2); (3) certain dealer or brokertransactions under Sections 4(3) and 4(4); and (4) restricted issuer transactions to accredited investors underSection 4(6). See Baldwin v. Kulch Assoc., Inc., 39 F. Supp. 2d 111, 115 (D.N.H. 1998) (“[D]efendants mayavoid the broad registration requirements of Section 5 by proving the affirmative defense that the securitieswere exempt under 15 U.S.C. Section 77d.”).

A defendant bears the burden of proving that a challenged transaction is exempt under Section 4. Western Fed.Corp. v. Erickson, 739 F.2d 1439, 1442-43 (9th Cir. 1984); Butler v. Phlo Corp., No. 00 CIV 1607, 2001 WL863426, at *5 (S.D.N.Y. July 31, 2001). Failure to carry this burden means the exemption is lost and defendantwill be liable under Section 12(a)(1) strict liability.

d. No Due Diligence Defense

Unlike Sections 11 and 12(a)(2), Section 12(a)(1) does not provide for a “reasonable investigation” or“reasonable care” defense, i.e., a due diligence defense.

e. Measure Of Damages Under Section 12(a)(1)

Upon tender of the security, a plaintiff may sue to recover actual damages measured by the amount paid for asecurity, plus interest, less any income received. See 15 U.S.C. § 77(a)(2). If the plaintiff no longer owns the

security, the plaintiff may recover actual damages or any real economic loss suffered. See Smith v. Comm’r, 67T.C. 570, 575 (1976) (“The measure of damages in a section 12(1) action is the actual or real loss suffered byeither a party who buys unregistered stock . . . and suffers an economic loss on its resale or a party who is leftholding a worthless security.”).

Any damages are rescissory in nature, and any “income received” includes amounts that the plaintiff receivedfrom the sale of the security. See Randall v. Loftsgaarden, 478 U.S. 647, 656 (1986).

3. Section 12(a)(2)


To state a cause of action under Section 12(a)(2) of the 1933 Act, a plaintiff must allege: (1) an offer or sale ofa security; (2) by the use of any means of interstate commerce; (3) through a prospectus or oral communication;(4) which includes an untrue statement of a material fact or omits to state a material fact; and (5) that plaintiff“did not know of the untrue statements or omissions when purchas[ing] the securities.” In re Itel Sec. Litig., 89F.R.D. 104, 115 (N.D. Cal. 1981); see also In re NationsMart Corp. Sec. Litig., 130 F.3d 309, 318 (8th Cir.1997).

1) No Reliance

A plaintiff need not allege reliance on the misrepresentation or omission. Sanders v. John Nuveen & Co., Inc.,619 F.2d 1222, 1225-26 (7th Cir. 1980); Hines v. ESC Strategic Funds, Inc., No. 3:99-0530, 1999 WL1705503, at *7 (M.D. Tenn. Sept. 17, 1999). Some courts have required that the misinformation beinstrumental in the sale. See Davis v. Avco Fin. Servs., Inc., 739 F.2d 1057, 1068 (6th Cir. 1984) (findingimpact of defendant’s activities on plaintiff purchaser relevant to determining whether defendant was a “seller”subject to Section 12(a)(2) liability). However, Davis employed a “proximate cause--substantial factor” test todetermine whether the defendant was a Section 12(a)(2) “seller,” an approach that was rejected by the SupremeCourt four years later in Pinter, at least in the 12(a)(1) context. Pinter v. Dahl, 486 U.S. 622, 649-50 (1988). In any event, instrumentality may be shown by demonstrating that the market in the purchased securities wasbolstered by the misinformation. See Sanders, 619 F.2d at 1227 (finding a sufficient link, even though someplaintiffs did not know of defendant’s representations because the market would have collapsed had the truthbeen divulged).

2) No Scienter

Scienter is not a requirement for alleging a 12(a)(2) claim. Miller v. Thane International, Inc., 519 F.3d 879(9th Cir. 2008) (citing In re Convergent Tech. Sec. Litig., 948 F.2d 507, 512 (9th Cir. 1991) (“Section 12(a)(2)is a virtually absolute liability provision that does not require an allegation that defendants possessed scienter.”)

3) No Causation

Courts have held that plaintiffs asserting a 12(a)(2) claim need not prove causation, i.e., that the sale would nothave occurred absent the material misrepresentation or omission. See, e.g., Hill York Corp. v. Am. Int’lFranchises Inc., 448 F.2d 680, 696 (5th Cir. 1971), disagreed with on other grounds in Pinter v. Dahl, 486 U.S.622, 649 n.25 (1988). Other courts have imposed at least a minimal causation requirement. See MetromediaCo. v. Fugazy, 983 F.2d 350 (2d Cir. 1992) (noting that Section 12(a)(2) requires “some” causal connection

between the alleged communication and the sale); Jackson v. Oppenheim, 533 F.2d 826, 830 n.8 (2d Cir. 1976)(holding that misleading communication must have been intended or perceived as instrumental in effecting thesale).

With the passage of the PSLRA, Congress created a defense to Section 12(a)(2) claims to the extent that adefendant can establish the absence of loss causation. Section 12(b) of the Securities Act provides:

In an action described in subsection (a)(2) of this section, if the person who offered and sold suchsecurity proves that any portion or all of the amount recoverable under subsection (a)(2) of this sectionrepresents other than the depreciation in value of the subject security resulting from such part of theprospectus or oral communication with respect to which the liability of that person is asserted, not beingtrue or omitting to state a material fact required to be stated therein or necessary to make the statementnot misleading, then such portion or amount, as the case may be, shall not be recoverable.

15 U.S.C. § 77(b); see also In re Salomon Smith Barney Mutual Fund Litig., 441 F. Supp. 2d 579, 588(S.D.N.Y. 2006) (noting that the Reform Act added express loss causation provision to §12).

4) Limited To Initial Offering Or Sale – No Tracing

A plaintiff must have purchased the security directly from the issuer of the prospectus. See Pinter, 486 U.S. at644, n. 21 (“[A] buyer cannot recover against his seller’s seller.”); Hertzberg v. Dignity Partners, Inc., 191 F.3d1076, 1081 (9th Cir. 1999). Tracing shares purchased in the secondary market back to the initial offering is notsufficient. Gustafson v. Alloyd Co., Inc., 513 U.S. 561, 577-78 (1995) (stating that only investors whopurchased shares in an offering have standing to sue under Section 12(a)(2)); see also Ballay v. Legg MasonWood Walker, Inc., 925 F.2d 682, 693 (3d Cir. 1991) (“Section 12[(a)](2) applies only to initial offerings andnot to aftermarket trading.”). Cf. Gannon v. Cont’l Ins. Co., 920 F. Supp. 566, 575 (D.N.J. 1996) (explainingthat shares redeemed after merger were not issued “pursuant to an initial offering;” hence no Section 12(a)(2)liability); Flake v. Hoskins, 55 F. Supp. 2d 1196, 1228 (D. Kan. 1999) (“To have standing under Section 12, aplaintiff must allege a ‘public offering’ of securities.”). But see Feiner v. SS&C Techs Inc., 47 F. Supp. 2d 250,253 (D. Conn. 1999) (“Section 12(a)(2) extends to aftermarket trading of a publicly offered security so long asthat aftermarket trading occurs ‘by means of a prospectus or oral communication.’”).

5) Scope Of Investors’ Duty

Under Section 12(a)(2), statements made in a prospectus that are “literally true on their face may nonetheless bemisleading when considered in context,” but investors are not required to look beyond a document to discoverwhat in the document is true. Miller v. Thane International, Inc., 519 F.3d 879, 886 (9th Cir. 2008). In Miller,the Ninth Circuit found that the district court was in error for imputing knowledge of the contents of drafts ofthe Prospectus to shareholders who received the final Prospectus. Id. at 887.

b. “Seller” Status Issues Under 12(a)(2)

In addition to traditional privity based claims, Section 12(a)(2) claims against sellers arise in a variety ofcontexts.

1) Defendants In Public Offering Litigation

Plaintiffs in public offering litigation often assert Section 12(a)(2) claims against an issuer, its officers and

directors, and underwriters.

2) Firm Commitment Indemnity

In a firm commitment underwriting, where the underwriting syndicate purchases the issuer’s shares and resellsto the public, the underwriters are not the “agents” of the issuer or its officers and directors and, thus, there is noprivity between the issuer, the officers and directors, and the investor. In re Fortune Sys. Sec. Litig., 604 F.Supp. 150, 159-60 (N.D. Cal. 1984); Lone Star Ladies Inv. Club v. Schlotzsky’s Inc., 238 F.3d 363, 370 (5thCir. 2001). But see Degulis v. LXR Biotechnology, Inc., No. 95 Civ. 4204 (RWS), 1997 WL 20832, at *6(S.D.N.Y. Jan. 21, 1997) (“[N]o authority cited stands for the proposition that signatories of a registrationstatement cannot be considered statutory ‘sellers’ under Section 12(a)(2) merely because there was a firmcommitment underwriting of the offering.”).

3) Actual Participation

Courts generally hold that the issuer and its officers and directors are not liable under Section 12(a)(2) merelybecause they were involved in planning the offering, drafting the prospectus, and negotiating the stock pricebecause such acts are typically part of any public offering. “Seller” status must be predicated on “actualparticipation” in the selling process to the named plaintiffs. In re Craftmatic Sec. Litig., 890 F.2d 628, 636 (3dCir. 1989) (“The purchaser must demonstrate direct and active participation in the solicitation of the immediatesale to hold the issuer liable as a Section 12[(a)](2) seller.”); Steed Fin. LDC v. Nomura Sec. Int’l, Inc., No. 00CIV. 8058 (NRB), 2001 WL 1111508, at *7 (S.D.N.Y. Sept. 20, 2001); In re Wicat Sec. Litig., 600 F. Supp.1236, 1242 (D. Utah 1984). But see Degulis, 1997 WL 20832, at *6 (finding allegation that issuer signed theregistration statement is not “conclusory” and survives a motion to dismiss at the pleadings stage); Schaffer v.Evolving Sys., Inc., 29 F. Supp. 2d 1213 (D. Colo. 1998) (finding allegations that underwriters signed theregistration statement and sold stock sufficient to allege solicitation of sale and pecuniary gain).

The Second Circuit affirmed summary judgment in favor of an issuer in Akerman v. Oryx Commc’ns, Inc., 810F.2d 336 (2d Cir. 1987), holding that (1) the issuer was not in privity with plaintiffs because the stock was soldin a firm commitment underwriting; and (2) no “participant” liability could attach unless scienter was proven. Similarly, an underwriter cannot incur participant liability to investors who did not purchase from it byperforming typical duties as a lead underwriter. Klein v. Computer Devices, Inc., 602 F. Supp. 837, 840(S.D.N.Y. 1985).

4) Section 12 Claims Against Professionals

The judicial expansion of Section 12 “seller” status to persons other than the direct seller (or offeror) of asecurity has transformed Section 12 into a weapon frequently used against professionals because Sections 12(a)(1) and 12(a)(2), unlike Rule 10b-5, usually do not require proof of scienter.

5) Professionals As Sellers

Before Pinter v. Dahl, many courts rejected Section 12 claims against professionals under a “proximate cause”analysis. In Croy v. Campbell, 624 F.2d 709 (5th Cir. 1980), for example, the Fifth Circuit affirmed a directedverdict in favor of an attorney who had arranged a meeting between plaintiffs and a real estate limitedpartnership developer, recommended the tax shelter project, gave plaintiffs a brochure from the developer,made potential tax liability estimates for plaintiffs, and was paid for his services by the developer. The court

held that his participation in the sale of a security to plaintiffs was not a substantial factor in the transaction. See Stokes v. Lokken, 644 F.2d 779 (8th Cir. 1981) (attorneys); Westlake v. Abrams, 504 F. Supp. 337 (N.D.Ga. 1980) (attorneys); McFarland v. Memorex Corp., 493 F. Supp. 631, 648-49 (N.D. Cal. 1980) (accountants);Canizaro v. Kohlmeyer & Co., 370 F. Supp. 282, 287 (E.D. La. 1974) (“[W]hen the broker represents the buyeralone and executes a purely unsolicited order, it is difficult to see how he could be considered one who ‘sells’even within the meaning of the Securities Act.”), aff’d, 512 F.2d 484 (5th Cir. 1975).

After Pinter, some courts held that a professional can be liable under Section 12(a)(2), though the trend is tofind a professional not liable. The following cases have held that a professional defendant may be liable as aseller: Lee v. Spicola, No. 86-1808 CIV-T-10, 1988 WL 152013, at *2 (M.D. Fla. Dec. 9, 1988) (accountant);In re Prof. Fin. Mgmt., Ltd., 692 F. Supp. 1057 (D. Minn. 1988) (attorneys).

In the following cases, the professional was not subject to liability as a seller: Wilson v. Saintine Exploration &Drilling Corp., 872 F.2d 1124 (2d Cir. 1989) (law firm); Bank of Denver v. Se. Capital Group, Inc., 763 F.Supp. 1552 (D. Colo. 1991) (attorneys); Dawe v. Main Street Mgmt. Co., 738 F. Supp. 36, 37 (D. Mass. 1990)(accountants merely “collateral participants” in sale of security); Med Safe Nw. Inc. v. Medvial, Inc., No. 98-1375, 2001 WL 13259, at *6 (10th Cir. Jan. 5, 2001).

6) No Secondary Liability

Prior to Pinter v. Dahl, several courts had indicated that a plaintiff could state a cause of action for secondaryliability under Section 12. See, e.g., Kilmartin v. H.C. Wainwright & Co., 637 F. Supp. 938 (D. Mass. 1986); Inre Itel Sec. Litig., 89 F.R.D. 104, 115 (N.D. Cal. 1981). Although Pinter did not expressly resolve whethersecondary liability could exist under Section 12(a)(1), most courts have held that a plaintiff may not state aclaim for secondary liability under Section 12(a)(2). See, e.g., Ackerman v. Schwartz, 947 F.2d 841 (7th Cir.1991); In re Am. Bank Note Holographics Inc., Sec. Litig., 93 F. Supp. 2d 424, 438 (S.D.N.Y. 2000);Craftmatic Sec. Litig. v. Kraftsow, 890 F.2d 628 (3d Cir. 1989) (holding that persons who fail to qualify as“sellers” under the Pinter test may not be held liable under Section 12(a)(2) on an aiding and abetting theory ofliability). But see Dawe v. Main Street Mgmt. Co., 738 F. Supp. 36 (D. Mass 1990); In re Worlds of WonderSec. Litig., 721 F. Supp. 1140, 1148 (N.D. Cal. 1989).

c. Measure Of Damages Under Section 12(a)(2)

1) Rescission

Section 12(a)(2) provides express statutory authority for rescission. Randall v. Loftsgaarden, 478 U.S. 647, 655(1986); Mathews v. Kidder Peabody & Co., Inc., 260 F.3d 239, 249 (3d Cir. 2001). A Section 12 plaintiff maynot recover rescissionary damages after disposing of the stock, however. In re MetLife Demutualization Litig.,156 F. Supp. 2d 254, 269 (E.D.N.Y. 2001). The legislative purpose of rescission was deterrence, notcompensation. Globus v. Law Research Serv., Inc., 418 F.2d 1276, 1288 (2d Cir. 1969); Feit v. Leasco DataProcessing Equip. Corp., 332 F. Supp. 544, 567 (E.D.N.Y. 1971). In order to rescind the transaction underSection 12(a)(2), a purchaser must tender the security to the seller. A plaintiff, therefore, “cannot rescind thetransaction under Section 12[(a)](2) and at the same time retain his status as a security holder in order to sue fordamages under Section 11.” In re Gap Stores Sec. Litig., 79 F.R.D. 283, 307 (N.D. Cal. 1978). However, “it isreasonable to assume that the plaintiff may pursue both remedies to judgment, electing his choice at the lastpossible moment.” Id.

Courts are divided on the issue of the specificity with which a plea for rescission must be recited in thecomplaint to constitute a sufficient offer to tender under Section 12. Compare Metz v. United Counties

Bancorp, 61 F. Supp. 2d 364, 379 (D.N.J. 1999) (holding a complaint’s recital that plaintiffs are “entitled eitherto rescind their [stock] purchases . . . or to receive payment from [the defendants] for damages sustained”insufficient to constitute proper offer to tender under Section 12), with Wigand v. Flo-Tek, Inc., 609 F.2d 1028,1035 (2d Cir. 1979) (finding a demand for rescission containing an implicit offer to tender sufficient to satisfythe statute).

2) Damages

As with Section 12(a)(1), a plaintiff unable to rescind, e.g., having sold or unable to tender the securities, mayobtain damages. 15 U.S.C. § 771(2). Goldkrantz v. Griffin, No. 97 CIV. 9075, 1999 WL 191540, at *6(S.D.N.Y. Apr. 6, 1999), aff’d, 201 F.3d 431 (2d Cir. 1999). The statute does not specify the measure ofdamages recoverable.

When a Section 12(a)(2) plaintiff no longer owns shares and seeks damages, those damages are to be measuredso that the result is the substantial equivalent of rescission: namely, the difference between the purchase priceand plaintiff’s resale price, plus interest, less any income or return of capital (with interest) that the plaintiffreceived on the security. L. Loss, Fundamentals of Security Regulations 1025 (1983); see also Randall v.Loftsgaarden, 478 U.S. 647, 656 (1986) (quoting Loss). “Income received” includes “payments in cash orproperty received by virtue of ownership of a security, such as distributions or dividends on stock, interest onbonds, or a limited partner’s distributive share of the partnership’s capital gains or profits.” Id. at 657. However, “income received” excludes tax benefits. Id.

3) Reform Act Limitation

The Reform Act bars recovery of any loss that the defendant proves is attributable to any factor other thandepreciation in value resulting from a material misstatement or omission in a prospectus or oralcommunication. 15 U.S.C. § 77l(b).

4) Attorney’s Fees

Although Section 12 does not specifically provide for the recovery of attorney’s fees, Section 11, 15 U.S.C. §77k(e), provides that “[i]n any suit under this or any other section of this title . . .,” the prevailing party may beawarded attorney’s fees if the court finds that a claim or defense asserted by the losing party is without merit(emphasis added).

5) Punitive Damages

Punitive damages are not available under Section 12(a)(2). Hill York Corp. v. Am. Int’l Franchises, Inc., 448F.2d 680 (5th Cir. 1971), disagreed with on other grounds in Pinter v. Dahl, 486 U.S. 622, 649 n.25 (1988).

d. Not Applicable To Private Offerings

Although Section 12(a)(2) had been repeatedly applied to private as well as public offerings of securities, seefor example Metromedia Co. v. Fugazy, 983 F.2d 350 (2d Cir. 1992) (and cases cited therein), the U.S.Supreme Court in Gustafson v. Alloyd Co., Inc., 513 U.S. 561, 584 (1995), held that Section 12(a)(2) does notextend to a private sale contract, since a contract and its recitations that are not held out to the public are not a

“prospectus” as the term is used in the 1933 Act. See also In re WorldCom, Inc. Sec. Litig., 294 F. Supp. 2d431, 453-56 (S.D.N.Y. 2003) (holding no Section 12 liability because explicit restrictions of the offeringmemorandum indicate offering was not a public offering even though bonds were offered to hundreds ofinvestors); Am. High-Income Trust v. AlliedSignal, 329 F. Supp. 2d 534, 543 (S.D.N.Y. 2004) (holding offeringmemorandum issued as part of private placement and exchange offering is not a prospectus).

e. Defenses Available Under Section 12(a)(2)

1) Plaintiff’s Knowledge

The fact that the plaintiff knew the truth of the misrepresented or omitted material fact is a defense to a Section12(a)(2) claim. Section 12(a)(2); In re Itel Sec. Litig., 89 F.R.D. 104, 115 (N.D. Cal. 1981); Ames v. Uranus,Inc., No. 92-2170-JWL, 1994 WL 482626, n.16 (D. Kan. Aug. 24, 1994). In bringing a motion to dismiss forfailure to state a Section 12(a)(2) claim, defendants are entitled to raise all information or documents of whichplaintiff had “actual notice” and upon which plaintiff must have relied in drafting the complaint. Cortec Indus.,Inc. v. Sum Holding, L.P., 949 F.2d 42 (2d Cir. 1991).

2) Reasonable Care/Due Diligence

Another defense may be made out if the Defendant did not know and, through the exercise of reasonable care,could not have known of the misrepresentation or omission of material fact. 15 U.S.C. § 771(a)(2); Sanders v.John Nuveen & Co., Inc., 619 F.2d 1222, 1229 (7th Cir. 1980); In re BankAmerica Corp. Sec. Litig., 78 F.Supp. 2d 976, 992 (E.D. Mo. 1999).

3) Materiality

There is no liability if the misrepresented or omitted fact was not material. Section 12(a)(2); Parnes v. Gateway2000, Inc., 122 F.3d 539, 546 (8th Cir. 1997) (“information of common knowledge, insignificant data, or vaguestatements are examples of immaterial information” that is not actionable under Section 11 or 12(a)(2)); seealso In re BankAmerica Corp. Sec. Litig., 78 F. Supp. 2d at 991-92; In re WebSecure, Inc. Sec. Litig., 182F.R.D. 364 (D. Mass. 1998).


Section 13 of the 1933 Act, 15 U.S.C. § 77m, provides that:

[n]o action shall be maintained to enforce any liability created under Section 77k or 77l(2) of this titleunless brought within one year after the discovery of the untrue statement or the omission, or aftersuch discovery should have been made by the exercise of reasonable diligence, or, if the action is toenforce a liability created under Section 771(1) of this title, unless brought within one year after theviolation upon which it is based. In no event shall any such action be brought to enforce a liabilitycreated under Sections 77k or 771(1) of this title more than three years after the security was bona fideoffered to the public, or under Section 771(2) of this title more than three years after the sale.

Plaintiff must plead in the complaint compliance with Section 13’s statute of limitations to state a claim underSections 12(a)(1) or 12(a)(2). Toombs v. Leone, 777 F.2d 465, 468 (9th Cir. 1985); Meadows v. Pacific Inland

Sec. Corp., 36 F. Supp. 2d 1240, 1249 (S.D. Cal. 1999).

In interpreting Section 13, “the vast majority of courts... have impliedly or expressly found that the three-yearperiod begins when the security is first bona fide offered.” P. Stoltz Family P’ship L.P. v. Daum, 355 F.3d 92,100 (2d Cir. 2004) (collecting cases) (emphasis in original). But see In re Bestline Prods. Sec. & AntitrustLitig., No. MDL 162-CIV-JLK, 1975 WL 386, at *1-2 (S.D. Fla. Mar. 21, 1975) (holding that the three yearrepose period begins after the security was last offered to the public); Bradford v. Moench, 809 F. Supp. 1473,1485-90 (D. Utah 1992) (same); Hudson v. Capital Mgmt, Int’l Inc., No. C-81-1737, 1982 WL 1384, at *3 n.3(N.D. Cal. Jan. 6, 1982) (same).

Inquiry notice triggers an investor’s duty to exercise reasonable diligence in discovering a materialmisstatement or omission. See Grubka v. WebAccess Int’l, 445 F. Supp. 2d 1259, 1266 (D. Colo. 2006)(holding standard of diligence is whether reasonably diligent investor would have discovered the relevant facts);see also DeBenedictis v. Merrill Lynch & Co., 492 F.3d 209, 217-18 (3d Cir. 2007) (finding inquiry notice fromwidespread publication of articles concerning plaintiff’s situation).

Several plaintiffs have attempted to argue that the extended statute of limitations under Sarbanes-Oxley appliesto Section 12 claims, but courts that have considered the issue have rejected the application of the extendedstatute of limitations for claims involving “fraud, deceit, manipulation, or contrivance” to non-fraud claimsbrought under the 1933 Act. See, e.g., Ato Ram, II, Ltd. v. SMC Multimedia Corp., No. 03 CIV. 5569 HB, 2004WL 744792, at *5 (S.D.N.Y. Apr. 7, 2004); Lawrence E. Jaffe Pension Plan v. Household Int’l, Inc., No.02C5893, 2004 WL 574665, at *13 (N.D. Ill. Mar. 22, 2004).

5) Equitable Tolling

The one-year limit on Section 12(a)(1) may be subject to equitable tolling. Katz v. Amos Treat & Co., 411 F.2d1046, 1055 (2d Cir. 1969). But see Cook v. Avien, Inc., 573 F.2d 685, 691 (1st Cir. 1978); Blatt v. MerrillLynch, Pierce, Fenner & Smith, Inc, 916 F. Supp. 1343, 1354 (D.N.J. 1996) (finding that the one year limitationapplicable to Section 12(a)(1) claims is absolute); Pell v. Weinstein, 759 F. Supp. 1107, 1111 (M.D. Pa. 1991)aff’d without opinion, 961 F.2d 1568 (3d Cir. 1992) (“[V]ast majority of cases have concluded that thelimitations period runs from the date of the violation regardless of whether the plaintiff knew of theviolation.”). While there is disagreement with respect to Section 12(a)(1), it is more widely recognized that theone-year limit on Section 12(a)(2) claims is subject to equitable tolling, such as for acts of fraudulentconcealment by the defendant. Cook, 573 F.2d at 691; Hudson, 1982 WL 1384, at *3.

The three-year statute of repose for Sections 12(a)(1) and 12(a)(2) claims is absolute and is not subject toequitable tolling. Engl v. Berg, 511 F. Supp. 1146, 1151 (E.D. Pa. 1981); Jackson Nat’l Life Ins. v. MerrillLynch & Co., Inc., 32 F.3d 697, 704 (2d Cir. 1994) (“The three-year period is an absolute limitation whichapplies whether or not the investor could have discovered the violation.”); Jensen v. Allison-Williams Co., No.98-CV-2229 TW, 1999 U.S. Dist. LEXIS 22170, at *10 (S.D. Cal. Aug. 23, 1999).

6) Rule 9(b)

Although Rule 9(b) applies only to averments sounding in fraud and thus has been held inapplicable to claimsunder Section 12 (see, for example, Roskos v. Shearson/Am. Express, Inc., 589 F. Supp. 627, 631 (E.D. Wis.1984); Somerville v. Major Exploration, Inc., 576 F. Supp. 902, 909 n.9 (S.D.N.Y. 1983)), some courts havesuggested that a Rule 9(b) motion may be appropriate where a 1933 Act claim “sounds essentially in fraud.” Inre Westinghouse Sec. Litig., 90 F.3d 696, 716 (3d Cir. 1996); see also Rombach v. Chang, 355 F. 3d 164, 171(2d Cir. 2004) (holding Rule 9(b)’s pleading standard applies to 12(a)(2) claim premised on allegations offraud, even though plaintiff needed only to allege negligence under 12(a)(2)); Melder v. Morris, 27 F.3d 1097

(5th Cir. 1994); In re Stac Elecs. Sec. Litig., 89 F.3d 1399, 1404-05 (9th Cir. 1996); Ellison v. Am. Image MotorCo., 36 F. Supp. 2d 628, 639 (S.D.N.Y. 1999).

7) Not Applicable To Aftermarket Transactions

The Supreme Court has confirmed that Section 12(a)(2) applies only to sales by a prospectus of newly issuedstock in a public offering and not to secondary trading in aftermarket transactions in Gustafson v. Alloyd Co.,Inc., 513 U.S. 561, 1064, 1073-74 (1995), as discussed supra. See also Stack v. Lobo, 903 F. Supp. 1361, 1375(N.D. Cal. 1995) (“The Supreme Court held that Section 12[(a)](2) applies only to initial public offerings.”);Komanoff v. Mabon, Nugent & Co., 884 F. Supp. 848, 857 (S.D.N.Y. 1995) (same); Endo v. Albertine, No. 88C 1815, 1995 WL 170030, at *n. 3 (N.D. Ill. Apr. 7, 1995) (finding that Gustafson “limits recovery underSection 12[(a)](2) to only those class members who purchased securities in a public offering”).

4. Comparison Of Due Diligence Defense Under Sections 11 And 12(a)(2)

a. Different Standards

Section 11 requires a reasonable investigation and reasonable grounds for belief that statements made are notmisleading. Section 12(a)(2) requires the exercise of reasonable care. The distinction between the Section 11“reasonable investigation/reasonable grounds” standard and the Section 12(a)(2) “reasonable care” standard isan open question.

1) The Section 11 Standard As More Stringent

The Southern District of New York has expressed the view that the standards for the defense under Section 11are somewhat stricter. In re Worldcom, Inc. Sec. Litig., 346 F. Supp. 2d 628 (S.D.N.Y. 2004). Mostcommentators agree that the “reasonable investigation” requirement is more stringent than the “reasonablecare” requirement. See, e.g., Epstein, “Reasonable Care” in Section 12(a)(2) of the Securities Act of 1933, 48U. CHI. L. REV. 372, 388 (1982). Justice Powell has noted that “‘[i]nvestigation’ commands a greaterundertaking than ‘care’” and argues that the SEC shares his view. John Nuveen & Co., Inc. v. Sanders, 450U.S. 1005, 1009 (1981) (dissenting).

2) The Sections 11 And 12(a)(2) Standards As Equivalent

In Sanders v. John Nuveen & Co., Inc., 619 F.2d 1222, 1228 (7th Cir. 1980), the court held that, under thecircumstances of that case, the difference in the language of the Section 11 and 12(a)(2) standards, as applied toan underwriter, was not significant. See also Folk, Civil Liabilities Under the Federal Securities Acts: TheBarChris Case, 55 VA. L. REV. 199, 207-16 (1969); In re Software Toolworks, Inc. Sec. Litig., 50 F.3d 615, 621(9th Cir. 1994) (finding that the two articulations of due diligence are “similar” if not identical).

3) The Section 12(a)(2) Standard As More Stringent

The proposition that the Section 12(a)(2) standard is more stringent than the Section 11 standard has somesupport. See Kaminsky, An Analysis of Securities Litigation Under Section 12(a)(2) and How It Compares withRule 10b-5, 13 HOUS. L. REV. 231 (1976). Moreover, the Seventh Circuit’s decision in John Nuveen & Co. v.

Sanders, 619 F.2d 1222, 1228 (7th Cir. 1980), can be read as requiring an investigation under Section 12(a)(2)in a situation where Section 11 would not require one: a non-expert sued with regard to “expertised” material. Thus, although the Court said the standards were not significantly different, the Seventh Circuit instead mayhave imposed a greater burden under Section 12(a)(2). See John Nuveen & Co., 450 U.S. at 1010 (Powell, J.,dissenting from denial of certiorari in Sanders).

In any event, the standards are not equivalent for all purposes. Regardless of how Sanders is read, the decisiondoes not support the proposition that the Section 12(a)(2) standard is identical to the Section 11 standard for allSection 12(a)(2) “sellers.” The Seventh Circuit was careful to limit its discussion to underwriters. Sanders v.John Nuveen & Co., Inc., 619 F.2d 1222, 1228 (7th Cir. 1980). For other “sellers” who are more distant fromthe offering materials and have more limited access to the issuer, imposing the due diligence standard that isimposed on the specific persons made liable by Section 11 would not make sense.

D. Section 14 Of The 1934 Act

1. Section 14(a) And SEC Rule 14a-9

a. Section 14(a)

Section 14(a) prohibits the solicitation of any proxy in a manner that violates rules promulgated by the SEC The provision states, in relevant part, that “[i]t shall be unlawful for any person, by use of the mails or by anymeans or instrumentality of interstate commerce or of any facility of a national securities exchange orotherwise, in contravention of such rules and regulations as the Commission may prescribe . . . to solicit . . . anyproxy . . . in respect of any security (other than an exempted security) registered pursuant to Section 12 of thistitle.” 15 U.S.C. § 78n(a).

b. Rule 14(a)‑9

S.E.C. Rule 14a-9, which was promulgated under Section 14(a), specifically prohibits solicitation of proxies bymeans of proxy statements that contain false or misleading statements concerning any material fact oromissions of material facts that make any part of the statement misleading. The rule states, in relevant part,“[n]o solicitation subject to this regulation shall be made by means of any proxy statement . . . containing anystatement which . . . is false or misleading with respect to any material fact, or which omits to state any materialfact necessary in order to make the statements therein not false or misleading.” 17 C.F.R. § 240.14a-9.

c. Elements Of A Section 14(a) And Rule 14(a)(9) Violation

Plaintiffs establish a violation of Section 14(a) and Rule 14a-9 by demonstrating that: (1) the proxy statementcontains a material misrepresentation or omission; (2) the defendants are chargeable with some degree ofculpability or fault; and (3) the proxy caused an injury to plaintiffs (i.e., the proxy was an essential link in thechallenged transaction). See Rudolph v. UTStarcom, 2008 WL 4002855, at *7 (N.D. Cal. Aug.21, 2008)(dismissing 14(a) claim for failing to allege misleading statements or omissions were an “essential link” in thetransaction); Bender v. Jordan, 439 F. Supp. 2d 139, 163 (D.D.C. 2006); In re BankAmerica Corp. Sec. Litig.,78 F. Supp. 2d 976, 988-89 (E.D. Mo. 1999); Mendell v. Greenberg, 612 F. Supp. 1543, 1548 (S.D.N.Y. 1985),aff’d, 927 F.2d 667 (2d Cir. 1990); National Home Prods., Inc. v. Gray, 416 F. Supp. 1293, 1312 (D. Del.1976).

The Third Circuit has abandoned the culpability requirement in favor of a standard closer to strict liability. Under these cases, establishing a violation of Section 14(a) and Rule 14a-9 requires plaintiffs to show that (1)

the proxy statement contained a material misrepresentation or omission; (2) which caused the plaintiff injury;and (3) the proxy solicitation was an essential link in effecting the proposed corporate action. Tracinda Corp.v. DaimlerChrysler AG, 364 F. Supp. 2d 362, 388 (D. Del. 2005) (explaining defendant may be liable underSection 14(a) for merely allowing his name to be used in a manner substantially connected to a proxysolicitation); Gen. Elec. Co. v. Cathcart, 980 F.2d 927, 932 (3d Cir. 1992).

An omitted fact or misrepresentation in a proxy statement is material when there is a substantial likelihood thata reasonable shareholder would consider it important in deciding how to vote. See TSC Indus., Inc. v.Northway, Inc., 426 U.S. 438 (1976); Charal Inv. Co., Inc. v. Rockefeller, 131 F. Supp. 2d 593, 603 (D. Del.2001), aff’d, 311 F.3d 198 (3d Cir. 2002). However, compliance with SEC rules may act as a shield toliability. Seinfeld v. Gray, 404 F.3d 645, 649 (2d Cir. 2005) (denying claim of material omission becausedefendant complied with Rule 14a-101).

d. Breach Of Fiduciary Duty

Breach of a fiduciary duty does not give rise to a securities law claim under Section 14(a) and Rule 14e-9,which relate only to disclosure obligations. See Bond Opportunity Fund v. Unilab Corp., No. 99-CIV. 11074,2003 WL 21058251 (S.D.N.Y. May 9, 2003), aff’d, 2004 WL 249583 (2d Cir. Feb. 10, 2004).


Some district courts have held that the Reform Act applies to even those Section 14(a) claims not involvingfraud and contains no exception for a lack of scienter. See In re JP Morgan Chase & Co. Sec. Litig., No. 06 C4675, 2007 WL 4531794, at *7 (N.D. Ill. Dec. 18, 2007); Beck v. Dobrowski, No. 06 C 6411, 2007 WL3407132 (N.D. Ill. Nov. 14, 2007) (finding the Reform Act applicable regardless of whether fraud is pled); NewJersey v. Sprint Corp., No. 03 2071 JWL, 2008 WL 191780 (D. Kan. Jan 23, 2008) (noting that the Tellabs“strong inference” pleading requirement applies to section 14(a) negligence claims and is not limited to claimsrequiring scienter).

f. Statute Of Limitations

Because a Section 14(a) claim does not “sound in fraud,” the extended statute of limitations under the Sarbanes-Oxley Act does not apply to claims under Section 14(a). See Rudolph v. UTStarcom, 560 F. Supp. 2d 880, 892(N.D. Cal. 2008); In re Ditech Networks, Inc. Derivative Litig., No. 06-5157, 2007 WL 2070300, at *9 (N.D.Cal. July 16, 2007); In re Zoran Corp. Derivative Litig., 511 F. Supp. 2d 986, 1016-17 (N.D. Cal. 2007). Thestatute of limitations expires one year after the discovery of facts constituting the violation, and in no eventmore than three years following publication of the false statement.

2. Section 14(d) And SEC Rule 14d-10

a. Best Price Provision

Section 14(d)(7) is commonly known as the “best-price” provision of the Williams Act, which regulates tenderoffers. The provision states, in relevant part, that “[w]here any person varies the terms of a tender offer . . .before the expiration thereof by increasing the consideration offered to holders of such securities, such personshall pay the increased consideration to each security holder whose securities are taken up and paid for pursuantto the tender offer.” 15 U.S.C. § 78n(d)(7).

The purpose of Section 14(d)(7) is to “prevent a tender offeror from discriminating in price among tendering

shareholders.” Field v. Trump, 850 F.2d 938, 942 (2d Cir. 1988); S.E.C. Release No. 34-22198, 1985 WL551642, at *3 (July 01, 1985); see also Karlin v. Alcatel, No. SA CV 00-0214, 2001 WL 1301216, at *1-2 (C.D.Cal. Aug. 13, 2001).

b. SEC Rule 14d-10

S.E.C. Rule 14d-10 was promulgated under Section 14(d)(7) and, like Section 14(d)(7), Rule 14d-10 regulatestender offers. Paragraph (a)(2) of Rule 14d-10 reads “[n]o bidder shall make a tender offer unless . . . [t]heconsideration paid to any security holder pursuant to the tender offer is the highest security paid to any othersecurity holder during such tender offer.” 17 C.F.R. § 240.14d-10.

Rule 14d-10 codifies the SEC’s interpretation of Section 14(d)(7), which is that Section 14(d)(7) requires “abidder [to] pay a security holder in a tender offer . . . the highest consideration offered to any other securityholder of the same class at any time during such tender offer.” S.E.C. Release No. 34-22198, 1985 WL 551642,at *1-3; see also Field, 850 F.2d at 942-43; Millionerrors Inv. Club v. Gen. Elec. Co., No. CIV. A. 99-781,2000 WL 1288333, at *3 (W.D. Pa. Mar. 21, 2000).

Several courts have recognized a private right of action under Section 14(d)(7) and Rule 14d-10. See, e.g.,Epstein v. MCA, Inc., 50 F.3d 644 (9th Cir. 1995), rev’d on other grounds, 516 U.S. 367 (1996); Alidina v.Penton Media, Inc., No. 98 Civ. 8474(JES), 2000 WL 98025 (S.D.N.Y. Jan. 26, 2000); Gerber v. ComputerAssocs. Int’l, Inc., 812 F. Supp. 361 (E.D.N.Y. 1993).

c. Elements Of A Rule 14d-10 (a)(2) Violation

In order to establish a violation of the “best price” rule, a plaintiff “must allege and prove . . . four elements: (1)that the bidder; (2) during the pendency of the bidder’s tender offer; (3) purchased a security that is the subjectof the tender offer; (4) for more consideration than the bidder paid to other shareholders pursuant to the tenderoffer.” See, e.g., Kahn v. Va. Ret. Sys., 783 F. Supp. 266, 269 (E.D. Va. 1992), aff’d, 13 F.3d 110 (4th Cir.1993); Walker v. Shield Acquisition Corp., 145 F. Supp. 2d 1360, 1374 (N.D. Ga. 2001).

Currently, there is a split of authority regarding the meaning of the elements “during pendency of the . . . tenderoffer” and “pursuant to the tender offer.” See generally Lerro v. Quaker Oats Co., 84 F.3d 239 (7th Cir. 1996);Epstein v. MCA, Inc., 50 F.3d 644 (9th Cir. 1995), rev’d on other grounds, 516 U.S. 367 (1996); MillionerrorsInv. Club, 2000 WL 1288333, at *4-5 (adopting the reasoning of Epstein); In re Digital Island Sec. Litig., 357F.3d 322 (3d Cir. 2004) (synthesizing the Lerro and Epstein approaches).

1) During Pendency Of The Tender Offer

(a) Formal Test

Transactions entered into before or after a tender offer are outside the scope of Section 14(d)(7) and Rule14d-10. See Lerro, 84 F.3d 239 (holding that a distributor agreement between a bidder and a stockholder didnot occur “during the pendency of a tender offer” because the agreement was entered into before the tenderoffer had officially begun).

(b) Possible Exception For Successive Tender Offers

In Field v. Trump, 850 F.2d 938 (2d Cir. 1988), the defendant bidders announced a tender offer but thenwithdrew the offer four days later. The bidders then purchased a block of shares from a group of directors ofthe target corporation who opposed the tender offer and subsequent merger. Shortly thereafter, the biddersannounced a new tender offer. The price paid for the directors’ shares exceeded the amount offered undereither tender offer. The issue in the case was whether the payment for the directors’ shares could be considered“during” the tender offer in light of the fact that it occurred after a withdrawal of one tender offer and before theannouncement of the new one.

The Second Circuit stated that, “[u]nless successive tender offers interrupted by withdrawals can, in appropriatecircumstances, be viewed as a single tender offer for purposes of the Williams Act, the ‘best-price’ rule ismeaningless.” Field, 850 F.2d at 944. The Court held that if the purpose of bidder’s withdrawal was merely toescape application of the Williams Act, the withdrawal is ineffective and successive tender offers will beconsidered a single tender offer. As a result, transactions occurring between a withdrawal and theannouncement of a new tender offer can be considered to have occurred “during” the tender offer.

(c) Functional Test

If the challenged transaction was an “integral” part of the tender offer, the transaction occurs “during thependency of the tender offer.” The focus of the inquiry is on what the purpose of the challenged transactionwas, rather than on when the bidder entered into the transaction. See Epstein v. MCA, Inc., 50 F.3d 644 (9thCir. 1995), rev’d on other grounds, 516 U.S. 367 (1996).

“[A] transaction is integral to the tender offer . . . [when it] is ‘conditioned on the tender offer’s success,’ or ifthe transaction and tender offer are interdependent.” Padilla v. MedPartners, Inc., No. CV 98-1092-RSWL(SHx), 1998 WL 34073629, at *10 (C.D. Cal. July 27, 1998) (quoting Epstein, 50 F.3d 644); see also Epstein,50 F.3d at 656 (holding that a transaction entered into prior to, and finalized after completion of, a tender offerwas “integral” to the tender offer because the transaction was conditioned on the success of the tender offer andthe redemption value of the stock the shareholder received as payment for his tender incorporated the tenderoffer price).

The Epstein decision was reversed by the United States Supreme Court on grounds unrelated to the NinthCircuit’s interpretation of Rule 14(d)(7). See Matsushita Elec. Indus. Co., Ltd. v. Epstein, 516 U.S. 367 (1996)(concluding that the Ninth Circuit never should have reached the merits of the case because of a prior settlementof class litigation in Delaware). Nevertheless, several federal district courts have followed and upheld thereasoning of Epstein. See Millionerrors Inv. Club, 2000 WL 1288333, at *4-5; Padilla v. MedPartners, Inc.,No. CV98-1092-RSWL, 1998 WL 34073629, at *10 (C.D. Cal. July 27, 1998); Dr. Perera v. Chiron Corp., No.C-95 20725, 1996 WL 251936, at *3-4 (N.D. Cal. May 8, 1996). However, at least one Circuit has stated thatthe case “lacks precedential value.” Lerro v. Quaker Oats Co., 84 F.3d 239 (7th Cir. 1996).

(d) The Third Circuit’s Approach

The Third Circuit has attempted to reconcile the formal test of Lerro with the functional test of Epstein. See Inre Digital Island Sec. Litig., 357 F.3d 322 (3d Cir. 2004). In Digital Island, the Third Circuit held that a mergeragreement executed before the tender offer that agreed to cash out the stock options and restricted stock held bythe target’s directors and provided a “lucrative” employment contract to the target’s CEO did not violateSection 14(e) or Rule 14d-10. In analyzing whether the alleged additional compensation to the directorsviolated the Best Price Rule, the court held that the formal test of Lerro – that transactions outside the tenderoffer period are not violations of Rule 14d-10 – generally controls, but there is an exception pursuant to Epstein

for transactions designed to evade the requirements of the Williams Act. 357 F.3d at 333-34. However, theThird Circuit held that the “exception to the general rule is a narrow one” and only when transactions outsidethe offer period constitute a fraudulent attempt to circumvent the Best Price Rule will the outside transaction beconsidered a violation of Rule 14d-10. Id. “Accordingly, when reviewing a complaint alleging a violation ofRule 14d-10 based on a transaction executed prior to the commencement of a tender offer, the trial court shoulddetermine whether the plaintiff has met the heightened pleading requirements of Rule 9(b) and the PSLRA.” Id. at 337. In Digital Island, because the court had already rejected the plaintiffs’ Section 14(e) claim, the courtheld that there was no adequately pled fraud exception to the general rule that transactions outside the tenderoffer period are not violations of Rule 14d-10.

2) Pursuant To The Tender Offer

A tender offer followed by a second-step merger is not a single, continuous, integrated transaction. Instead,tender offers and mergers are separate transactions, governed by different rules of law. Consequently, ifbidders make payments to shareholders pursuant to a merger agreement, rather than pursuant to a tender offeragreement, the payments are made pursuant to the merger and not “pursuant to the tender offer.” Therefore,Section 14(d)(7) and Rule 14d-10, which apply only to tender offers, are inapplicable to second-step mergers. See Kramer v. Time Warner, Inc., 937 F.2d 767 (2d Cir. 1991).

The ruling in Kramer does not have an impact on the formal test for “during the pendency of the tender offer.” If a challenged transaction occurs pursuant to or during a follow-up merger, the transaction is, by definition, notduring the preceding tender offer.

In addition, any transaction occurring during or pursuant to a merger is not “pursuant to the tender offer.” TheCourt in Lerro cited Kramer with approval and stated that tender offers and follow-up mergers are “differenttransactions, under different bodies of law (federal law regulates the tender offer and state law the merger).” Lerro v. Quaker Oats Co., 84 F.3d 239 (7th Cir. 1996) (holding that a distributor agreement between a bidderand a stockholder, which became effective with a second-step merger, did not occur pursuant to the tender offerbecause a follow-up merger should not be integrated with a tender offer).

How courts applying the functional test established in Epstein will incorporate the ruling in Kramer is unclear. The functional test collapses the “during” and “pursuant to” elements of a Section 14(d)(7) and Rule 14d-10claim into one inquiry: whether the transaction in question was an integral part of the tender offer. However,whether a court applying the functional test would consider the possibility that a transaction occurring during orpursuant to a follow-up merger could be an “integral” part of a preceding tender offer is unclear. The NinthCircuit did not actually address this issue in Epstein. Instead, in a footnote, the Epstein court discussed theruling in Kramer and then stated that Kramer was distinguishable on the facts. Kramer involved a tender offerand a second-step statutory merger whereas in Epstein, only a tender offer was involved. Consequently, theCourt found that the outcome in Epstein was not dictated by the ruling in Kramer. See Epstein v. MCA, Inc., 50F.3d 644, 659, n.21 (9th Cir. 1995).

At least one court has held that payments made pursuant to a second-step merger could still be considered an“integral” part of a tender offer. See Millionerrors Inv. Club, 2000 WL 1288333, at *5. In MillionerrorsInvestment Club, plaintiffs alleged that prior to the commencement of a pending tender offer (that was to befollowed by a merger), the board of directors of Fore Systems, Inc. provided several of its executives with stockoptions. General Electric Co. (“the bidder”) agreed that, pursuant to the tender offer, GE would pay allshareholders $35.00 a share and, pursuant to the merger agreement, would purchase all outstanding stockoptions from the executives. Plaintiffs alleged that payment for the stock options constituted a premium for theexecutives’ shares in Fore Systems, Inc. and that the bidder agreed to purchase the stock options in order toreceive approval of the tender offer from the executives. This action, according to plaintiffs, violated the “bestprice” rule.

Defendants filed a motion to dismiss on the grounds that the transaction between the bidder and the executiveswas not “during” the tender offer. The transaction was entered into before the tender offer, and payment wasnot made until after the tender offer was complete.

Relying on the Epstein decision, the court denied the defendants’ motion to dismiss. The court did not find thatthe Epstein analysis was affected by the fact that the payments in question in Millionerrors Investment Clubwere made pursuant to a merger, rather than a tender offer. See generally id.

d. Other Important Provisions In Rule 14d-10

1) The “All-Holders” Rule

Rule 14d-10 (a)(1) states that “[n]o bidder shall make a tender offer unless . . . [t]he tender offer is open to allsecurity holders of the class of securities subject to the tender offer.” 17 C.F.R. § 240.14d-10. The purpose ofthis section is to “make explicit that a bidder’s tender offer must be open to all holders of the class of securitiessubject to the tender offer.” Proposed Amendments to Tender Offer Rules, S.E.C. Release No. 34-22198, 1985WL 551642, at *1 (July 1, 1985).

2) Offering More Than One Type Of Consideration In A Tender Offer

Paragraph (c) of Rule 14d-10 states that 14d-10 paragraph (a)(2) “shall not prohibit the offer of more than onetype of consideration in a tender offer.” 17 C.F.R. § 240.14d-10. So long as “[s]ecurity holders are affordedequal right to elect among each of the types of consideration offered” and “[t]he highest consideration of eachtype paid to any security holder is paid to any other security holder receiving that type of consideration,” thetender offeror may offer more than one type of consideration. Id. Where a tender offer does not “make the typeof consideration offered to some security holders available to all, a court may presume “that the selectively-offered consideration was ‘higher consideration’ for purposes of Section (a)(2).” Epstein, 50 F.3d at 654.

e. Applicability Of The Reform Act To Section 14(d) Claims

The Reform Act imposes strict pleading requirements on any claim in which a plaintiff alleges that a defendant“made an untrue statement of material fact . . . or omitted to state a material fact necessary in order to make thestatements made, in light of the circumstances in which they were made, not misleading.” 15 U.S.C. §78u-4(b)(1). No cases applying the heightened pleading standards of the Reform Act to a plaintiff’s claims forviolations of Section 14(d)(7) and Rule 14d-10 exist. In fact, one court has held that the Reform Act’sheightened pleading standard does not apply to a claim for violation of Section 14(d)(7). See Maxick v.Cadence Design Sys., Inc., No. C-00-0658-PJH, 2000 WL 33174386, at *1 (N.D. Cal. Sept. 21, 2000).

3. Section 14(e)

a. Purpose

Section 14(e), like section 14(d), is a portion of the Williams Act regulating tender offers. The section reads, inrelevant part, that “[i]t shall be unlawful for any person to make any untrue statement of a material fact or omitto state any material fact necessary in order to make the statements made . . . not misleading . . . in connectionwith any tender offer or request or invitation for tenders, or any solicitation of security holders in opposition to

or in favor of any such offer, request, or invitation.” 15 U.S.C. § 78n(e).

The provision is “designed to insure that shareholders confronted with a tender offer have adequate andaccurate information on which to base the decision whether or not to tender their shares.” In re ValueVisionInt’l Inc. Sec. Litig., 896 F. Supp. 434, 448 (E.D. Pa. 1995).

b. Private Cause Of Action

Section 14(e) does not expressly provide for a private cause of action and some dispute exists as to whetherSection 14(e) implicitly authorizes such actions. The Supreme Court of the United States has held that, becausethe purpose of the Williams Act is to protect individual shareholders, a tender offeror does not have standing tosue under Section 14(e) if the offeror is suing in its capacity as a takeover bidder. See Piper v. Chris-CraftIndus., Inc., 430 U.S. 1, 42 n.28 (1977). Furthermore, at least one federal circuit has held that an issuer doesnot have standing to sue for violations of Section 14(e). See Liberty National Ins. Holding Co. v. Charter Co.,734 F.2d 545, 547 (11th Cir. 1984). However, the Ninth Circuit has held that Section 14(e) implicitlyauthorizes shareholder-offerees, whether or not they have tendered their shares, to bring private causes of actionfor violations of Section 14(e). See Plaine v. McCabe, 797 F.2d 713, 717-18 (9th Cir. 1986); see also Sedighimv. Donaldson, Lufkin & Jenrette, Inc., 167 F. Supp. 2d 639.

c. Elements Of A Section 14(e) Claim For Misstatements Or Omissions

In order to state a claim for a violation of Section 14(e), a plaintiff “must allege that: (1) the defendant mademisstatements or omissions of material fact; (2) with scienter; (3) in connection with a tender offer; (4) uponwhich plaintiff relied; and (5) that plaintiff’s reliance was the proximate cause of their injury.” In reValueVision, 896 F. Supp. at 448.

Instead of damages, a plaintiff may seek a permanent injunction as relief for a violation of Section 14(e) bydemonstrating that: (1) the defendant made misstatements or omissions of material fact; (2) with scienter; (3) inconnection with a tender offer. See Clearfield Bank & Trust Co. v. Omega Fin. Corp., 65 F. Supp. 2d 325, 340(W.D. Pa. 1999).

1) Materiality

“A misstatement or omission is material if there is a substantial likelihood that a reasonable shareholder wouldconsider it important in deciding whether to accept the tender offer.” Polar Int’l Brokerage Corp. v. Reeve, 108F. Supp. 2d 225, 236 (S.D.N.Y. 2000) (citations omitted); see also TSC Indus., Inc. v. Northway Inc., 426 U.S.438, 439 (1976) (“An omitted fact is material if there is a substantial likelihood that a reasonable shareholderwould consider it important in deciding how to vote.”).

2) Scienter

“The language of the Williams Act clearly demonstrates that Congress envisioned scienter to be an element of[Section] 14(e).” Adams v. Standard Knitting Mills, Inc., 623 F.2d 422, 431 (6th Cir. 198`0); see alsoClearfield Bank & Trust Co., 65 F. Supp. 2d at 343; In re Digital Island Sec. Litig., 357 F.3d 322, 328 (3d Cir.2004). As a result, in order to state a valid claim under Section 14(e), a plaintiff must plead intent to defraud,knowledge of falsity, or a reckless disregard for the truth. See Conn. Nat. Bank v. Fluor Corp., 808 F.2d, 957,961 (2d Cir. 1987); Sogevalor, SA v. Penn. Cent. Corp., 771 F. Supp. 890, 895 (S.D. Ohio 1991).

3) In Connection With A Tender Offer

The Williams Act does not define “tender offer.” See Beaumont v. Am. Can Co., 621 F. Supp. 484, 499-500(S.D.N.Y. 1985), aff’d, 797 F.2d 79 (2d Cir. 1986). As a result, the courts have developed various tests fordifferentiating between a tender offer and a private transaction. See id.; see also Gorman v. Coogan, No. 03-173-P-H, 2004 WL 60271, at *18-20 (D. Me. Jan. 13, 2004); Gas Natural v. E.ON AG, 468 F. Supp. 2d 595,611 (S.D.N.Y. 2006) (holding that prior to the commencement of a tender offer as defined by Rule 14d-2, apotential offerer has no duty to disclose the material, non-public information that is required to be disclosedonce a tender offer commences).

4) Reliance/Causation

(a) Permanent Injunctions

If plaintiff seeks a permanent injunction as relief for a violation of Section 14(e), plaintiff is not required toplead and prove reliance and/or causation. See Clearfield Bank & Trust Co., 65 F. Supp. 2d at 340.

(b) Omissions

In cases where a plaintiff alleges that a defendant made a material omission (as opposed to a misstatement),once the plaintiff proves that material facts were withheld, the reliance and causation elements of a Section14(e) claim are established. See Berman v. Gerber Prods., Co., 454 F. Supp. 1310, 1324 (W.D. Mich. 1978)(citations omitted). “[P]laintiffs need only demonstrate that the omission created a material misimpressionregarding the facts at issue.” Feinman v. Dean Witter Reynolds, Inc., No. 94 CIV. 7798, 1995 WL 562177, at*3 (S.D.N.Y. Sept. 21, 1995), aff’d, 84 F.3d 539 (2d Cir. 1996).

(c) Misstatements

General Rule. Ordinarily, in a suit for damages for a violation of Section 14(e), if a plaintiff alleges that theviolation occurred because a defendant made a material misstatement, that plaintiff must plead and prove thatshe relied on that misstatement and suffered harm as a result. See Atchley v. Qonaar Corp., 704 F.2d 355, 360(7th Cir. 1983) (stating that if plaintiffs did not rely on the misstatements defendant allegedly made, thenplaintiffs’ Section 14(e) claim should be dismissed); Berman, 454 F. Supp. at 1324 (“In general, a plaintiff mustdemonstrate . . . reliance in securities fraud cases.”); Waldrop v. Amway Asia Pac. Ltd., No. 99 Civ. 12093(DC), 2001 U.S. Dist. LEXIS 2857, at *14-15 (S.D.N.Y. Mar. 19, 2001).

Exception. There have been cases where a plaintiff has established that a defendant made materialmisstatements in connection with a tender offer; however, the defendant was then able to demonstrate that theplaintiff did not rely on the misstatements. In these cases, the defendant has moved to dismiss plaintiff’s claimon the grounds that the plaintiff lacks standing. Courts facing this issue have held that, if a plaintiff can provethat other persons relied on the defendants’ misstatements and that the plaintiff suffered harm as a result, theplaintiff has standing to bring the claim. See, e.g., In re PHLCORP Sec. Tender Offer Litig ., 700 F. Supp.1265, 1276 (S.D.N.Y. 1988) (“In the context of Section 14 of the Exchange Act, ‘the reliance of the individual

plaintiff is irrelevant where the plaintiff may have been damaged by the reliance of others.’”) (quoting Jones v.National Distillers & Chem. Corp., 484 F. Supp. 679, 684 (S.D.N.Y. 1979)).

In Plaine v. McCabe, a shareholder of an acquired corporation alleged that the acquiror had made misstatementsin the tender offer for the shares of the target corporation. 797 F.2d 713 (9th Cir. 1986). The plaintiff-shareholder had not tendered her shares in the tender offer because of the misstatements, but the vast majorityof the other shareholders had tendered their shares. As a result, the merger was consummated and the plaintiffwas forced to sell shares at (what she felt was) an inadequate price. The plaintiff then brought a claim againstthe acquiror for violation of Section 14(e).

Defendant moved to dismiss the complaint on the grounds that the plaintiff could not establish the element ofreliance. However, the Ninth Circuit held that, if other shareholders had relied on defendant’s misstatementsand that plaintiff suffered injury as a result, the plaintiff could maintain her claim. See generally id.

d. Section 14(e)’s Prohibition Of “Fraudulent, Deceptive, Or Manipulative”Practices

Section 14(e) also contains language making it unlawful for any person to engage in “any fraudulent, deceptive,or manipulative acts or practices . . . in connection with a tender offer.” 15 U.S.C. § 78n(e). The section givesthe SEC the authority to create rules and regulations that “define, and prescribe means reasonably designed toprevent, such acts and practices as are fraudulent, deceptive, or manipulative.” Id. Thus, the SEC possesses thepower to prohibit any particular conduct that is, at some point, deemed fraudulent.


The Reform Act imposes strict pleading requirements on any claim in which a plaintiff alleges that a defendant“made an untrue statement of material fact . . . or omitted to state a material fact necessary in order to make thestatements made . . . not misleading.” 15 U.S.C. § 78u-4(b)(1). In addition, the Reform Act imposes similarpleading requirements on claims where a plaintiff can recover money damages “only on proof that thedefendant acted with a particular state of mind.” 15 U.S.C. § 78u-4(b)(2). As a result, the Reform Act appearson its face to apply to claims brought under Section 14(e). See 15 U.S.C. § 78n(e). Federal court decisionshave applied the requirements of the Reform Act to claims brought under Section 14(e). See Rombach v.Chang, 355 F.3d 164, 171 (2d Cir. 2004); In re Digital Island Sec. Litig., 357 F.3d 322, 328-31 (3d Cir. 2004);Brody v. Transitional Hosp. Corp., 280 F.3d 997, 1006 (9th Cir. 2002); Conn. Nat’l Bank v. Flour Corp., 808F.2d 957, 962 (2d Cir. 1987); Rubke v. Capital Bancorp, No. 05-4800PJH, 2006 WL 1699569, at *16-17 (N.D.Cal. June 16, 2006); Gas Natural v. E.ON AG, No. 06-13607(DLC), 2006 WL 3734425, at *8, 18 (S.D.N.Y.Dec. 19, 2006); Polar Int’l Brokerage Corp. v. Reeve, 108 F. Supp. 2d 225, 230-31 (S.D.N.Y. 2000); ClearfieldBank & Trust Co. v. Omega Fin. Corp., 65 F. Supp. 2d 325, 343-44 (W.D. Pa. 1999).

E. Section 16 Of The 1934 Act

Section 16(b) of the 1934 Act, 15. US.C.A. §78p(b) governs the recovery of “short-swing” profits by insiders. “Short-swing” profits are defined as “profits earned within a six months’ period by the purchase and sale ofsecurities.” Blau v. Lehman, 368 U.S. 403, 405, 82 S.Ct. 451, 7 L.Ed.2d 403 (1962). Specifically, Section 16(b)provides that:

For the purpose of preventing the unfair use of information which may have been obtainedby such beneficial owner, director, or officer by reason of his relationship to the issuer, anyprofit realized by him from any purchase and sale, or any sale and purchase, of any equitysecurity of such issuer (other than an exempted security) or a security-based swap agreement(as defined in Section 206B of the Gramm-Leach-Bliley Act) involving any such equity

security within any period of less than six months, unless such security or security-basedswap agreement was acquired in good faith in connection with a debt previously contracted,shall inure to and be recoverable by the issuer, irrespective of any intention on the part ofsuch beneficial owner, director, or officer in entering into such transaction of holding thesecurity or security-based swap agreement purchased or of not repurchasing the security orsecurity-based swap agreement sold for a period exceeding six months.

1. Purpose

Section 16(b) was designed to prevent corporate insiders “‘from profiteering through short-swing securitiestransactions on the basis of inside information.’” Roth v. Reyes, 567 F.3d 1077, 1079 (9th Cir. 2009) (citingForemost-McKesson, Inc. v. Provident Securities Co., 423 U.S. 232, 234 (1976).

2. Strict Liability

Section 16(b) is a strict liability rule that “‘requires the statutorily defined inside, short-swing trader to disgorgeall profits realized on all ‘purchases’ and ‘sales’ within the specified time period, without proof of actual abuseof insider information, and without proof of intent to profit on the basis of such information.’” Id.

3. Standing

An action to recover short-swing profits pursuant to Section 16(b) may be brought by the issuer whose stockwas traded or by a stockholder “in behalf of the issuer.” 15 U.S.C. §78p(b).


Section 16(b) expressly provides that a 16(b) suit may not be brought “more than two years after the date such[short-swing] profit was realized.” 15 U.S.C. § 78p(b). The Roth court held that this two-year limitation periodshould not be tolled, even where insiders erroneously claim an exemption from Section 16(a) (which requirescertain corporate insiders to file statements disclosing their acquisitions and dispositions of company stock, aswell as annual statements of their holdings and transactions). Roth, 567 F. 3d at 1082.

F. Section 17 Of The 1933 Act

Section 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q, provides that:

It shall be unlawful for any person in the offer or sale of any securities by the use of anymeans or instruments of transportation or communication in interstate commerce or by useof the mails, directly or indirectly –

a) to employ any device, scheme, or artifice to defraud;

to obtain money or property by means of any untrue statement of a material fact or any omission to statea material fact necessary in order to make the statements made, in the light of the circumstances underwhich they were made, not misleading;

or

b) to engage in any transaction, practice, or course of business which operates or would operate as a fraud ordeceit upon the purchaser.


Although the Supreme Court has thus far declined to address the issue (See Bateman Eichler, Hill Richards,Inc. v. Berner, 472 U.S. 299, 304 n.9 (1985); Herman & MacLean v. Huddleston, 459 U.S. 375, 378 n.2(1983)), most Circuits have refused to imply a private right of action under Section 17(a). See Maldonado v.Dominguez, 137 F.3d 1 (1st Cir. 1998); Finkel v. Stratton Corp., 962 F.2d 169, 175 (2d Cir. 1992); Newcome v.Esrey, 862 F.2d 1099 (4th Cir. 1988) (en banc); Landry v. All Am. Assurance Co., 688 F.2d 381, 384-91 (5thCir. 1982) (reasoning that the four tests for implying private rights set forth in Cort v. Ash, 422 U.S. 66 (1975),were not met); Schlifke v. Seafirst Corp., 866 F.2d 935, 942-43 (7th Cir. 1989) (overruling previous SeventhCircuit authority in light of the “decisive majority of recent authorities [which] have refused to imply a right ofaction under Section 17(a)”); Deviries v. Prudential-Bache Sec., Inc., 805 F.2d 326, 328 (8th Cir. 1986);Brannan v. Eisenstein, 804 F.2d 1041, 1042 n.1 (8th Cir. 1986); In re Wash. Public Power Supply Sys. Sec.Litig., 823 F.2d 1349 (9th Cir. 1987) (en banc) (overruling earlier Ninth Circuit rulings); Bath v. Bushkin,Gaims, Gaines and Jonas, 913 F.2d 817, 819 (10th Cir. 1990) (following “our six sister Circuits”), abrogated inpart by Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 354 n.1 (1991); Rotella v.Wood, 528 U.S. 549, 553-54 (2000); Currie v. Cayman Res. Corp., 835 F.2d 780 (11th Cir. 1988). Districtcourts, rejecting a private right of action under Section 17(a), usually adopt the Fifth Circuit’s reasoning inLandry, 688 F.2d 381. See, e.g., Abbell Credit Corp. v. Banc of Am. Sec., L.L.C., Inc., No. 01 C2227, 2001 WL1104601, at *4 (N.D. Ill. Sept. 17, 2001); Dafofin Holdings S.A. v. Hotelworks.com, Inc., No. 00 CIV. 7861,2001 WL 940632, at *6 (S.D.N.Y. Aug. 17, 2001); Hammerman v. Peacock, 607 F. Supp. 911, 914-15 (D.D.C.1985); Ethanol Partners Accredited v. Weiner, Zuckerbrot, Weiss & Brecher, 635 F. Supp. 18, 21 (E.D. Pa.1985).

2. SEC Enforcement Actions

At least one court has held that SEC enforcement actions alleging violations of Section 17(a) do not have tocomply with the provisions of the Reform Act because it applies only to private actions. S.E.C. v. Dunn, 587 F.Supp. 2d 486, 501 (S.D.N.Y. 2008).

G. Section 18 Of The 1934 Act

Section 18(a) of the 1934 Act, 15 U.S.C. § 78r(a), addresses fraudulent or misrepresentative statements, andprovides that:

Any person who shall make or cause to be made any statement in any application, report, ordocument filed pursuant to this chapter or any rule or regulation thereunder or anyundertaking contained in a registration statement as provided in subsection (d) of Section78o of this title, which statement was at the time and in the light of the circumstances underwhich it was made false or misleading with respect to any material fact, shall be liable to anyperson (not knowing that such statement was false or misleading) who, in reliance upon suchstatement, shall have purchased or sold a security at a price which was affected by suchstatement, for damages caused by such reliance, unless the person sued shall prove that heacted in good faith and had no knowledge that such statement was false or misleading.

1. Elements Of Claim

In order to state a claim under Section 18(a), a plaintiff must allege the following elements:

a. Purchaser/Seller

Plaintiff must have either purchased or sold at a price which was affected by such statement. See Ross v. A.H.

Robins Co., Inc., 607 F.2d 545, 552 (2d Cir. 1979); Stromfeld v. Great Atl. & Pac. Tea Co. Inc., 484 F. Supp.1264, 1269 (S.D.N.Y.), aff’d, 646 F.2d 563 (2d Cir. 1980); see also In re Adelphia Commc’ns Corp. Sec. &Deriv. Litig., No. 03 MD 1529(LMM). 2007 WL 2615928, at *11 (S.D.N.Y. Sept. 10, 2007) (holding that whenthe “person who actually decides to purchase, and carries out the purchase of, a security is the same one whoread and relied on the misstatement . . . the Section 18 claim may proceed”).

b. Specific Reliance

Plaintiff must actually rely on the statements in the document to successfully allege an 18(a) claim. See Ross,607 F.2d at 552; Wachovia Bank & Trust Co., N.A. v. Nat’l Student Mktg. Corp., 461 F. Supp. 999, 1006(D.D.C. 1978), rev’d on other grounds, 650 F.2d 342 (D.C. Cir. 1980) (ruling that application of Section 18(a)is not justified without actual reliance on specific statements); Berger v. Ludwick, No. C-97-0728-CAL, 1998U.S. Dist. LEXIS 22734, at *11-12 (N.D. Cal. Sept. 15, 1998) (holding that because reliance for Section 18(a)violations was imposed expressly by Congress and reliance based on the “fraud on the market” theory will notsuffice). Some courts have held that a plaintiff must plead actual reliance with particularity. In re Enron Corp.Sec., Derivative & ERISA Litig., 540 F. Supp. 2d 800 (S.D. Tex. 2007) (holding that a plaintiff is required toplead actual reliance with particularity, as opposed to constructive or presumed reliance or reliance based on thefraud-on-the-market theory). However, it is important to note that a plaintiff may assert both a Section 10(b)claim and a Section 18(a) claim. Both claims require that the plaintiff show actual reliance. However, to provean 18(a) claim the reliance need not be reasonable. See In re Adelphia Commc’ns Corp. Sec. & DerivativeLitig., 542 F. Supp. 2d 266, 268 (S.D.N.Y. 2008).

Although courts require proof of actual reliance, merely viewing a copy of the document is sufficient. If,however, plaintiff knew that the statement was false or misleading at the time, then plaintiff cannot assertreliance. See Erath v. Xidex Corp., No. CIV-89-198TUCACM, 1991 WL 338322, at *8-9. (D. Ariz. Feb. 7,1991), aff’d, 963 F.2d 378 (9th Cir. 1992).

The false or misleading statement must be made in a document filed with the SEC See In re Digi Int’l Inc. Sec.Litig., 6 F. Supp. 2d 1089, 1103 (D. Minn. 1998), aff’d, 2001 WL 753869 (8th Cir. Jul. 5, 2001); Rankow v.First Chicago Corp., 678 F. Supp. 202, 207-08 (N.D. Ill. 1988), rev’d on other grounds, 870 F.2d 356 (7th Cir.1989) (plaintiffs must allege that a false statement was filed with SEC); Berger, 1998 U.S. Dist. LEXIS 22734,at *11-12.

c. Material Misstatement

A material misstatement or omission of fact in connection with a document required to be filed with the SEC isnecessary for a violation of Section 18(a). See Kennedy v. Chomerics Inc., 669 F. Supp. 1157, 1164 (D. Mass.1987); Erath, 1991 WL 338322, at *6. In Deephaven Private Placement Trading, Ltd. v. Grant Thornton &Co., 454 F.3d 1168, 1177 (10th Cir. 2006), the mere certification of financial statements was deemed not amaterial misstatement under §18(a) sufficient to render an independent auditor liable.

2. Documents To Which Section 18(a) Applies

Section 18(a) applies to documents, such as Forms 10-K, that must be filed with the SEC pursuant toSection 15(d) of the 1934 Exchange Act, as well as to the Act’s registration and periodic reportingrequirements. Plaintiff must have actual knowledge of the materials filed with the SEC Thus, Section 18(a)does not apply to filings under the 1933 Act or any other securities laws. Similarly, Section 18(a) does notapply to annual reports disseminated to shareholders under the proxy rules. 17 C.F.R. 240.14a-3(b).

3. Liability Under Section 18

Liability under Section 18 extends to “any person who shall make or cause to be made” any misstatement oromission. Liability is not limited to the issuer or other person filing the document and can extend to thecompany’s officers and directors or to those who sign the filed documents.

Because the Supreme Court eliminated aiding and abetting liability under Section 10(b), to the extent plaintiffscan demonstrate actual reliance, the courts may witness an increase in claims brought directly against lawyersand accountants under Section 18(a). In fact, Section 18(a)’s application could be deemed broader than Section10(b) based upon its distinct language, and thus might encompass actions against lawyers and accountants.

4. Defenses Under Section 18

If the defendant can prove that he “acted in good faith and had no knowledge that such statement was false ormisleading,” then liability will not be imposed. Ross, 607 F.2d at 556; Magna Inv. Corp. v. Does, 931 F.2d 38,39-40 (11th Cir. 1991).

5. Attorneys’ Fees

Section 18(a) provides that in addition to court costs, the court in its discretion, may assess reasonableattorney’s fees against either party.


Section 18(c) provides that the lawsuit must be brought “within one year after the facts constituting the cause ofaction and within three years after such cause of action accrued.” 15 U.S.C. § 78r(c). Lindner Dividend FundInc. v. Ernst & Young, 880 F. Supp. 49, 53 (D. Mass. 1995); City of Painesville, Ohio v. First Montauk Fin.Corp., 178 F.R.D. 180 (N.D. Ohio 1998). Most courts have held that the lengthened limitations period of theSarbanes-Oxley Act does not apply to section 18(a) claims. See, e.g., In re Enron Corp. Sec., Derivative, &“ERISA” Litig., 465 F. Supp. 2d 687, 712-13 (S.D. Tex. 2006).

H. Insider Trading Claims Under Section 10(b) And Section 20A


a. Section 10(b) Of The 1934 Act

Section 10(b), 15 USC § 78j, pertains to insider trading, and provides that it is unlawful:

To use or employ, in connection with the purchase or sale of any security registered on a nationalsecurities exchange or any security not so registered . . . any manipulative or deceptive device orcontrivance in contravention of such rules and regulations as the Commission may prescribe as necessaryor appropriate in the public interest or for the protection of investors.

Rule 10b-5, 17 C.F.R. §240.10b-5, promulgated thereunder provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality ofinterstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud;

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order tomake the statements made, in the light of the circumstances under which they were made, not

misleading; or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceitupon any person, in connection with the purchase or sale of any security.

b. Section 20A Of The 1934 Securities Exchange Act

Insider trading is also addressed in Section 20A, which provides in part:

Any person who violates any provision of this Act or the rules or regulations thereunder by purchasing orselling a security while in possession of material, nonpublic information shall be liable in an action inany court of competent jurisdiction to any person who, contemporaneously with the purchase or sale ofsecurities that is the subject of such violation, has purchased (where such violation is based on a sale ofsecurities) or sold (where such violation is based on a purchase of securities) securities of the same class.

2. Private Right of Action For Insider Trading

a. Actions Brought Under Rule 10(b)

Rule 10b-5, a broad anti-fraud provision, does not specifically address insider trading, but nonetheless hasemerged as the fundamental insider trading provision. Three key cases, Chiarella v. United States, 445 U.S.222 (1980), Dirks v. S.E.C., 463 U.S. 646 (1983), and United States v. O’Hagan, 117 S. Ct. 2199 (1997), definethe scope of insider trading under Rule 10b-5. The central tenet of these cases is that insiders, or those withsimilar fiduciary duties who possess material nonpublic information, must either abstain from trading ordisclose the information. See S.E.C. v. Adler, 137 F.3d 1325, 1333 (11th Cir. 1998).

1) Classical Theory

Under the classical theory, a person who buys or sells securities on the basis of material nonpublic informationviolates Rule 10b-5 if: (1) he owes a fiduciary duty to the other party; (2) he is an insider; or (3) he is a tippeewho received information from an insider and knows, or should know, that the insider breached a fiduciary dutyin disclosing the information to him. Chiarella, 445 U.S. 222. Under this theory, a tipper is liable only if hegarnishes the information with his own benefit in mind. Dirks, 463 U.S. 646. The benefit to the tipper need notbe financial, e.g., a reputational benefit may suffice. Id.; see also S.E.C. v Maxwell, 341 F. Supp. 2d 941, 948(S.D. Ohio 2005) (the reputational benefit must be reasonably calculated to translate into a future advantage forthe tipper). The tippee’s duty is an extension of the tipper’s fiduciary duty, and the tippee is not liable unlessthe tipper breached a duty in disclosing the information. The tipper need not know that his breach of fiduciaryduty in revealing the information would lead to the tippee’s trading; rather, the fact that the tipper knows hehimself breached a duty is sufficient to establish that he expected the tippee would misuse the information. United States v. Liberia, 989 F.2d 596 (2d Cir. 1993).

The Ninth Circuit adopted a contemporaneous trading requirement for insider trading claims brought underSection 10(b) and Rule 10b-5. See Brody v. Transitional Hosp. Corp., 280 F.3d 997, 1001 (9th Cir. 2002)(rejecting argument that O’Hagan does away with contemporaneous trading requirement); see also In re Sec.Litig. BMC Software, Inc., 183 F. Supp. 2d 860, 916 (S.D. Tex. 2001) (stating that the contemporaneous tradingrequirement applies both to claims brought under 10(b) and 20A).

2) Misappropriation Theory

The misappropriation theory expands liability to trading by corporate outsiders by imposing liability on thosewith a duty to the source of the insider information, even though the person is a corporate outsider and has nodirect duty to the trading shareholders. Under this theory, Rule 10b-5 is violated when a person(1) misappropriates material, nonpublic information, (2) by breaching a duty arising out of a relationship oftrust and confidence, and (3) uses that information in a securities transaction, (4) regardless of whether he owedany duty to the shareholders of the traded stock. O’Hagan, 117 S. Ct. at 2207; S.E.C. v. Clark, 915 F.2d 439(9th Cir. 1990); United States v. Cusimano, 123 F.3d 83 (2d Cir. 1997) (trading by an outsider in possession ofmaterial nonpublic information obtained and used in violation of duty owed to source treated as insidertrading).

In S.E.C. v. Cuban, 634 F. Supp. 2d 713, 725 (N.D. Texas, 2009), the court held that misappropriation liabilitycould arise from a contractual duty by agreement, absent any preexisting fiduciary or fiduciary-like relationship,if the agreement consisted of more than an express or implied promise merely to keep information confidentialand imposed on the party who received the information the legal duty to refrain from trading on or otherwiseusing the information for personal gain.

The Eleventh Circuit has ruled that tippers must intend to derive a benefit from the tip for misappropriationliability to attach. See S.E.C. v. Yun, 327 F.3d 1263, 1271 (11th Cir. 2003). Also, because the duty of trust runsfrom the tippee to the source, the tippee may avoid liability by revealing his intentions to trade to the source. O’Hagan, 117 S. Ct. at 2209.

Damages under this theory are disgorgement of all profits and dividends received or credited plus interest. S.E.C. v. Tome, 638 F. Supp. 596 (S.D.N.Y. 1986).

b. Actions Under Section 20A

Section 20A codified the common law discussed above by articulating a private right of action forcontemporaneous traders, i.e., where a plaintiff and insider complete trades at or near the same time. Section 20A provides that any person who violates the Securities Exchange Act by purchasing or selling asecurity while in possession of material, nonpublic information shall be liable to any person who,contemporaneously with the insider trading, purchased or sold securities of the same class. Section 20A is notexclusive; proper plaintiffs may still seek relief under Section 10(b). See 15 U.S.C. § 78t-1(d).

1) Independent Violation Required

Section 20A is not a primary source of insider trading liability. In order to recover under Section 20A, plaintiffmust show an independent violation of the securities laws. See In re VeriFone Sec. Litig., 11 F.3d 865, 872 (9thCir. 1993); Carney v. Cambridge Tech. Partners, Inc., 135 F. Supp. 2d 235, 256 (D. Ma. 2001) (“[C]laimsunder Section 20(A) are derivative, requiring proof of a separate underlying violation of the Exchange Act.”)(citing In re Advanta Corp. Sec. Litig., 180 F.3d 525, 541-42 (3d Cir. 1999)). However, the expiration of thestatute of limitations for the underlying violation does not bar Section 20A claims. See Johnson v. Aljian, 490F.3d 778 (9th Cir. 2007).

2) Contemporaneous Traders

As noted, Section 20A creates a right of action only for contemporaneous traders. See Brody v. TransitionalHosp. Corp., 280 F.3d 997, 1001 (9th Cir. 2002) (rejecting argument that O’Hagan does away with thecontemporaneous trading requirement); In re MicroStrategy, Inc. Sec. Litig., 115 F. Supp. 2d 620 (E.D. Va.2000). See also, Fujisawa Pharm. Co., Ltd. v. Kapoor, 932 F. Supp. 208 (N.D. Ill. 1996), aff’d, 115 F.3d 1332

(7th Cir. 1997) (contemporaneous traders are those who purchase stock anonymously on the open market, notthose who purchase directly in face-to-face transactions). A plaintiff need not have traded on the same day asthe insider in order for the trades to be “contemporaneous.” Courts applying the contemporaneous tradingrequirement differ in how strictly they construe it. See, e.g. In re Cypress Semiconductor Sec. Litig., 836 F.Supp. 711, 714 (N.D. Cal. 1993) (trade by investor five days after sale of stock by defendants metcontemporaneous requirement); In re MicroStrategy, 115 F. Supp. 2d 620 (purchase of shares notcontemporaneous with insider’s sale three days earlier); Chanoff v. U.S. Surgical Corp., 857 F. Supp. 1011 (D.Conn.), aff’d, 33 F.3d 50 (2d Cir. 1994) (purchase of more than one month from any insider trade notcontemporaneous); In re Verifone Sec. Litig., 784 F. Supp. 1471 (N.D. Cal. 1992), aff’d, 11 F.3d 865 (9th Cir.1993) (stock purchase two weeks from insider trade not contemporaneous); Colby v. Hologic, Inc., 817 F.Supp. 204 (D. Mass. 1993) (trade eight days after insider trade not contemporaneous); In re Tyco Int’l, Ltd.,MDL No. 02-1335-B, 2007 WL 1703023 (D.N.H. June 11, 2007) (holding that purchases a week beforedefendant’s sales were not contemporaneous). See Section III.A.7.f above.

3) Same Class Of Securities

Congress further limited standing to those who traded in the “same class of securities” as the insider trader. SeeFujisawa, 115 F.3d at 1337. For example, a plaintiff who purchased class B securities may not bring an actionagainst an insider who sold class A shares.

c. Civil And Criminal Liability Under A Misappropriation Theory

In government actions alleging insider trading liability, various circuits have held that the government mustmeet an informational “use” requirement. S.E.C. v. Alder, 137 F.3d 1325 (11th Cir. 1998); United States v.Smith, 155 F.3d 1051 (9th Cir. 1998). Merely showing that an insider traded while in possession of materialnonpublic information is not a per se violation. In the civil context, “[W]hen an insider trades while inpossession of material nonpublic information, a strong inference arises that such information was used by theinsider in trading.” Alder, 137 F.3d at 1337. The insider can attempt to rebut the inference that a causalconnection existed between his possession of information and his trading, but the SEC is still able to make out aprima facie case without having to present more direct evidence of any causal connection. In the criminalcontext, however, constitutional questions would be present if an evidentiary presumption gave rise to aninference of use of the insider information. Although this makes a prosecution by the government somewhatmore difficult, many pieces of circumstantial evidence are relevant to causation.

SEC rules that were enacted in November 2000 address this use requirement and identify circumstances wherefamily, personal, or other non-business relationships may give rise to a duty of trust or confidence for purposesof the “misappropriation theory” of insider trading. The rules also establish two affirmative defenses to insidertrading charges: (1) under Rule 10b5-1(c), a person will not be viewed as having traded on the basis of materialnonpublic information if the trade was made pursuant to a pre-existing contract, instruction or an eligiblewritten plan; and (2) under Rule 10b5-1(c)(2), which applies only to entities, an entity can demonstrate that aninvestment decision was not made “on the basis of” material non-public information if shown that: (1) theindividual making the investment decision was not aware of the information; and (2) the entity had reasonablepolicies and procedures in place to prevent insider trading.

d. Definition Of Insider

An insider is defined as a party that (1) has direct or indirect access to information intended to be available forcorporate purposes only and not for the personal benefit of any individual and (2) takes advantage of suchinformation knowing it is unavailable to those with whom he is dealing. See In re Cady, Roberts & Co., S.E.C.Release No. 8-3925, 1961 WL 60638 (Nov. 8, 1961) (announcing test); S.E.C. v. Texas Gulf Sulphur Co., 401

F.2d 833 (2d Cir. 1968) (adopting Cady test). Under this test, mere access to inside information is notsufficient. In order to impose liability there must be a “relationship giving access” to such information. Cady,1961 WL 60638, at *4; see also S.E.C. v. Lund, 570 F. Supp. 1397, 1402 (C.D. Cal. 1983) (holding that insidertrading liability is directed at those who are in a special relationship with the company and privy to its internalaffairs). The innocent eavesdropper is excluded from liability.

In addition to officers, directors, and controlling shareholders, certain other individuals may be consideredinsiders for purposes of 10(b) and 20A. Myzel v. Fields, 386 F.2d 718 (8th Cir. 1967) (ruling that relatives andfriends of traditional insiders may themselves be insiders); S.E.C. v. Cherif, 933 F.2d 403 (7th Cir. 1991)(extending insider liability to certain family members); In re Tacoma Sec., Inc., 30 S.E.C. 1067 (1984)(concluding that broker-dealer and investment company were liable as insiders); Shapiro v. Merrill Lynch,Pierce, Fenner & Smith, Inc., 495 F.2d 228 (2d Cir. 1974) (holding that underwriters were considered insidersfor purposes of 10(b)); United States v. Marcus Schloss & Co., Inc., 710 F. Supp. 944 (S.D.N.Y. 1989) (rulingthat insider trading liability extends to an employee of a law firm who has acquired material, nonpublicinformation regarding a corporate client). But see U.S. Steel & Carnegie Pension Fund, Inc. v. Orenstein, 557F.2d 343 (2d Cir. 1977) (stating that because bank stood to receive proceeds from securities offering did notnecessarily make it an insider); Feldman v. Simkins Indus., Inc., 679 F.2d 1299 (9th Cir. 1982) (holding thatfourteen percent stockholder was not a corporate insider because he had no access to confidential corporateinformation), receded from on other grounds in In re Wash. Public Power Supply Sys. Sec. Litig., 823 F.2d1349, 1352 (9th Cir. 1987).

e. Materiality

Whether the nonpublic information is material is crucial to determining liability. The general test of materialityis whether a substantial likelihood that a reasonable investor would consider the information important inmaking an investment decision exists. S.E.C. v. Antar, 15 F. Supp. 2d 477 (D.N.J. 1998); see also United Statesv. Smith, 155 F.3d 1051 (9th Cir. 1998) (holding that “soft” information may be material and may give rise toinsider trading liability); United States v. Cusimano, 123 F.3d 83 (2d Cir. 1997) (noting that a statement that“something was happening” was sufficiently material to support a conviction for insider trading).

I. Securities-Related RICO Suits

In response to congressional concerns that RICO served as a loophole for attorneys to bring stale securitiesactions, the Reform Act amended the civil RICO statute to eliminate RICO liability for most securities fraudclaims, except for those premised on securities violations where criminal convictions have been entered. 18U.S.C. § 1964(c), as amended by the Reform Act, § 107. The primary mechanism of the amendment was toalter RICO to exclude securities fraud as a predicate act. Accordingly, courts have broadly interpreted theamendment to preclude RICO claims rooted in conduct that could be actionable as securities fraud, regardlessof whether the plaintiff presents an actionable securities claim. See Howard v. America Online Inc., 208 F.3d741, 749-50 (9th Cir. 2000); Fezzani v. Bear, Stearns & Co., Inc., No. 99CIV0793(RCC), 2005 WL 500377 at*5 (S.D.N.Y. Mar. 2, 2005) (holding that the RICO amendment bars reliance on any conduct actionable assecurities fraud); Gatz v. Ponsoldt, 297 F. Supp. 2d 719, 730 (D. Del. 2003) (holding the Reform Act bars classaction and derivative RICO suits based on securities fraud even if plaintiffs do not allege that they purchased orsold securities). However, the Reform Act does not bar RICO suits when the alleged conduct is not actionableas securities fraud, even if the fraud happens to involve a security. See Petters Co., Inc. v. Stayhealthy, Inc.,No. CIV. 03-3210 JRT/FLN, 2004 WL 1465830 (D. Minn. June 1, 2004) (finding the connection between thealleged fraud and the securities transaction too tenuous where plaintiff alleged misrepresentations to secure aloan and creditor received both a promissory note and a separate security agreement providing an option fordebtor’s common stock).

In In re Prudential Securities Inc. Ltd. Partnership Litigation, 930 F. Supp. 68, 77-81 (S.D.N.Y. 1996), thecourt held that the Reform Act did not apply retroactively to RICO claims filed prior to the Reform Act’s

enactment. See also Mathews v. Kidder, Peabody & Co., Inc., 161 F.3d 156 (3d Cir. 1998) (holding ReformAct RICO Amendment not retroactive where plaintiff’s only viable claims came under RICO statute); Baker v.Pfeifer, 940 F. Supp. 1168 (S.D. Ohio 1996) (holding that the RICO Amendments do not apply retroactively). But see Krear v. Malek, 961 F. Supp. 1065, 1072 (E.D. Mich. 1997) (holding that provision of the Reform Acteliminating securities fraud as a predicate act for RICO claims applies retroactively); ABF Capital Mgmt. v.Askin Capital Mgmt., L.P., 957 F. Supp. 1308, 1320 (S.D.N.Y. 1997) (same).

J. The Investment Company Act Of 1940

Congress passed the Investment Company Act of 1940 as a comprehensive federal regulatory scheme to protectinvestment company shareholders from self-dealing and other abuses that were perceived to be rampantthroughout the mutual fund industry. 15 U.S.C. § 80a-1 (1997) (Findings and Declarations of Policy). Unlikethe Securities Act of 1933 and the Securities Exchange Act of 1934, which emphasize disclosure, the 1940 Actemphasizes regulatory and remedial measures, and contains various prohibitions and requirements includingthat the board of directors of a fund consist of “disinterested” members who are not affiliated with theinvestment adviser of the fund. 15 U.S.C. § 80a-10(a). The Supreme Court has instructed that these personsserve as “independent watchdogs” who supply “an independent check upon the management.” Burks v. Lasker,441 U.S. 471, 484 (1979).

As mutual funds experienced rapid growth in the 1950’s and 1960’s, investment advisers earned fees that didnot necessarily reflect the perceived economies of scale realized in managing larger funds. Securities andExchange Commission, Public Policy Implications of Investment Company Growth, reprinted in H.R. Rep. No.2237, 89th Cong., 2d Sess., 10-12 (1966). Congress determined that the unique structure of the mutual fundindustry resulted in closer relationships between mutual funds and their investment advisers than those usuallyexisting between other buyers and sellers of investment advisory services. Because of this closeness, “theforces of arm’s length bargaining [did] not work in the mutual fund industry in the same manner as they [did] inother sectors of the American economy.” S. Rep. No. 184, 91st Cong., 1st Sess. 5, reprinted in 1970 U.S. CodeCong. & Ad. News 4897, 4901. In 1970, Congress sought to address the problem by adding Section 36(b) tothe Act, 15 U.S.C. § 80a-35(b), thereby imposing a fiduciary duty upon investment advisers in connection withtheir receipt of compensation. Section 36(b) is the only provision under the entire Act that expressly providesprivate citizens with a right of action.

Many federal courts previously found implied private rights of action under various sections of the 1940 Actand have, in effect, superimposed a layer of judicial scrutiny over the actions of mutual fund advisers andindependent directors. More recent decisions, however, have declined to find an implied private right of actionunder certain sections. Other federal courts have narrowed the scope of claims under the Act and embracedimportant doctrinal defenses. In the future, cases are likely to focus primarily on two areas: (i) the existence ofimplied private rights of action under the Act; and (ii) the standard for pleading (as opposed to proving) claimsunder Section 36(b), the Act’s only express right of action.

1. Section 36(b) Of The Investment Company Act

Section 36(b) of the Investment Company Act of 1940, 15 U.S.C. § 80a-35(b), provides:

An action may be brought under this subsection by the Commission, or by a security holder of suchregistered investment company on behalf of such company, against such investment adviser, or anyaffiliated person of such investment adviser, or any other person enumerated in subsection (a) of thissection who has a fiduciary duty concerning such compensation or payments, for breach of fiduciary dutyin respect of such compensation or payments paid by such registered investment company or by thesecurity holders thereof to such investment adviser or person.

By its terms, Section 36(b) is limited to breaches of fiduciary duty involving an investment adviser’s receipt of

compensation and does not, on its face, give plaintiffs the right to sue for alleged breaches of general fiduciaryduties. It does not require that plaintiff prove that a defendant engaged in personal misconduct. 15 U.S.C.§ 80a-35(b)(1). Furthermore, fees charged are not inevitably found excessive simply because the defendant hasbreached a fiduciary duty. Mutchka v. Harris, 373 F. Supp. 2d 1021, 1025 (C.D. Cal. 2005). Section 36(b)gives private litigants a short, one-year limitations period in which to bring suit, in direct contrast with thelonger, five-year limitations period given the SEC for enforcement proceedings. Damages under Section 36(b)are limited to fees received by investment advisers within the prior year. 15 U.S.C. § 80a-35(b)(3). Onlyrecipients of advisory compensation or other payments shall be liable for damages under § 36(b). Id.

Because Section 36(b) is “equitable” in nature, plaintiffs are not entitled to a jury trial. See Gartenberg v.Merrill Lynch Asset Mgmt., Inc., 487 F. Supp. 999, 1001 (S.D.N.Y. 1980), aff’d sub nom. In re Gartenberg, 636F.2d 16, 17 (2d Cir. 1980); Kalish v. Franklin Advisers, Inc., 928 F.2d 590, 591 (2d Cir. 1991); Schuyt v. RowePrice Prime Reserve Fund, Inc., 663 F. Supp. 962 (S.D.N.Y.), aff’d, 835 F.2d 45, 46 (2d Cir. 1987).

The demand requirement governing derivative actions brought by shareholders of a corporation does not applyto an action brought by an investment company shareholder under Section 36(b) of the Act. See Daily IncomeFund, Inc. v. Fox, 464 U.S. 523 (1984).

2. Initial Litigation – The Excessive Fee Cases

In connection with the increased popularity of money market funds in the 1980’s, plaintiffs brought numerousclaims under Section 36(b) alleging that investment advisers were charging these funds excessive managementfees.

Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982), was the first case toundertake a comprehensive analysis of the standards courts should apply when evaluating “excessive fee”claims under Section 36(b). The court reviewed the “tortuous” legislative history of Section 36(b) andconcluded that, to be guilty of a violation, the fee must be “so disproportionately large that it bears noreasonable relationship to the services rendered and could not have been the product of arm’s-lengthbargaining.” Id. at 928; see also In re Salomon Smith Barney Mutual Fund Litig., 441, F. Supp. 2d 579, 599(S.D.N.Y. 2006) (holding it is insufficient to plead that fees are excessive, a complaint must also plead factsshowing that fees are disproportionate to the services rendered).

The court identified six factors to be considered in determining whether fees charged by the investment adviserwere disproportionate to the services rendered: (1) the nature and quality of the services provided to fundshareholders; (2) the profitability of the fund to the adviser-manager; (3) economies of scale of operating thefund as it grows larger; (4) comparative fee structures; (5) fallout benefits, i.e., indirect profits to the adviserattributable in some way to the existence of the fund; and (6) the independence and conscientiousness of thedirectors. Id.

Subsequent to Gartenberg, plaintiffs have been generally unsuccessful in pursuing “excessive fee” claims underSection 36(b). See, e.g., Krinsk v. Fund Asset Mgmt., Inc., 875 F.2d 404, 409 (2d Cir. 1989); Levy v. AllianceCapital Mgmt., L.P., No. 97 CIV. 4672 (DC), 1998 WL 744005, at *4 (S.D.N.Y. Oct. 26, 1998), aff’d, 189 F.3d 461 (2d Cir. 1999) (dismissing Section 36(b) claim where plaintiff “fail[ed] to explain how the fees andexpenses are excessive in light of the ‘Gartenberg’ factors”); Schuyt, 663 F. Supp. 962. But see Millenco L.P.v. MEVC Advisors, Inc., No. CIV. 02-142-JJF, 2002 WL 31051604, at *3-4 (D. Del. Aug. 21, 2002); Sins v.Janus Capital Mgmt., LLC, No. 04-cv-01647-WDM-MEH, 2006 WL 3746130, at *3-4 (D. Colo. Dec. 15,2006) (finding, under Gartenberg, allegations that the defendant provided identical services to third parties atlower rates weigh against granting a motion to dismiss). Notably, in affirming dismissal of a 36(b) claim, theSeventh Circuit rejected the Gartenberg analysis altogether, finding that the market for mutual fund fees was amore appropriate predictor of what is “reasonable” than judicially created standards. Jones v. Harris Assocs.,527 F.3d 627, 632 (7th Cir. 2008). Additionally, the Eighth Circuit has supported both the Gartenberg andJones analysis, holding that while the Gartenberg factors were useful, their flaw was that they could be applied

so as to “create a safe harbor of exorbitance” and “be diluted to a simple and easily satisfiable requirement notto charge a fee that is egregiously out of line with industry norms.” Gallus v. Ameriprise Fin., Inc., 561 F.3d816, 822-23 (8th Cir. 2009) (finding the proper approach to Section 36(b) would be to look “to both advisers’conduct during negotiations and the end result”).

In 2010, the Supreme Court affirmed the Seventh Circuit decision in Jones, but on a different ground. Itdisagreed with the Seventh Circuit’s rejection of the Gartenberg standard, holding that it fully expresses themeaning of “fiduciary duty” in Section 36(b) and reflects the section’s “place in the statutory scheme and, inparticular, its relationship to the other protections that the Act affords investors.” Jones v. Harris Assoc. L.P.,130 S. Ct. 1418, 1427 (2010). While “all relevant circumstances “must be considered in determining wither afund manager’s compensation is lawful, the Court reaffirmed that the Act “does not call for judicial second-guessing of informed board decisions, id. at 1430; if disinterested directors consider the relevant factors, “theirdecision to approve a particular fee agreement is entitled to considerable weight, even if a court might weighthe factors differently.” Id. at 1429.

3. Recent Attempts To Expand The Scope Of Section 36(b)

Rather than alleging that an adviser’s fees are “excessive,” plaintiffs now invoke Section 36(b) to challengecorporate transactions involving investment companies. Plaintiffs are now also attacking the structure of thefees themselves as per se violations of Section 36(b), without necessarily alleging that they are excessive ordisproportionate to the services rendered. Challenges to fees have also been brought under Section 36(b) on theground that advisory agreements were not properly approved by disinterested directors, since the directorsserved on multiple fund boards and received significant remuneration for such services. The Supreme Court’sdecision in Jones v. Harris Assocs., by focusing broadly on fiduciary duties, will be an obstacle to many suchefforts.

a. Mergers

In Olesh v. Dreyfus Corp., No. CV-94-1664 (CPS), 1995 WL 500491 (E.D.N.Y. Aug. 8, 1995), plaintiffshareholders in two mutual funds managed by The Dreyfus Corporation alleged that the merger of Dreyfus andMellon Bank violated Section 36(b). Plaintiffs asserted that Dreyfus breached its fiduciary duties under Section36(b) by failing to negotiate any reduction in the funds’ advisory fees or protections against future feeincreases. The district court dismissed the complaint, holding that the failure to negotiate reduced fees orprotection against future fee increases in connection with a merger was not a breach of fiduciary duty underSection 36(b). Applying the Gartenberg standard, the Court noted that plaintiffs had failed to allege that eitherexisting or contemplated future fees bore “no reasonable relationship to the services rendered and could nothave been the product of arm’s-length bargaining.” Id. at *19 (quoting Gartenberg v. Merrill Lynch AssetMgmt., Inc., 694 F.2d 923, 928 (2d Cir. 1982)).

Similarly, in Wexler v. Equitable Capital Management Corp., No. 93 CIV. 3834 (RPP), 1994 WL 48807(S.D.N.Y. Feb. 17, 1994), the court dismissed a challenge under Section 36(b) to an investment adviser’s salebecause plaintiffs failed to support their claims with specific allegations that after the sale the investmentadvisory fees would be excessive under the Gartenberg standard.

b. Rights Offerings

In In re Nuveen Fund Litigation, No. 94 C 360, 1996 WL 328006 (N.D. Ill. June 11, 1996), plaintiffs brought aclaim under Section 36(b) against an adviser to closed-end mutual funds challenging the issuance of new stockpursuant to a rights offering. Plaintiffs alleged that the adviser issued new shares in the funds to generateadditional management fees for itself, regardless of the harmful consequences to the funds. The court held thatalthough Section 36(b) imposes a fiduciary duty with respect to the receipt of compensation or payment for

services, it does not regulate the propriety of underlying transactions (such as the rights offering) upon whichadditional compensation may be based. Id. at *5. The court opined that “Congress enacted Section 36(b) inorder to address a narrow area of concern: the negotiation and enforcement of payment arrangements betweenthe investment adviser and its fund.” Id. at *13. The Court concluded that Section 36(b) should not be appliedbroadly to govern an investment adviser’s performance, and is not the proper vehicle for challenging anunderlying transaction that may, in fact, generate fees for the adviser. Id.

Similarly, in Strougo v. Scudder, Stevens & Clark, Inc., 964 F. Supp. 783, 805 (S.D.N.Y. 1997), the courtdismissed plaintiffs’ Section 36(b) claim where plaintiffs alleged that the rights offering was done to increasethe adviser’s fee. The court held that plaintiffs had failed to support the “conclusory allegation that [theadviser’s] compensation after the Rights Offering was unreasonably disproportionate to the value of [theadviser’s] services” and that allegations that the adviser’s fee “increased substantially as a result of a RightsOffering . . . [did] not, in itself, support an excessive fee claim under Section 36(b).” See also King v.Douglass, 973 F. Supp. 707, 722 (S.D. Tex. 1996) (dismissing a Section 36(b) claim for failing to allege thatthe fee was not commensurate with services provided or could not have been the product of a disinterestedbusiness transaction despite adequately pleading that defendants disproportionately received a large fee relativeto other investment companies).

c. Leveraged Funds

In two very similar cases involving the same plaintiffs, courts granted summary judgment for defendants,holding that potential conflicts of interest in an advisory agreement do not constitute a violation of Section36(b) unless there is an actual breach of the fiduciary duty imposed by that section.

In Green v. Fund Asset Management, L.P., 19 F. Supp. 2d 227 (D.N.J. 1998), shareholders in seven “leveraged”closed-end investment companies alleged that the funds and their adviser violated Sections 8(e), 34(b), 36(a)and 36(b) of the Act and state law by receiving compensation based upon the total assets of the funds, includingassets acquired by leveraging through the issuance of preferred stock. Plaintiffs asserted that thesecompensation arrangements created an improper conflict of interest because the adviser had an incentive toalways keep the funds fully leveraged in order to maximize advisory fees, even when economic conditionsdictated that the leverage should be reduced.

The district court granted defendants’ motion to dismiss the claims under Sections 8(e), 34(d) and 36(a) on theground they were time-barred, and also because Section 36(b) is the exclusive remedy for allegationsconcerning excessive advisory fees. The court declined, however, to dismiss the Section 36(b) claim, eventhough plaintiffs conceded they had not alleged that the advisory compensation was disproportionate to theservices rendered. Id. at 235. Instead, the court held that if plaintiff’s claims were valid, “then the feescollected by [the adviser] to date were the result of a breach of fiduciary duty in violation of Section 36(b),” and“[i]t would follow that such fees were excessive and recoverable to the extent permitted under that Section.” Id.

The district court subsequently granted defendants’ motion for summary judgment dismissing the Section 36(b)claim, and the United States Court of Appeals for the Third Circuit affirmed that dismissal. Green v. FundAsset Mgmt., L.P., 147 F. Supp. 2d 318 (D.N.J. 2001), aff’d, 286 F.3d 682 (3d Cir. 2002). The Third Circuit, inaffirming, agreed that potential conflicts of interest in an advisory fee agreement “are not per se violations of aninvestment advisors’ fiduciary duties [under Section 36(b)]: an actual breach must be alleged and proven.” Green, 286 F.3d at 685. Because plaintiffs did not allege that they or the funds had suffered any actualdamages during the relevant time period as a result of any improper decision by the adviser, the court concludedthat they did not have a cognizable claim under Section 36(b).

The district court in Green v. Nuveen Advisory Corp., No. 97 C 5255, 2001 WL 1035652 (N.D. Ill. Sept. 10,2001), aff’d, 295 F.3d 738 (7th Cir. 2002), brought by the plaintiffs who also brought Green v. Fund AssetManagement, likewise granted defendants’ motion for summary judgment, adopting much of the district court’sopinion in Green v. Fund Asset Management. The Seventh Circuit affirmed dismissal of the complaint, noting

that “while an abuse of this inherent conflict may violate § 36(b), its mere existence does not.” Green, 295 F.3dat 742. The court agreed with the district court’s observations that the Investment Advisers Act of 1940 permitssuch advisory contracts and that the fund’s directors, not the adviser, had made the leveraging decisions. Id. at743-45.

d. Annuity Contracts

In Levy v. Alliance Capital Management, L.P., No. 97 CIV. 4672 (DC), 1998 WL 744005 (S.D.N.Y. Oct. 26,1998), aff’d, 189 F.3d 461 (2d Cir. 1999), plaintiff invested in an annuity contract issued by Equitable LifeAssurance, a life insurance company, that combined both insurance and investment features. The investmentfeature permitted contract holders to allocate annuity contract contributions to an account funded by variousmutual funds. Plaintiff alleged that the combined insurance and advisory fees charged by Equitable andAlliance were excessive in violation of Section 36(b).

Plaintiff sought to hold Equitable (an affiliate of the Funds’ advisor) liable under Section 36(b), on the theorythat the insurance charges were really disguised investment advisory fees. The court, however, held thatEquitable could not be held liable under Section 36(b) because it neither provided investment advisory servicesnor received any compensation for providing such services. As to the investment adviser, the court held thatplaintiff had failed to allege that the fees were so disproportionate as to bear no reasonable relationship to theservices rendered.

e. Multiple Fund Boards

A series of cases have indirectly attacked advisory fees by challenging the propriety of directors serving on theboards of multiple funds. These cases are based on the theory that outside directors who (1) serve on boards ofmultiple funds advised by the same adviser and (2) receive significant compensation for such service are“interested directors” under the Act, and therefore advisory fees are not properly approved under Section 15(c). These cases allege that the improperly approved advisory agreements violate Section 36(b). As seen below,courts have largely rejected this argument.

SEC-promulgated regulations now require disclosure of the total number of funds on which a director serves,but there is no prohibition against service on multiple boards. See 17 C.F.R. § 240.14a-101 (2003).

For example, in Migdal v. Rowe Price-Fleming International, Inc., No. AMD 98-2162, 2000 WL 350400 (D.Md. Mar. 20, 2000), aff’d, 248 F.3d 321 (4th Cir. 2001), plaintiffs brought suit under Section 36(b) against theinvestment adviser and five individual directors of the T. Rowe Price International Stock Fund. Two of the fivedirectors were also employees of the investment adviser. Plaintiffs alleged that the three non-employeedirectors were “interested person(s)” of the adviser because they served on multiple fund boards, for which theyreceived compensation of $81,000. The Fourth Circuit affirmed the District Court’s ruling that a “non-employee, non-affiliate director, who is statutorily presumed to be disinterested, is not rendered interested ornon-independent by virtue of the number of interlocking boards on which she or he serves within a family offunds,” notwithstanding the amount of aggregate income that such a director receives for such service. Id. at*3. The court also pointed out that the SEC did not prohibit the use of interlocking boards within fundcomplexes and affirmed its position that “a director of a fund who also is a director of another fund managed bythe same adviser generally would not be viewed as an interested person of the fund under section 2(a)(19) [ofthe ICA] solely as a result of this relationship.” 248 F.3d at 330 (citations omitted); see also Krantz v.Prudential Invs. Fund Mgmt. LLC, 77 F. Supp. 2d 559 (D.N.J. 1999), aff’d, 305 F.3d 140 (3d Cir. 2002)(holding that a director’s well-compensated service on boards of multiple funds alone will not support a claimthat the director is controlled by the adviser); Strougo v. BEA Assocs., 188 F. Supp. 2d 373, 380-82 (S.D.N.Y.2002) (granting summary judgment dismissing plaintiff’s claims under Sections 36(a) and 36(b)); Krantz v.Fidelity Mgmt. & Research Co., 98 F. Supp. 2d 150, 157 (D. Mass. 2000) (dismissing allegations that outside

directors who sat on multiple boards and received fees were “interested,” but permitting limited discovery forthe Section 36(b) claim).

f. Membership Dues To ICI

In Rohrbaugh v. Inv. Co. Inst., No. CIV. A. 00-1237, 2002 WL 31100821 (D.D.C. July 2, 2002), two fundshareholders brought Section 36(b) claims against the Investment Company Institute (“ICI”) alleging that theICI, a trade organization whose membership included approximately 7,700 mutual funds and 500 closed-endfunds, collected its membership dues from fund shareholders but was “dominated” by investment advisers whoheld more than 80% of the seats on the ICI Board of Governors, thus creating an inherent conflict of interest tothe detriment of the investment companies. Id. at *3. Plaintiffs conceded that they were challengingmembership dues, not advisory fees, but contended that those dues fell within the definition of “payments”under Section 36(b). See 15 U.S.C. § 80a-36b (“[A]n action may be brought . . . against such investmentadviser, or any affiliated person of such . . . who has a fiduciary duty concerning such compensation orpayments.”); Rohrbaugh, 2002 WL 31100821 at *8.

The court disagreed, noting that the legislative history was clear that “payments” covered “situations where aninvestment adviser would try to evade liability for charging excessive fees by arranging for payments to bemade to an affiliated person of the adviser rather than directly to the adviser.” Id. at *9. Thus, the court heldthat a Section 36(b) claim must either “involve a challenge to excessive advisory fees per se or to conduct thatresults in excessive advisory fees.” Id. Since plaintiffs admitted that their claim had “absolutely noconnection” to excessive advisory fees, the court concluded that they had no cognizable claim under Section36(b) and granted defendant’s motion to dismiss. Id.

4. Preemption Of State Law Claims In Section 36(b) Action

In a case of first impression in the federal courts, the U.S. District Court for the District of New Jersey, in Greenv. Fund Asset Management, L.P., 53 F. Supp. 2d 723 (D.N.J. 1999), dismissed plaintiffs’ state law claims forbreach of fiduciary duty and deceit on the ground that they were preempted by Section 36(b). The court heldthat “allowing plaintiffs’ inconsistent state law parallel actions would frustrate the statutory schemepurposefully put into place by Congress in Section 36(b).” Id. at 731.

On appeal, the Third Circuit reversed the district court decision and remanded for further proceedings. SeeGreen v. Fund Asset Mgmt., L.P., 245 F.3d 214 (3d Cir. 2001). The Third Circuit was not persuaded bydefendants’ argument that various procedural differences between the Section 36(b) action and similar state lawclaims indicated congressional intent to preempt the plaintiffs’ state law claims; instead, it found suchprocedural differences evidence of a congressional balancing between a “markedly more ‘plaintiff-friendly’”Section 36(b) and the “‘corporate waste’ standard applied by most state courts prior to 1970.” Id. at 229.

5. Implied Right Of Action Under The 1940 Act

a. Legislative History

When originally enacted, the 1940 Act did not expressly provide private citizens with any enforcement rightsunder any provision of the Act. The 1940 Congress did not provide for implied rights because: (1) claims underthe 1940 Act could usually be brought as registration or disclosure claims under the 1933 or 1934 Act, whereprivate enforcement remedies already existed; and (2) the Act was passed as a comprehensive federal regulatoryscheme to protect shareholders from self-dealing and other abuses. 15 U.S.C. § 80a-1 (1997) (Findings andDeclarations of Policy).

Responding to the specific problem of escalating investment advisory fees, Congress expressly provided privatecitizens (“security holders”) with a limited cause of action under the 1970 Amendments to the Act at Section36(b). Also, as part of the 1970 Amendments, Congress enacted Section 36(a) (discussed infra), whichauthorizes the SEC to bring an action “alleging that a person . . . has engaged within five years of thecommencement of the action or is about to engage in any act or practice constituting a breach of fiduciary dutyinvolving personal misconduct in respect of any registered investment company.” 15 U.S.C. § 80a-35(a).

The Senate and House Reports accompanying the 1970 Amendments have noted that the fact that Section 36(b)specifically provides for a private right of action “should not be read to affect Section 36(a).” S. Rep. No. 91-184, 91st Cong. 1st Sess. (1969); H. Rep. No. 91-1382, 91st Cong. 2d Sess. 38 (1970). Some courts haveinterpreted this language as an indication of congressional intent to imply a private right of action under Section36(a).

In 1980, the 1940 Act was amended again. The 1980 House Report – written some 40 years after the originalpassing of the Act – expresses the expectation that courts will imply private rights of action under the Actwhere the plaintiff falls into the class of people protected by the statutory provision in question. Pub. L. No.96-477, 94 Stat. 2275 (1980) (although the Committee fails to specify any particular statutory section other thanSection 36(a), it stated that the “Committee wishes to make plain that it expects the courts to imply privaterights of action under this legislation.”). Some courts have cited this House Report as supporting the existenceof implied private rights of action under the Act, especially Section 36(a).

b. Courts Finding Implied Rights Of Action

The U.S. Supreme Court has never recognized an implied right of action under the 1940 Act, instead expresslydeclining the opportunity to do so. Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 97 n.4 (1991); DailyIncome Fund, Inc. v. Fox, 464 U.S. 523, 536-41 (1984). It has, moreover, signaled a strong presumptionagainst implying private rights of action under the federal securities laws. See Central Bank of Denver v. FirstInterstate Bank of Denver, 511 U.S. 164 (1994) (no implied private right of action for aiding and abetting aviolation of Section 10(b) under the 1934 Act).

In Alexander v. Sandoval, 532 U.S. 275 (2001), a case involving implied rights of action under the Civil RightsAct of 1964, the U.S. Supreme Court reiterated the importance of contemporaneous congressional intent, statingthat “[t]he judicial task is to interpret the statute Congress has passed to determine whether it displays an intentto create not just a private right but also a private remedy,” and that “[s]tatutory intent on this latter point isdeterminative” because “[w]ithout it, a cause of action does not exist and courts may not create one, no matterhow desirable that might be as a policy matter, or how compatible with the statute.” Id. at 286-87.

Nevertheless, prior to the Second Circuit’s decision in Olmsted v. Purco Life Insurance Co., 283 F.3d 429 (2dCir. 2002), discussed below in full, district and circuit courts alike had been implying rights of action under the1940 Act for private citizens. See, e.g., Fogel v. Chestnutt, 668 F.2d 100, 112 (2d Cir. 1981) (“In adopting astatute intended as a thorough and pervasive regulation of the investment company industry . . . it seems to ushighly unlikely that Congress intended that . . . enforcement should be solely the task of the SEC and of thecriminal law, and that injured investors should have no recourse in a federal court.”); McLachlan v. Simon, 31F. Supp. 2d 731 (N.D. Cal. 1998) (Section 36(a)); Strougo v. Scudder, Stevens & Clark, Inc., 964 F. Supp. 783(S.D.N.Y. 1997) (Section 36(a)); In re Nuveen Fund Litig., No. 94 C 360, 1996 WL 328006, at *6 (N.D. Ill.June 11, 1996) (Sections 34(b) and 36(a)); Young v. Nationwide Life Ins. Co., 2 F. Supp. 2d 914 (S.D. Tex.1998) (Section 36(a)); Blatt v. Merrill Lynch, Pierce, Fenner & Smith Inc., 916 F. Supp. 1343, 1349-50 & n.5(D.N.J. 1996) (Section 7); Langner v. Brown, 913 F. Supp. 260, 267 (S.D.N.Y. 1996) (Section 10).

c. Courts Finding No Implied Rights Of Action

In a case of first impression, the Second Circuit affirmed the district court’s decision holding that there is no

private right of action for violations of Sections 26(f) or 27(i) of the Act. Olmsted, 283 F.3d 429 (affirming 134F. Supp. 2d 508 (E.D.N.Y. 2000)). It was the first time a United States Court of Appeals refused to find animplied private right of action under the 1940 Act.

Plaintiffs in Olmsted invested in variable annuity contracts and alleged that virtually all of the fees collected onthose contracts represented profit to the defendants and thus violated Sections 26(f) and 27(i) of the Act. Thosesections prohibit the sale of variable insurance contracts unless the fees and charges deducted under thecontract, in the aggregate, are “reasonable in relation to the services rendered, the expenses expected to beincurred, and the risks assumed by the insurance company.” 15 U.S.C. § 80a-26(f)(2)(A). The Second Circuitnoted the Supreme Court’s statement that congressional intent is “determinative” of whether a federal privateright of action exists for violations of a federal statute. It found three compelling indicia that Congress did notintend to create a private right of action under Sections 26(f) and 27(i): (i) the sections do not contain “rights-creating language,” but instead state that “it shall be unlawful”; (ii) Section 42 of the Act already provides forenforcement of all Act provisions by the SEC, but not by private litigants; and (iii) Congress’ provision of anexpress right of action under Section 36(b) of the Act suggests the intentional omission of a private right toenforce other sections. Olmsted, 283 F.3d at 432-33.

The Second Circuit recognized that its decision represented a significant break from the long-standing practiceof an “overwhelming majority of courts” finding implied private rights of action under the 1940 Act. Nevertheless, the Court found this break was compelled by a series of Supreme Court decisions declaring thepractice of implying private rights of action an “ancien regime.” Id. at 434 (quoting Alexander v. Sandoval, 532U.S. 275, 287 (2001)); see also Boland v. Engle, 113 F.3d 706, 715 n.9 (7th Cir. 1997) “[Central Bank] has castdoubt on the type of analysis that courts have used to find implied rights of action [under the 1940 Act].”).

Following Olmsted, courts have consistently found that no implied private right of action exists under variousprovisions of the Act, despite previous decisions to the contrary:

· No implied private right of action under Section 34(b). See, e.g., In re Merrill Lynch & Co., Inc.Research Reports Sec. Litig., 272 F. Supp. 2d 243 (S.D.N.Y. 2003); White v. Heartland High-Yield Mun. BondFund, 237 F. Supp. 2d 982, 987 (E.D. Wis. 2002); Dorchester Investors v. Peak Int’l Ltd., 134 F. Supp. 2d 569,581 (S.D.N.Y. 2001); In re Van Wagoner Funds, Inc. Sec. Litig., No. C 02-03383 JSW, 2004 WL 2623972, at*11-12 (N.D. Cal. July 27, 2004) (noting that in dicta the Ninth Circuit, in Pegasus Funds, Inc. v. Laraneta, 617F.2d 1335, 1341 (9th Cir. 1980), has found it “doubtful that [Section 34(b)] implies a private right of action”);In re Goldman Sachs Mut. Funds Fee Litig., No. 04 Civ. 2567, 2006 WL 126772 (S.D.N.Y. Jan. 17, 2006)(applying Olmsted and holding that there is no private cause of action under Section 34(b)).

No implied private right of action under Section 22. See White v. Heartland High-Yield Mun. Bond Fund,237 F. Supp. 2d 982, 987 (E.D. Wis. 2002).

No implied private right of action under Section 12(d)(1)(A). See meVC Draper Fisher Jurvetson Fund I,Inc. v. Millennium Partners, L.P., 260 F. Supp. 2d 616 (S.D.N.Y. 2003).

No implied private right of action under Section 47(b). Smith v. Franklin/Templeton Distribs., Inc., 2010U.S. Dist. LEXIS 56516 (N.D. Cal. 2010).

No implied private right of action under section 13(a). Northstar Fin. Advisors, Inc. v. SchwabInvestments, 615 F.3d 1106, 1115-18 (9th Cir. 2010).

6. Section 36(a)—The Perceived Catchall

a. Elements Of Section 36(a)

Section 36(a) of the Investment Company Act of 1940, 15 U.S.C.§ 80a-35(a), provides:

“The Commission is authorized to bring an action in the proper district court of the United States, or in theUnited States court of any territory or other place subject to the jurisdiction of the United States, alleging that aperson serving or acting in one or more of the following capacities has engaged within five years of thecommencement of the action or is about to engage in any act or practice constituting a breach of fiduciary dutyinvolving personal misconduct in respect of any registered investment company for which such person soserves or acts....”

Section 36 as originally enacted in 1940 required a showing of “gross misconduct or gross abuse of trust.” 15U.S.C. § 80a-35(c) (1940). In 1970, Congress amended Section 36 to add Section 36(a), which changed thestandard from gross abuse of trust to “breach of fiduciary duty involving personal misconduct.” Theamendment was designed to give the SEC more flexibility in bringing actions against investment advisers anddirectors without attaching the “gross abuse of trust” label.

The original version of Section 36(a) would have permitted the SEC to bring actions for any breach of fiduciaryduty. See Hearings of S. 1659 Before the Senate Comm. on Banking and Currency, 90th Cong., 1st Sess. 167(1967) and Hearings of H.R. 9510 Before the Subcomm. on Commerce and Finance of the House Comm. onInterstate and Foreign Commerce, 90th Cong., 1st sess. (1967). Congress, reacting to complaints of industryrepresentatives that such a broad standard would lead to actions for even minor disagreements with theCommission, added the term “involving personal misconduct” in order to limit recoveries against advisers anddirectors to cases of self-dealing or some clear-cut personal impropriety. S. 1659.

b. Judicial Evolution Of Section 36(a)

Historically, courts interpreting Section 36(a)’s “personal misconduct” standard found a violation only wherethe defendant had exhibited some type of self-interested behavior. See, e.g., S.E.C. v. Vintage Group, Inc.,No. C-94-0772, 1994 WL 615222 (N.D. Cal. Nov. 2, 1994) (enjoining defendants from future violations ofSection 36(a) where they had misappropriated offering proceeds); S.E.C. v. Strategic Mgmt., Inc., No. 3-91 CV2489-P, 1993 WL 268506 (N.D. Tex. July 9, 1993) (finding a violation of Section 36(a) where defendantsaccepted a $2 million payment for the sale of an investment advisory contract); S.E.C. v. Commonwealth Chem.Sec., Inc., 410 F. Supp. 1002 (S.D.N.Y. 1976) (self-dealing violated Section 36(a)), aff’d in part, modified inpart, 574 F.2d 90 (2d Cir. 1978).

c. Private Right Of Action

Securities plaintiffs have tried to utilize Section 36(a) as a catch-all for any alleged bad acts by advisers,directors and managers. Some federal courts have sustained plaintiffs’ rights to bring an implied right of actionunder Section 36(a) and taken a liberal view of what plaintiffs must allege under this Section to state a claim. In most cases, courts have been unwilling to dismiss Section 36(a) claims before trial – whether or not they areaccompanied by specific allegations of self-dealing or personal impropriety by the defendants. Instead, somecases suggest that “ordinary” breaches of fiduciary duty may be sufficient to state a claim under Section 36(a). See, e.g., Young v. Nationwide Life Ins. Co., 2 F. Supp. 2d 914, 927 (S.D. Tex. 1998) (finding “personalmisconduct” clause was not limited to conduct constituting self-dealing or personal impropriety, but extendedto “any ‘nonfeasance of duty or abdication of responsibility”); Strougo v. Scudder, Stevens & Clark, Inc., 964 F.Supp. 783, 800 (S.D.N.Y. 1997) (finding that allegations the directors affirmatively acted to benefit theinvestment adviser by approving a rights offering without regard for the fund’s interests sufficiently allegedconduct violative of the “prevailing standards of fiduciary duty” Congress intended to incorporate into Section36(a)); Seidel v. Lee, No. 94-422-JJF, 1996 WL 903947, at *8 (D. Del. Aug. 16, 1996) (denying defendants’motion to dismiss because the court was “hesitant at [that] stage of the proceeding, to limit the term ‘personalmisconduct’” to cases involving self-dealing, conflict of interest or some personal gain to the defendants and

concluding that if the directors breached their fiduciary duties, that breach in and of itself “is a form of personalmisconduct”) (emphasis added); In re Nuveen Fund Litig., No. 94 C 360, 1996 WL 328006 (N.D. Ill. June 11,1996) (holding that directors’ abdication of responsibility to protect shareholders from the adviser’s self-dealingwould constitute a violation of Section 36(a)). But see Prescott v. Allstate Life Ins. Co., 341 F. Supp. 2d 1023(N.D. Ill. 2004) (holding that plaintiffs failed to state a claim under § 36(a) because they did not allege “anyself-dealing or even personal impropriety”); Olesh v. Dreyfus, No. CV-94-1664 (CPS), 1995 WL 500491, at*20 (E.D.N.Y. Aug. 8, 1995) (dismissing plaintiffs’ § 36(a) claim because plaintiffs failed to allege anymisconduct by the officers of the fund manager).

d. Eliminating The Implied Right Of Action Under Section 36(a)

Following Sandoval and Olmsted, supra, a trend rejecting implied rights of action under Section 36(a) hasemerged. See, e.g., Dull v. Arch, No. 05 C 140, 2005 WL 1799270 at *2 (N.D. Ill. July 27, 2005) (holding thatSection 36(a) does not provide a private right of action); Jacobs v. Bremner, 378 F. Supp. 2d 861, 866 (N.D. Ill2005); Mutchka v. Harris, 373 F. Supp. 2d 1021, 1026 (C.D. Cal. 2005); Chamberlain v. Aberdeen AssetMgmt., No. 02 CV 5870 (SJ), 2005 WL 195520 (E.D.N.Y. Jan 21, 2005) (“[T]he Second Circuit has indicatedthere is no private right of action under this provision.”); In re Salomon Smith Barney Mut. Fund Litig., 441 F.Supp. 2d 579, 592 (S.D.N.Y. 2006).

e. Breach Of Fiduciary Duty Cases Involving Board Actions

The Ninth Circuit in Navellier v. Sletten, 262 F.3d 923 (9th Cir. 2001) agreed with the district court that theproposed new adviser owed no fiduciary duty to the fund shareholders at the time of the proposed change froma previous investment adviser because the decisions regarding investment advisory contracts were within thesole discretion of the fund’s independent directors. Thus, the proposed new adviser could not have been liableunder the Act for any breach of such a duty. Id. A district court in another case concluded that Section 36(a)“imposed a federal standard for fiduciary obligations” with obligations that were “at least as stringent as thoseat common law,” and thus applied Maryland common law on fiduciary duty to plaintiff’s claims. See Goldsteinv. Lincoln Nat’l Convertible Sec. Fund, Inc., 140 F. Supp. 2d 424, 436 (E.D. Pa. 2001) (concluding that theboard’s decision to enforce an advance notice provision and prevent plaintiff from bringing his business to theshareholders’ annual meeting was a breach of the board’s fiduciary duty to the fund’s shareholders).

7. Avoiding The Reform Act

Because of the strict pleading and other procedural requirements established by the Private Securities LitigationReform Act for claims arising under the 1933 and 1934 Acts, securities plaintiffs view the 1940 Act as astrategic litigation alternative and continue to creatively apply the Act to challenge various transactions.

a. Section 13(a)(3) (Investment Objectives)

Section 13(a)(3) prohibits a registered investment company from deviating from an investment policy it hasspecifically designated as fundamental in its prospectus. It provides essentially that “no registered investmentcompany shall, unless authorized by a vote of a majority of its outstanding voting securities . . . deviate fromany investment policy which is changeable only if authorized by shareholder vote, or deviate from any policyrecited in its registration statement [which the registrant deems a matter of fundamental policy].” 15 U.S.C.§ 80a-13(a)(3).

In these cases, plaintiffs generally seek to convert a possible change in investment strategy into a deviation froma “fundamental” investment policy prohibited by Section 13(a)(3). Courts have viewed these claims withskepticism, drawing a sharp distinction between investment objectives and investment strategies.

In In re Alliance North American Government Income Trust, Inc. Sec. Litig., the fund’s investment objectivewas to “seek[] the highest level of current income, consistent with what the Fund’s Adviser consider[ed] to beprudent investment risk, that is available from a portfolio of debt securities issued or guaranteed by thegovernments of the United States, Canada and Mexico.” No. 95 CIV. 0330 (LMM), 1996 WL 551732(S.D.N.Y. Sept. 27, 1996), aff’d in relevant part, rev’d in part, Hunt v. Alliance N. Am. Gov’t Income Trust,Inc., 159 F.3d 723 (2d Cir. 1998). The prospectus went on to state that the fund would not invest more than25% of its assets in Mexican securities. Plaintiffs alleged that defendants violated Section 13(a)(3) by investingmore than 25% of the fund’s assets in Mexican and Argentine securities without shareholder approval. In reAlliance N. Am., 1996 WL 551732 at *4.

The district court, however, agreed with defendants that the fundamental investment policy of the fund was onlythe single statement reflecting the fund’s goal to seek the highest level of income available from a portfolio ofUnited States, Canadian and Mexican government securities. The court held that “the investment policies[concerning the percentage of assets likely to be invested in Mexican securities] are the separate, detaileddescriptions of the Fund’s strategy, distinct from the statement of the Fund’s ‘investment objective.’” Id. at *5(emphasis added).

Other courts have reached similar conclusions. See, e.g., Sheppard v. TCW/DW Term Trust 2000, 938 F. Supp.171, 180 (S.D.N.Y. 1996) (dismissing Section 13(a)(3) claim because it amounted to an attack on strategyemployed by adviser in furtherance of fundamental objectives); Karpus v. Hyperion Capital Mgmt., Inc., No. 96CIV. 4671 (SAS), 1996 WL 668860, at *3 (S.D.N.Y. Nov. 18, 1996) (refusing to convert statement ofinvestment strategy into a statement of fundamental investment policy in dismissing Section 13(a) claim);Krouner v. Am. Heritage Fund, Inc., 899 F. Supp. 142, 148-49 (S.D.N.Y. 1995) (finding failure to state a claimunder Section 13(a)(3) where plaintiffs alleged fund improperly invested in “small cap” securities, but list offundamental investment policies did not include any policy regarding “small cap” securities); see also Phillipsv. Morgan Stanley Dean Witter High Income Advantage Trust III, No. 01 CIV.8139 DC, 2002 WL 31119441(S.D.N.Y. Sept. 25, 2002) (dismissing 13(a)(3) claims with prejudice, holding that a policy of not concentratingin “groups of industries” could not “be inferred from the registration statement’s silence”); Lapidus v. Hecht,No. C 98-3130 MMC, 2002 WL 1034042 (N.D. Cal. May 17, 2002) (finding fund could change its investmentobjective and could raise the 25% limitation on short sales to 40% without shareholder approval because theywere not part of the fund’s fundamental investment restrictions).

b. Section 7 (Unregistered Non-US Investment Companies)

In Blatt v. Merrill Lynch, Pierce, Fenner & Smith Inc., 916 F. Supp. 1343, 1347 (D.N.J. 1996), the plaintiffbrought claims under Section 7(d) of the 1940 Act. Section 7(d) prohibits any investment company notorganized or otherwise created under the laws of the United States, or of a State, to use the means of interstatecommerce, directly or indirectly, to issue its securities, unless such investment company is authorized by theCommission to register with the Commission as provided for by Section 8. Plaintiff contended that since thefund at issue was created under the laws of the Cayman Islands and made use of the means of interstatecommerce in issuing its securities, but was not registered under Section 8 of the Act, a violation of Section 7had occurred. Id. at 1348. The court dismissed the claim as untimely and did not reach the question of whetherplaintiff stated a claim under this provision.

c. Section 35(d) (Misleading Names)

In Young v. Nationwide Life Insurance Co., 2 F. Supp. 2d 914 (S.D. Tex. 1998), the court held that no impliedprivate right of action exists under Section 35(d), which provides that “it shall be unlawful for [an] . . .investment company to adopt as part of the name or title of such company . . . any word or words that theCommission finds are materially deceptive or misleading.” Plaintiffs alleged that a similarity in names betweena retail fund and a fund offered only to insurance companies led them to believe that the insurance-only fund

would “clone” the performance of the popular retail fund, in violation of Section 35(d). The court noted thatSection 35(d) “unequivocally prohibits the use of ‘any word or words that the Commission finds are materiallydeceptive or misleading,’” and thus it is necessary for the Commission to first find that the word or wordsviolate Section 35(d) before a party can be found liable under the Section. ID at 928 (citation omitted).

d. Section 12(b) (Distribution Plans)

In Bildstein v. Dreyfus/Laurel Funds, Inc., No. 97 CIV. 8919 (DC), 1999 WL 177349 (S.D.N.Y. Mar. 30),aff’d, 201 F.3d 430 (2d Cir. 1999), fund shareholders sued the fund, its adviser, and other defendants, claimingthat defendants violated Sections 12(b), 13(a)(3), 20(a) and 48(a) by (1) improperly amending the Fund’s 12b-1Plan to include a class of shares that had not been previously subject to the distribution plan and(2) misrepresenting the possibility that those shares would ever be subject to such a plan. The court granteddefendants’ motion to dismiss, concluding that defendants “were permitted by law to amend the Plan, and theproposed amendments were presented to, and approved by, the shareholders in question,” and thus plaintiffs’claims “[were] meritless.” Id. at *1.

8. Defenses To Implied Rights Suits

a. Statute Of Limitations

Although the Act does not provide for express private rights of action (with the exception of Section 36(b)),federal courts have followed the rationale articulated in Lampf, Pleva, Lipkind, Prupis & Petigrow v.Gilbertson, 501 U.S. 350, 361-62 (1991) (1933 Act claims), and thus consistently have applied a three-yearperiod of repose, and a one-year limit from plaintiff’s discovery of the wrong, as the appropriate limitationsperiods for implied private actions brought under the Act. See, e.g., Green v. Fund Asset Mgmt., L.P., 19 F.Supp. 2d 227 (D.N.J. 1998) (rejecting plaintiffs’ arguments that the five-year limitations period for Commissionactions under Section 36(a) should apply and that their claims accrued when plaintiffs purchased their shares inthe Funds, not when the registration statements and prospectuses were filed with the S.E.C.); see also Krinsk v.Fund Asset Mgmt., Inc., No. 85 Civ. 8428 JMW, 1986 WL 205, at *2-4 (S.D.N.Y. May 9, 1986) (affirming theone-year statute of limitations and three-year period of repose governing claims under the Investment CompanyAct, including claims under Sections 36(a) and 36(b)); In re ML-Lee Acquisition Fund Sec. Litig., 848 F. Supp.527, 550-52 (D. Del. 1994) (holding limitations period in private action pursuant to Investment Company Act isearlier of one year from discovery or three years from violation); Blatt v. Dean Witter Reynolds Intercapital,Inc., 566 F. Supp. 1294, 1298 (S.D.N.Y. 1983), aff’d, 732 F.2d 304 (2d Cir. 1984) (“[The] statute of limitationsunder Section 36(b) is only one year.”); Friedlob v. Trs. of Alpine Mut. Fund Trust, 905 F. Supp. 843, 855-56(D. Colo. 1995) (holding that claims brought under Sections 8(b), 13(a), 15(c), 17(e) and 21 of ICA are subjectto one-year/three-year limitations period under 1933 and 1934 Acts since ICA is intended to facilitate samecentral goal of protecting investors); Green v. Fund Asset Mgmt., 19 F. Supp. 2d 227, 231-32 (D.N.J. 1998)(holding that one-year/three-year limitations period is applicable to private plaintiffs’ claims under ICASections 8(e), 34(b) and 36(a)); Lapidus v. Hecht, No. C 98-3130 MMC, 2002 WL 1034042, at *7 (N.D. Cal.May 17, 2002); Seidel v. Lee, 954 F. Supp. 810 (D. Del. 1996); Omni Fin. Corp. v. Cohen, No. 91 Civ. 6837RO THK, 1994 WL 97125, at *7 (S.D.N.Y. Mar. 22, 1994) (applying one-year/three-year limitations to ICAclaim under Section 20); In re Taxable Mun. Bond Sec. Litig., No. Civ. A. MDL 863, 1992 WL 124783, at *3(E.D. La. June 4, 1992) (applying one-year/three-year limitations period to private claims under ICA Sections 7and 8), aff’d, 964 F.2d 1144 (5th Cir. 1992); Merine v. Prudential-Bache Util. Fund, Inc., 859 F. Supp. 715,721-22 (S.D.N.Y. 1994) (applying one-year/three-year limitations period to claim under Section 20(a) of ICA). Section 36(b) also places a substantive limit on damages, capping any damages to those incurred in the yearprior to filing. Krinsk, 1986 WL 205, at *4 (holding one-year limitation expressly provided by Congress inSection 36(b)(3) of ICA places “substantive limit on damages”).

One federal court decision from the Southern District of New York explicitly held that the extended statute of

limitations under the Sarbanes-Oxley Act of 2002 did not apply to claims under Sections 80a-10, 13, 15, 17, 30and 33 of the Investment Company Act, as such claims did not involve fraud, deceit, manipulation, orcontrivance. Phoenix Four, Inc. v. Strategic Res. Corp., No. 05-4837(HB), 2006 WL 399396, at *6-7(S.D.N.Y. Feb. 21, 2006); see also Kleinman v. Oak Assoc. Ltd., No. 5:07CV0698, 2007 WL 2071968, at *2-3(N.D. Ohio July 16, 2007) (deciding to apply the one year from discovery/three years from the injurylimitations period found in the Securities Act to claims under the Investment Advisors Act, rather than theextended statute of limitations under Sarbanes-Oxley).

b. Aiding And Abetting

Claims based on implied rights under the Act should be limited to principal violators only. See In re ML-LeeAcquisition Fund II, L.P. Sec. Litig., 848 F. Supp. 527, 545-47 (D. Del. 1994).

c. Direct Versus Derivative

Many courts have held that claims asserting implied rights under Section 36(a) and other sections of the Actmust be brought derivatively on behalf of the fund, rather than directly (as a class action or otherwise). See,e.g., In re Merrill Lynch & Co., Inc. Research Reports Sec. Litig., 272 F. Supp. 2d 243 (S.D.N.Y. 2003)(dismissing Section 34(b) claim for failure to bring it derivatively); Rohrbaugh v. Inv. Co. Inst., No. CIV. A.00-1237, 2002 WL 31100821 (D.D.C. July 2, 2002) (same for Section 17(d) claim); Marquit v. Dobson, No.98 CIV. 9089 (JSM), 2000 WL 4155 (S.D.N.Y. Jan. 3, 2000), aff’d sub nom. Marquit v. Williams, 229 F.3d1135 (2d Cir. 2000) (same for claims under Sections 36(a) and 48); In re Dreyfus Aggressive Growth Mut.Fund Litig., No. 98 CIV. 4318 (HB), 2000 WL 10211 (S.D.N.Y. Jan. 6, 2000) (same for claims under Sections13(a)(3), 34(b), 36(a), 17(e) and 17(j)); Green v. Nuveen Advisory Corp., 186 F.R.D. 486, 489-90 (N.D. Ill.1999) (same for claims under Sections 8(a), 34(b) and 36(a)); In re Goldman Sachs Mut. Funds, No. 04-2567(NRB), 2006 WL 126772, at *6 (S.D.N.Y. Jan. 17, 2006) (same for claims under Sections 34(b) and 36(a)); Inre Salomon Smith Barney Mut. Fund Litig., 441 F. Supp. 2d 579, 597 (S.D.N.Y. 2006) (same for claims underSection 36(b)); In re Dreyfus Mut. Funds Fee Litig., 428 F. Supp. 2d 357 (W.D. Pa. 2006) (same for claimsunder 36(a)); see also Krouner v. Am. Heritage Fund, Inc., No. 94 CIV. 7213 (WK), 1997 WL 452021(S.D.N.Y. Aug. 6, 1997) (denying plaintiff’s motion for class certification because Section 36(a) claim must bebrought derivatively rather than directly). But see In re Alliancebernstein Mut. Fund Excessive Fee Litig., No.04 CIV 4885 (SWK), 2005 WL 2677753 at *3-4 (S.D.N.Y. Oct. 19, 2005) (holding that the determination ofwhether a claim is to be brought directly or derivatively should be governed by the fund’s state ofincorporation).

In a case of first impression, one court held that plaintiff’s claim under Section 215 of the Investment AdvisersAct of 1940 (“IAA”) – the only implied private right of action available under the IAA – to rescind the fund’sadvisory contract based on the adviser’s alleged fraud under Section 206 of the IAA must be broughtderivatively on behalf of the fund, rather than directly, since the plaintiff shareholder was not a party to theadvisory contract and the plaintiff’s injuries were not separate and distinct from those of the fund. See Shahidiv. Merrill Lynch, Pierce, Fenner & Smith, Inc., No. 2:02CV 483 FTM29SC, 2003 WL 21488228 (M.D. Fla.Apr. 28, 2003).

However, a decision by the Second Circuit allowed Section 36(a) claims to be asserted directly by theshareholder, thus vacating the district court’s decision that such claims must be brought derivatively on behalfof the Fund. See Strougo v. Bassini, 282 F.3d 162, 175 (2d Cir. 2002) (finding plaintiffs’ alleged injuriesresulting from the coercive nature of a recent rights offering “do not derive from a reduction in the value of theFund’s assets or any other injury to the Fund’s business,” but rather from a “reallocation of equity value” fromshareholders who did not participate in the rights offering to those who did). Although that conclusion wasreached in the rather narrow context of rights offerings, it remains to be seen whether courts will start finding adirect right of action under Section 36(a) in other contexts. See also Lapidus v. Hecht, 232 F.3d 679 (9th Cir.

2000) (holding, where plaintiffs alleged that they sustained losses as a result of short sales made by the fund inviolation of the funds’ prospectus and that prospectus amendments regarding short sales were made withoutshareholder approval, that plaintiffs’ claims under sections 13(a)(2) and 13(a)(3) implicated plaintiffs’ right asshareholders to vote on proposed changes to short sale restrictions and could therefore be brought directly, butthat plaintiffs’ claim under Section 18(f) was based on diminution in the value of their shares and thus shouldbe brought derivatively); In re ML-Lee Acquisition Fund II, L.P., Sec. Litig., 848 F. Supp. 527 (D. Del. 1994)(rejecting argument that claims under sections 17, 36(a) and 57 of the Act alleging improper conflicts of interestand use of fund assets for the adviser’s personal gain could only be brought derivatively, and ruling that thoseclaims could also be brought directly as a class action).

d. Failure To Make A Demand

If a court determines that the action must be brought derivatively rather than directly, plaintiffs must complywith the requirements for bringing derivative claims under state law and Federal Rule of Civil Procedure 23.1,including the requirement that plaintiffs make a pre-suit demand on the fund’s board of directors, or be excusedfrom doing so. See, e.g., In re Merrill Lynch Focus Twenty Fund Inv. Co. Act Litig., 218 F.R.D. 377 (E.D.N.Y.2003) (applying decision in Werbowsky v. Collomb, 766 A.2d 123 (Md. 2001), regarding the demand futilityexception under Maryland law and dismissing Section 36(a) derivative claim for failure to make a demand, andfinding demand was not excused because of the independent directors’ well-compensated service on other fundboards).

By raising this defense, however, defendants may invite judicial scrutiny into the independence of theirdirectors and risk an adverse determination on that issue. See, e.g., Strougo v. Scudder, Stevens & Clark, Inc.,964 F. Supp. 783, 795 (S.D.N.Y. 1997) (excusing demand as futile under pre-Werbowsky Maryland law andallowing Section 36(a) claim to proceed because the independent directors served on multiple boards of fundsin the same complex and received substantial remuneration from their service on the boards which the courtbelieved called into question their independence).

e. Bespeaks Caution

The “bespeaks caution” doctrine, which holds that specific warnings about the risks of an investment mayrender alleged misrepresentations or omissions immaterial, has been applied with mixed results in defendingfraud claims involving investment companies. Compare Olkey v. Hyperion 1999 Term Trust, Inc., 98 F.3d 2, 5(2d Cir. 1996) (affirming dismissal of complaint where cautionary language employed in prospectus “warn[ed]investors of exactly the risk the plaintiffs claim[ed] was not disclosed”) with Hunt v. Alliance N. Am. Gov’tIncome Trust, Inc., 159 F.3d 723, 729 (2d Cir. 1998) (reversing, in part, district court’s dismissal of claimwhere cautionary language in prospectuses did not warn of the risk about which plaintiffs complain).

K. Sarbanes-Oxley And Dodd-Frank

The first decade of this century has seen Congress pass two milestone pieces of legislation in response tofinancial crises. First, in the wake of the celebrated collapses of companies like Enron and WorldCom and thedistress of the technology sector in the wake of the bursting of the internet bubble, Congress enacted theSarbanes-Oxley Act of 2002, also known as the “Public Company Accounting Reform and Investor ProtectionAct” in the Senate and the “Corporate and Auditing Accountability and Responsibility Act” in the House. Among other things, Sabanes-Oxley created the Public Company Accounting Oversight Board (“PCAOB”);mandated greater auditor independence and approval and rotation requirements; required senior executives tocertify the accuracy and completeness of financial reports; established enhanced reporting requirements for off-balance-sheet transactions; required timely reporting of material changes in financial condition; authorized theclawback of incentive compensation based on results that were later restated; required audits and reportsregarding internal controls; created a code of conduct for securities analysts and required disclosure of analyst

conflicts of interest; enhanced SEC regulatory and disciplinary authority; beefed up criminal penalties formanipulation, destruction or alteration of records or interfering with investigations; and provided protections forwhistle-blowers.

Sarbanes-Oxley has spawned less litigation than some observers had predicted. Noteworthy cases include SECv. Jenkins, 2010 U.S. Dist. LEXIS 57023 (D. Ariz. 2010) (denying CEO’s motion to dismiss action seekingclawback of compensation under Section 304 following restatements, even though CEO was not personallyaccused of wrongdoing); Free Enterprise Fund v. PCAOB, 130 S. Ct. 3138 (2010) (rejecting broad challenge toconstitutionality of PCAOB but requiring procedural correction to manner in which commissioners areappointed); and Cohen v. Viray, 2010 U.S. App. LEXIS 20197 (2d Cir. Sept. 30, 2010). In Cohen, the courtreversed an order approving settlement of a derivative action that, among other things, released and indemnifiedthe former CEO and CFO from any liability under the clawback provisions of Section 304. The court based itsdecision on a holding that, because there is no private right of action under Section 304 (relying on In reDigimarc Corp. Deriv. Litig., 549 F.3d 1223 (9th Cir. 2008)), private parties may not release claims that onlythe SEC could bring.

In the wake of the worldwide collapse of financial markets in 2007-08, Congress in July 2010 passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, widely regarded as the most sweeping change to U.S.financial regulation since the Great Depression. Dodd-Frank aims among other things to “promote the financialstability of the United States by improving accountability and transparency of the financial system, to end ‘toobig to fail’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financialservices . . . .” Its 26 titles require that regulators create 243 new rules, conduct 67 studies and issue 22 periodicreports. The Act substantially restructures the prior regulatory scheme by creating a host of new agencies,merging or eliminating other agencies, and enhancing the oversight of particular institutions viewed aspresenting systemic risk.

While Dodd-Frank’s changes are far-reaching, the provisions likely to impact future securities litigationrepresent somewhat less of a paradigm shift. Among those provisions we see as most likely to appear in futureupdates of this volume are the following: (1) Section 922(a) provides protections for whistle-blowers beyondthose contained in Sarbanes-Oxley and creates further incentives to blow the whistle on wrongdoing byestablishing a fund from monetary sanctions paid to the SEC that the SEC can use to pay a “bounty” towhistleblowers who voluntarily provide “original information” to the SEC that results in sanctions exceeding$1,000,000; (2) Section 954 requires issuers to implement clawback policies for disclosing incentive-basedcompensation and recovering it in the case of a restatement resulting from misconduct that leads to materialnoncompliance; (3) Section 929 lowers the state of mind required in an aiding-and-abetting charge by the SECfrom “knowingly” to “recklessly” providing substantial assistance to the primary violation, and directs theconduct of a study regarding the impact of restoring a private right of action for aiding and abetting; (3) Section929P allows the SEC to impose civil penalties in cease and desist proceedings against persons it does notregulate, restores for SEC and DOJ cases the “conduct and effects” test rejected in Morrison v. Nat’l. AustraliaBank, and directs a study regarding restoration of the test’s application in private actions as well, and extends‘control person’ liability under Section 20(a) of the ’34 Act to SEC actions as well as private actions; (5)Section 929X prohibits manipulative short selling and gives the SEC rulemaking authority regarding publicdisclosure of short sale activity; (6) Section 933 amends Section 15E of the ’34 Act to treat statements by creditrating agencies in the same manner as statements by accounting firms and securities analysts, to deprive suchstatements of safe-harbor protection as forward-looking statements, and to allow private plaintiffs to state aclaim by alleging only that the agency knowingly or recklessly failed to conduct a reasonable investigation ofthe facts relied on by its own methodology for evaluating credit risk or failed to obtain reasonable verificationof those facts from competent sources independent of the issuer and underwriter; (7) Section 951 requires theSEC to issue rules (proposed in October 2010) that prohibit the listing of companies not in compliance with the“say on pay” provisions that require issuers to disclose the relationship of executive compensation actually paidand the issuer’s financial performance and to submit approval of executive compensation and “goldenparachute” arrangements to an advisory shareholder vote; and (8) Section 971 permits the SEC to issue rules(done in August 2010 but suspended in light of litigation) requiring issuers to permit “proxy access” byallowing shareholders to use the company’s proxy solicitation materials for the purpose of nominating

directors. In addition, as the SEC issues the studies and promulgates the rules required by Dodd-Frank, we willno doubt see litigation regarding the constitutionality, interpretation and application of those rules.


A. Control Person Liability Under Section 15 Of The 1933 Act and Section 20(a) ofthe 1934 Act


a. Section 15 Of The 1933 Act

Section 15, 15 U.S.C. § 77o, addressing control person liability, provides that:

Every person who, by or through stock ownership, agency, or otherwise, or who, pursuant to or inconnection with an agreement or understanding with one or more other persons by or through stockownership, agency, or otherwise, controls any person liable under Sections 77k or 771 of this title, shallalso be liable jointly and severally with and to the same extent as such controlled person to any person towhom such controlled person is liable, unless the controlling person had no knowledge of or reasonableground to believe in the existence of the facts by reason of which the liability of the controlled person isalleged to exist.

b. Section 20(a) Of The 1934 Act

Section 20(a), 15 U.S.C. § 78t(a) also concerns control person liability and provides that:

Every person who, directly or indirectly, controls any person liable under any provision of this chapter orof any rule or regulation thereunder shall also be liable jointly and severally with and to the same extentas such controlled person to any person to whom such controlled person is liable, unless the controllingperson acted in good faith and did not directly or indirectly induce the act or acts constituting theviolation or cause of action.

Sections 15 and 20(a) are viewed as analogues by courts. See Pharo v. Smith, 621 F.2d 656, 673, aff’d inrelevant part, 625 F.2d 1226 (5th Cir. 1980) (Section 20(a) is an analogue of Section 15 and the two sectionshave the same interpretation); In re Asia Pulp & Paper Sec. Litig., 293 F. Supp. 2d 391 (S.D.N.Y. 2003)(“Although worded differently, both provisions are generally interpreted the same way.”).

Specifically, the controlling person analysis under Sections 15 and 20(a) is the same. In re Uni Capital Corp.Sec. Litig., 149 F. Supp. 2d 1353, 1367 (S.D. Fla. 2001) (explaining controlling person liability analysis underSections 15 and 20(a) is identical); Farley v. Henson, 11 F.3d 827 (8th Cir. 1993); Hollinger v. Titan CapitalCorp., 914 F.2d 1564, 1578 (9th Cir. 1990) (noting although Section 15 is not identical to Section 20(a), thecontrolling person analysis is the same); see also Lewis D. Lowenfels & Alan R. Bromberg, Controlling PersonLiability Under Section 20(a) of the Securities Exchange Act and Section 15 of the Securities Act, 53 Bus. Law.1 (1997).


Many courts have held that a claim for control person liability does not require a heightened pleading standard. See, e.g., In re Enron Corp. Sec., Derivative & ERISA Litig., No. MDL 1446, 2003 WL 22472155, at *32 (S.D.Tex Oct. 14, 2003) (holding claims for control person liability requires only notice pleading); Catton v. DefenseTech. Sys., 457 F. Supp. 2d 374, 382 (S.D.N.Y. 2006) (holding allegations of control are not averments of fraudand thus only require notice pleading); In re Tel-Save Sec. Litig., No. 98 CV 3145, 1999 WL 999427 (E.D. Pa.Oct. 19, 1999) (holding Fed. R. Civ. P. 9(b) does not apply to pleading of control person claim); In re TheLoewen Group Inc., No. CIV. A. 98-6740, 2004 WL 1853137 at *26 (E.D. Pa. Aug. 18, 2004) (explaining thatto survive a motion to dismiss, a plaintiff must only plead facts that support a reasonable inference thatdefendants had the potential to influence the activities of the primary violator). The First Circuit has held thatbecause the text of Section 20(a) does not require the plaintiff to prove any specific state of mind of thedefendant, the PSLRA requirement that the complaint allege facts supporting a strong inference of the requiredstate of mind does not apply to Section 20(a) claims. In re Stone & Webster, Inc. Sec. Litig., 424 F.3d 24 (1stCir. 2005); see also In re Asia Pulp & Paper Sec. Litig., 293 F. Supp. 2d at 396, n.6 (“It is less clear … whetherthe PSLRA – and thus the requirements of increased specificity and a showing of scienter – applies to claimsunder Section 20(a).”).

2. Elements Of A Control Person Cause Of Action

To state a control person claim under either Section 15 or 20(a), a plaintiff must allege; (1) a primary violationof the securities laws; (2) that the defendant exercised actual power (exercised control) over the primaryviolator; and (3) that the defendant possessed the power to directly or indirectly control the specific transactionor activity upon which the primary violation was predicated. Howard v. Everex Sys., Inc., 228 F.3d 1057,1065-67 (9th Cir. 2000); Paracor Fin. Inc. v. Gen. Elec. Capital Corp., 96 F.3d 1151 (9th Cir. 1996); Donohoev. Consol. Operating & Prod. Corp., 982 F.2d 1130 (7th Cir. 1992); Metge v. Baehler, 762 F.2d 621, 631 (8thCir. 1985); In re Nature’s Sunshine Prods. Sec. Litig., 486 F. Supp. 2d 1301, 1313-14 (D. Utah 2007)(“[L]iability may be imposed where a defendant possesses the power, directly or indirectly, to direct or causethe direction of management and policies of the primary violator.”).

a. Primary Violation

Plaintiff must allege a primary violation of the 1933 or 1934 Act. Greebel v. FTP Software, Inc., 194 F.3d 185,206 (1st Cir. 1999); Klein v. Gen. Nutrition Cos., 186 F.3d 338, 344 (3d Cir. 1999); Longman v. Food Lion,Inc., 197 F.3d 675, 686 (4th Cir. 1999); Heliotrope Gen., Inc. v. Ford Motor Co., 189 F.3d 971, 978 (9th Cir.1999). Where a primary violation has not been adequately alleged, no cause of action for secondary or “controlperson” liability will exist. Suna v. Bailey Corp., 107 F.3d 64, 72 (1st Cir. 1997); Wool v. Tandem Computers,Inc., 818 F.2d 1433, 1440 n.8 (9th Cir. 1987); Stat-Tech Liquidating Trust v. Fenster, 981 F. Supp. 1325, 1337(D. Colo. 1997); In re Wellcare Mgmt. Group, Inc. Sec. Litig., 964 F. Supp. 632, 640 (N.D.N.Y. 1997); Brownv. Hutton Group, 795 F. Supp. 1317, 1324 (S.D.N.Y. 1992) (explaining it is impossible to state a claim forsecondary liability under the Securities Act without first stating a claim for a primary violation of securitieslaws by a controlled person).

b. Nature And Degree Of Control Over Corporate Operations

Plaintiff has the burden of pleading and proving control person status. Brown v. Enstar Group, Inc., 84 F.3d393, 395 (11th Cir. 1996); G.A. Thompson & Co. v. Partridge, 636 F.2d 945, 958 (5th Cir. 1981). Plaintiffmust allege facts identifying the acts or status which indicate control. Hagert v. Glickman, Lurie, Eiger & Co.,520 F. Supp. 1028, 1035 (D. Minn. 1981). The test for control is identical under Section 15 and Section 20(a). Ellison v. Am. Image Motor Co., 36 F. Supp. 2d 628, 638 (S.D.N.Y. 1999).

1) SEC Definition Of Control

The SEC defines “control” in 17 C.F.R. § 230.405(f) as “the possession, direct or indirect, of the power todirect or cause the direction or management and policies of a person, whether through the ownership of votingsecurities, by contract, or otherwise.” Several courts have adopted the SEC definition of control. See, e.g.,Sheinkopf v. Stone, 927 F.2d 1259, 1270 (1st Cir. 1991); Pharo v. Smith, 621 F.2d 656, 670, aff’d in relevantpart, 625 F.2d 1226 (5th Cir. 1980); Paracor Fin., Inc. v. Gen. Elec. Capital Corp., 96 F.3d 1151, 1163 (9thCir. 1996); Maher v. Durango Metals, Inc., 144 F.3d 1302 (10th Cir. 1998) (citing with approval the SEC’sdefinition of control); Dietrich v. Bauer, 76 F. Supp. 2d 312, 333 (S.D.N.Y. 1999); see also In re AdlerColeman Clearing Corp., 469 F. Supp. 2d 112, 127-28 (S.D.N.Y. 2007) (finding control person liability of acompany appropriate where company was alter ego of individual control person).

2) Other Definitions Of Control

Other courts have defined “control” as the ability to exert influence, directly or indirectly, over the decision-making process of another person. Myzel v. Fields, 386 F.2d 718 (8th Cir. 1967); Rochez Bros., Inc. v.Rhoades, 527 F.2d 880 (3d Cir. 1975); In re Health Mgmt., Inc. Sec. Litig., 970 F. Supp. 192, 205 (E.D.N.Y.1997); Am. Gen. Ins. Co. v. Equitable Gen. Corp., 493 F. Supp. 721, 751 (E.D. Va. 1980). Courts often focuson the “power or potential power [of a defendant] to influence and control the activities of a person, as opposedto the actual exercise thereof.” Rochez Bros., 527 F.2d at 890-91; see also In re Cendant Corp. Litig., 60 F.Supp. 2d 354, 367 (D.N.J. 1999) (explaining in determining whether a defendant is a “control person” withinthe meaning of Section 15, “heavy consideration” should be given “to the power or potential power to influenceand control the activities of a person, as opposed to the actual exercise thereof”). Compare cases whereattorneys prepare or assist in preparing offering circulars or opinion letters containing incorrect information: S.E.C. v. Frank, 388 F.2d 486 (2d Cir. 1968) (finding it unreasonable to hold lawyer who was putting client’sdescription of events into plain English guilty of fraud; S.E.C. v. Spectrum, Ltd., 489 F.2d 535 (2d Cir. 1973)(finding an evidentiary hearing required to decide whether attorney-prepared opinion letter warranted liabilityfor attorney for violation of securities laws); Felts v. Nat. Account Sys. Ass’n, 469 F. Supp. 54 (N.D. Miss.1978) (holding lawyer owes duty of due diligence and reasonable inquiry to detect and correct false ormisleading materials that will be circulated in connection with sale of securities). But see In re Livent, Inc. Sec.Litig., 78 F. Supp. 2d 194, 221 (S.D.N.Y. 1999) (“[A]ctual control is essential to control person liability [underSection 20(a)].”); Dietrich v. Bauer, 76 F. Supp. 2d 312, 333 (S.D.N.Y. 1999) (same); In re Blech Sec. Litig.,961 F. Supp. 569, 586 (S.D.N.Y. 1997) (same). It is also possible that a corporation, where it controlssubsidiary organizations, may be viewed as a “control person.” See Teachers’ Ret. Sys. of LA v. A.C.L.N. Ltd.,No. 01-CIV. 11814 (MP), 2003 WL 21657255, at *18 (S.D.N.Y. July 14, 2003).

c. Exercising Control: A Circuit Split

Courts will employ one of three main tests to determine whether the control person actually exercises control. The three most prominent tests for control adopted by the courts are (1) the culpable participation test; (2) thecontrol by status test; and (3) the potential control test.

1) Culpable Participation Test

The courts are divided as to whether the controlling person must participate in the primary violation to incurliability under Sections 15 and 20.

(a) Culpable Participation Required

Several courts require proof that the control person was a culpable participant in the fraudulent activities. S.E.C. v. First Jersey Sec., Inc., 101 F.3d 1450, 1472 (2d Cir. 1996); In re Worldcom, Inc., 263 F. Supp. 2d 745(S.D.N.Y. 2003); Ellison v. Am. Image Motor Co., Inc., 36 F. Supp. 2d 628, 642 (S.D.N.Y. 1999); Dietrich v.Bauer, 76 F. Supp. 2d 312, 333 (S.D.N.Y. 1999); In re Cendant Corp. Litig., 60 F. Supp. 2d 354, 379 (D.N.J.1999); In re Livent, Inc. Sec. Litig., 78 F. Supp. 2d 194, 221-22 (S.D.N.Y. 1999); Rochez Bros., Inc. v. Rhoades,527 F.2d 880, 885 (3d Cir. 1975); Gordon v. Burr, 506 F.2d 1080, 1085 (2d Cir. 1974); In re Bell Atl. Corp.,Sec. Litig., No. CIV. A. 91-0514, 1997 WL 205709 (E.D. Pa. Apr. 17, 1997), aff’d, 142 F.3d 427 (3d Cir.1998). Courts are split regarding whether at the pleading stage, plaintiffs need to allege culpable participationby the defendants. In re Parmalat Sec. Litig., 375 F. Supp. 2d 278, 307-309 (S.D.N.Y. 2005) (holding that theSecond Circuit does not require plaintiff to plead culpable participation to state a legally sufficient Section 20(a)claim); Fraternity Fund Ltd. v. Beacon Hill Asset Mgmt., 376 F. Supp. 2d 385, 406 (S.D.N.Y. 2005); In reCambrex Sec. Litig., No. 03-CV-4896 (WJM), 2005 WL 2840336 at *16 (D.N.J. Oct. 27, 2005). But see Kalinv. Xanboo, Inc., No. 04-CV-593, 2007 WL 273546, at *12 (S.D.N.Y. Jan. 16, 2007) (holding that althoughcourts in the Second Circuit were split on the issue, a plaintiff must plead culpable participation in thecomplaint with particularity); In re Am. Bus. Fin. Servs., Litig., No. 05-232, 2007 WL 81937 at *11 (E.D. Pa.Jan. 9, 2007) (finding that courts in the Third Circuit are split on the question). Decisions from the SouthernDistrict of New York hold that culpable participation does not require conduct amounting to scienter, andsuggest that the requirement may be meaningless. In re Initial Pub. Offerings Sec. Litig., 241 F. Supp. 2d 281,392-97 (S.D.N.Y. 2003); In re Worldcom, Inc. Sec. Litig., No. 02 CIV 3288DLC, 2005 WL 638268 at *13(S.D.N.Y. Mar. 21, 2005) (“There is no basis in the language of Section 20(a) itself to support a scienterrequirement.”). Although the First Circuit has not decided whether a plaintiff must plead culpable participation,recognizing that, a district court in Massachusetts extended control person liability to Audit Committeemembers with respect to financial reports because: (1) they had signed the SEC filings; (2) they had the abilityto retain advisors to investigate the accounting improprieties alleged; (3) they had the power to force theresignation of senior officers; (4) they had access to the company’s financial information; (5) they had frequentmeetings with outside auditors; and (6) the committee reviewed each financial statement with the outsideauditors before the statement was released. In re Lernout & Hauspie Sec. Litig., 286 B.R. 33, 40 (D. Mass.2002).

(b) Culpable Participation Not Required

Other circuits have held that culpable participation is not a prerequisite to control person liability. See, e.g.,Harrison v. Dean Witter Reynolds, Inc., 974 F.2d 873 (7th Cir. 1992); Hollinger v. Titan Capital Corp., 914F.2d 1564, 1575 (9th Cir. 1990); Metge v. Baehler, 762 F.2d 621, 631 (8th Cir. 1985); G.A. Thompson & Co. v.Partridge, 636 F.2d 945, 957-58 (5th Cir. 1981); Haynes v. Anderson & Strudwick, Inc., 508 F. Supp. 1303,1315 (E.D. Va. 1981); In re Health Mgmt., Inc. Sec. Litig., 970 F. Supp. 192, 205 (E.D.N.Y. 1997); DorchesterInvestors v. Peak Trends Trust, No. 99 CIV. 4696 (LMM)(F), 2003 WL 223466, at *3 (S.D.N.Y. Feb. 3, 2003);see also In re Nat’l Century Fin. Enters., Inc., 504 F. Supp. 2d 287, 303 (S.D. Ohio 2007) (holding that tosurvive a motion to dismiss, plaintiffs “must allege only the power to control, and not an actual exercise ofcontrol”); In re Enron Sec., Derivative & ERISA Litig., No. MDL 1446, 2003 WL 22472155, at *30-31 (S.D.Tex Oct. 14, 2003) (holding that a prima facie case of control requires a factual showing that defendant hadpower to directly or indirectly control or influence corporate policy, but culpable participation is not required).

(c) Allegations Of Status Alone Deemed Sufficient

Some courts have held that allegations of a defendant’s status as an officer or director are sufficient to pleadcontrol person liability. Thus, specific allegations that a defendant was a director, assistant secretary, orattorney of an allegedly controlled corporation may be sufficient to survive a motion to dismiss. See In re

Valujet, Inc., 984 F. Supp. 1472, 1480 (N.D. Ga. 1997) (defendants’ positions as management and/or directorswere sufficient to state a cause of action for controlling-person liability); Health Mgmt. Inc., 970 F. Supp. at206 (control by status may be adequate to overcome a 12(b)(6) motion, but more proof is needed at trial); In reZZZZ Best Sec. Litig., 864 F. Supp. 960, 970 (C.D. Cal. 1994) (explaining whether corporate counsel is acontrolling person is a question of fact).

(d) Status Alone Deemed Insufficient

The majority of cases hold that “mere titles are not adequate indicators of control authority.” See, e.g., Ellisonv. Am. Image Motor Co., Inc., 36 F. Supp. 2d 628, 642 (S.D.N.Y. 1999); In re Livent, 78 F. Supp. 2d at 222(finding “[o]fficer or director status alone does not constitute control” for purposes of Sections 15 or 20(a);neither does membership on a corporation’s audit committee); see also Adams v. Kinder-Morgan, Inc., 340F.3d 1083, 1108 (10th Cir. 2003) (noting that membership on a board of directors alone is insufficient toestablish one as a control person; instead, the court examined whether there existed ultimate managementauthority on a daily basis); Paracor Fin., Inc. v. Gen. Elec. Capital Corp., 96 F.3d 1151, 1163 (9th Cir. 1996)(finding status as officer or director does not create any presumption of control for purposes of establishingcontrol person liability); Wool v. Tandem Computers, Inc., 818 F.2d 1433, 1441 (9th Cir. 1987), effectivelyoverruled on other “culpable participation” grounds (“[O]rdinarily status or position of an alleged controllingperson, by itself, is insufficient to presume or warrant a finding of power to control or influence.”); S.E.C. v.Coffey, 493 F.2d 1304, 1315 (6th Cir. 1974); Davis v. Coopers & Lybrand, 787 F. Supp. 787 (N.D. Ill. 1992);Smith v. Network Equip. Tech., Inc., No. C-90-1138 DLJ, 1990 WL 263846 (N.D. Cal. Oct. 19, 1990); Loan v.F.D.I.C., 717 F. Supp. 964, 968 (D. Mass. 1989) (holding status as officer or director alone is insufficient toimpose Section 10(b) liability); Sloane Overseas Fund, Ltd. v. Sapiens Int’l Corp., 941 F. Supp. 1369 (S.D.N.Y.1996). Conversely, the mere absence of status is insufficient to show a lack of control. In re AdelphiaCommc’ns Corp. Sec. & Derivative Litig., 398 F. Supp. 2d 244, 262 (S.D.N.Y. 2005) (holding that defendantneed not be an officer to be liable under Section 20(a)).

Thus, membership on a board committee by itself is insufficient to establish control person liability. See In reLivent, Inc. Sec. Litig., 78 F. Supp. 2d 194, 222 (S.D.N.Y. 1999); Rubinstein v. Skyteller, Inc., 48 F. Supp. 2d315, 323 (S.D.N.Y. 1999); In re ASK Computer Sys. Sec. Litig., No. C-85-20207(A)-WAI, 1991 WL 138334,at *5 (N.D. Cal. Mar. 11, 1991) (finding outside director who was member of the Audit Committee was not“controlling person” for purposes of the offering); In re Rospatch Sec. Litig., 760 F. Supp. 1239, 1264 (W.D.Mich. 1991) (holding that outside directors who served on various committees and signed certain publicdocuments were not control persons of a large, publicly held corporation); Crazy Eddie, 747 F. Supp. at 861(holding that a director who was a member of Company’s Audit Committee was not a control person underSection 20(a)).

(e) Potential Control Test

Courts in the Seventh, Eighth, and Ninth Circuits require evidence that the alleged control person (1) actuallyexercised general control over the operations of the entity principally liable, and (2) possessed the power tocontrol directly or indirectly the specific transaction or activity upon which the primary violation waspredicated. See Howard v. Everex Sys. Inc., 228 F.3d 1057, 1065-66 (9th Cir. 2000); Paracor Fin., 96 F.3d at1151; Donohoe v. Consol. Operating & Prod. Corp., 982 F.2d 1130 (7th Cir. 1992); Metge, 762 F.2d at 631; Inre Silicon Graphics Inc., Sec. Litig., 970 F. Supp. 746, 763 (N.D. Cal. 1997) (holding plaintiffs must showactual power or influence over the company).

The First, Fifth, Sixth, Tenth, and Eleventh Circuits are also gravitating toward this approach. See, e.g., TIG

Specialty Ins. Co. v. Pinkmonkey.com, Inc., 375 F.3d 365, 372 (5th Cir. 2004) (“The rationale behind controlperson liability is that a control person is in a position to prevent the securities violation of issue.”) PRDiamonds, Inc. v. Chandler, 91 F. App’x 418, 441 (6th Cir. 2004) (explaining controlling person must have thepower to direct or cause the direction of management and policies of a person); Adams v. Kinder-Morgan, Inc.,340 F.3d 1083 (10th Cir. 2003) (finding insufficient allegations of control person liability when person was notalleged to have exerted control or influence over day-to-day operations of company). Brown v. Enstar Group,Inc., 84 F.3d 393, 396 (11th Cir. 1996) (explaining a defendant liable as a controlling person underSection 20(a) if he “had power to control the general affairs of the entity primarily liable at time entity violatedthe securities laws” and “had requisite power to directly or indirectly control or influence the specific corporatepolicy which resulted in the primary liability”) (citation omitted).

3. Factual Nature Of Inquiry

The Ninth Circuit has stated that whether a person is a controlling person “is an intensely factual question,involving scrutiny of the defendant’s participation in the day-to-day affairs of the corporation and thedefendant’s power to control corporate actions.” Paracor Fin., Inc., 96 F.3d at 1162 (quoting Kaplan v. Rose,49 F.3d 1363, 1382 (9th Cir. 1994)). Relying on the SEC’s definition of “control,” the court in Paracor notedthat its inquiry must revolve around the “‘management and policies’ of the corporation, not around discretetransactions.” Paracor, 96 F.3d at 1162. The court ultimately found that the defendant did not exercise controlover the “management and policies” of the Company, nor did it direct its day-to-day affairs in any sense. Accordingly, the court held that investors could not sustain a secondary liability claim against the defendant. Id. at 1163; see also In re Sears, Roebuck and Co. Sec. Litig., 291 F. Supp. 2d 722, 727 (N.D. Ill. 2003)(“Determining whether an individual defendant is a ‘controlling person’ under § 20(a) is a question of fact thatcannot be determined at the pleading stage.”).

Some courts have held that signing an allegedly misleading corporate SEC filing or shareholder report is notenough to establish control. See In re Rospatch Sec. Litig., 760 F. Supp. 1239, 1264 (W.D. Mich. 1991); In reCrazy Eddie Sec. Litig., 747 F. Supp. 850, 861 (E.D.N.Y. 1990); Kimmel v. Labenski, No. 85 CIV 0804 (CSH),1988 WL 19229, at *5 (S.D.N.Y. Feb. 10, 1988) (unpublished). But see In re Quintel Entm’t, Inc. Sec. Litig.,72 F. Supp. 2d 283, 298 (S.D.N.Y. 1999) (denying motion to dismiss control person allegations wheredefendants were directors, signed SEC filings and were in a position to control and influence the company’sbusiness and operations).

Similarly, providing critical services to an issuer is not necessarily equivalent to control. Barker v. Henderson,Franklin, Starnes & Holt, 797 F.2d 490, 494 (7th Cir. 1986) (explaining for purposes of Section 20(a),attorney’s ability to persuade and give counsel is not the same thing as “control,” which almost always meansthe practical ability to direct the actions of the people who issue or sell securities); Dietrich v. Bauer, 76 F.Supp. 2d 312, 333 (S.D.N.Y. 1999) (holding that plaintiff’s allegation that individual defendant was a lawyerfor a corporate issuer of securities, without more, is insufficient under Section 20(a) to withstand motion todismiss); Wright v. Schock, 571 F. Supp. 642, 664 (N.D. Cal. 1983) (providing indispensable services to abroker does not establish a bank or title company as a “control” party), aff’d, 742 F.2d 541 (9th Cir. 1984); In reCommonwealth Oil/Tesoro Petroleum Sec. Litig., 484 F. Supp. 253, 268-69 (W.D. Tex. 1979) (givingindependent accounting advice does not by itself establish control party liability).

Finally, minority stock ownership does not necessarily establish control person status. Ellison v. Am. ImageMotor Co., Inc., 36 F. Supp. 2d 628, 638 (S.D.N.Y. 1999); In re Refco. Inc. Sec. Litig., 503 F. Supp. 2d 611,638 (S.D.N.Y. 2007) (holding that mere minority ownership is insufficient to establish control, but is sufficientto survive a motion to dismiss so that plaintiffs can develop a record of control); In re Genentech Inc. Sec.Litig., No. C-88-4038-DLJ, 1989 WL 201577, at *7 (N.D. Cal. Dec. 11, 1989) (finding nine percent ownershipand representation on board insufficient to assert control); Martin v. EVP Second Corp., No. 90 CIV. 7074(LLS), 1991 WL 131176, at *3-4 (S.D.N.Y. July 9, 1991); Travelers Ins. Co. v. Lewis, 756 F. Supp. 172, 174(S.D.N.Y. 1991) (owning twenty percent stock share of company and board representation are insufficient); Inre Jenny Craig Sec. Litig., No. 92-0845-IEG (LSP), 1992 WL 456819 (S.D. Cal. Dec. 19, 1992); Dennis v.

Gen. Imaging, Inc., 918 F.2d 496, 509-10 (5th Cir. 1990) (maintaining a minority stake and working as adirector is insufficient to establish control party liability on summary judgment); Sloane Overseas Fund, Ltd. v.Sapiens Int’l Corp., 941 F. Supp. 1369 (S.D.N.Y. 1996) (holding eight percent ownership and representation onboard is insufficient to establish control). But see City of Painesville v. First Montauk Fin. Corp., 178 F.R.D.180, 192 (N.D. Ohio 1998) (“Stock can be a means of control over a corporate entity but it is not the exclusivemeans of exercising control for purposes of Section 20(a).”).

4. “Transitive” Control Liability

Certain plaintiffs have alleged that any company that controls another entity’s control person is also a controlperson over that entity. In general, courts have rejected this argument. See, e.g., In re Enron Corp. Sec.,Derivative, & “ERISA” Litig., 463 F. Supp. 2d 628, 642 (S.D. Tex. 2006) (holding that requiring an employeeof a corporation to obtain the permission of that corporation to sit on the board of another corporation does notmake the first corporation a controlling person); In re Worlds of Wonder Sec. Litig., 721 F. Supp. 1140, 1149(N.D. Cal. 1989) (holding a venture capitalist who owned shares of the issuer and placed a principal on itsboard did not “control” issuer); Xoma Corp. Sec. Litig., No. C-91-2252 (TEH), 1990 WL 357807, at *10 (N.D.Cal. Dec. 27, 1991) (appointing a principal as an outside director did not establish it as a control person overissuer).

5. Defenses Under Control Person Statutes

a. Securities Act, Section 15

A plaintiff may not prevail if “the controlling person had no knowledge of or reasonable ground to believe inthe existence of the facts by reason of which the liability of the controlled person is alleged to exist.” 15 U.S.C.§ 77o.

Burden of Proof. Once a plaintiff has pleaded a prima facie case of primary violation and control, the defendantbears the burden of proving lack of knowledge and reasonable ground to believe in the alleged underlyingfacts. G.A. Thompson & Co. v. Partridge, 636 F.2d 945, 958 (5th Cir. 1981); Swenson v. Engelstad, 626 F.2d421, 427 (5th Cir. 1980). The standard of reasonableness to be applied is that required of a prudent man in themanagement of his own property. In re Worldcom Sec. Litig., No. 02 CIV 5288DLC, 2005 WL 638268 at *16(S.D.N.Y. Mar. 21, 2005).

b. Securities Exchange Act, Section 20(a)

A plaintiff may not prevail if “the controlling person acted in good faith and did not directly or indirectly inducethe act or acts constituting the violation or cause of action.” 15 U.S.C. § 78t(a).

c. Burden Of Proof

The defendant bears the burden of proving good faith and noninducement of the alleged violation by thecontrolled person. In re Quintel Entm’t, Inc. Sec. Litig., 72 F. Supp. 2d 283, 298 (S.D.N.Y. 1999) (explainingonce plaintiff alleges and proves control under Section 20(a), burden shifts to defendant to plead good faith andlack of participation); see also Arthur Children’s Trust v. Keim, 994 F.2d 1390, 1397 (9th Cir. 1993); Donohoev. Consol. Operating & Prod. Corp., 982 F.2d 1130 (7th Cir. 1992); Harrison v. Dean Witter Reynolds, Inc.,974 F.2d 873, 880 (7th Cir. 1992); G.A. Thompson & Co. v. Partridge, 636 F.2d 945, 958 (5th Cir. 1981)(explaining defendant has burden of proof as to both good faith and nonparticipation in alleged underlyingcontrolled person violation); Marbury Mgmt., Inc. v. Kohn, 629 F.2d 705, 716 (2d Cir. 1980).

1) Good Faith Defense

In Arthur Children’s Trust, the Ninth Circuit noted that a plaintiff need not establish a controlling person’sscienter as distinct from the controlled company’s scienter; the controlling persons of an entity that acted withscienter have the burden of proving the absence of scienter, i.e., that they acted in good faith. 994 F.2d at1397. To prove the good faith defense, “it is necessary for [the] controlling person to show that someprecautionary measures were taken to prevent an injury caused by an employee.” Carpenter v. Harris, Upham& Co., Inc., 594 F.2d 388, 394 (4th Cir. 1979) (affirming summary judgment in favor of brokerage firm); seealso Haynes v. Anderson & Strudwick, Inc., 508 F. Supp. 1303, 1311 (E.D. Va. 1981). Cf. S.E.C. v. FirstJersey Sec., Inc., 101 F.3d 1450 (2d Cir. 1996); S.E.C. v. First Sec. Co. of Chi., 463 F.2d 981, 987 (7th Cir.1972) (brokerage firm facilitated fraud).

2) Duty

Control persons owe a duty of care to the investing public. In Carpenter, the court observed:

The primary duty owed by a broker-dealer to the public is to supervise its employees in an adequate andreasonable fashion. While the standards of supervision may be stringent, this does not create absolute liabilityfor every violation of the securities laws committed by a supervised individual. It is required of the controllingperson only that he maintain an adequate system of internal control and that he maintain the system in a diligentmanner.

594 F.2d at 394 (citation omitted). The Ninth Circuit in Hollinger v. Titan Capital Corp. held that an allegedcontrol person cannot satisfy the burden of proving good faith “merely by saying it has supervisory proceduresin place. . . .” 914 F.2d 1564, 1576 (9th Cir. 1990). Rather, the controlling person must prove he “maintainedand enforced a reasonable and proper system of supervision and internal control.” Id.; see also First Jersey,101 F.3d at 1450 (finding control person must prove he exercised due care in supervision and maintained andenforced reasonable and proper systems of supervision and internal controls).

3) Sliding Scale

Some courts have adopted a “sliding scale” interpretation of the good faith defense. In Haynes, the courtobserved that the good faith defense “should be applied on a sliding scale so that what may be good faith in onecase may not necessary [sic] constitute good faith in another.” 508 F. Supp. at 1314. The court concluded:

a more stringent supervisory duty should be imposed upon a broker-dealer than upon an officer or director of abrokerage firm … since the broker-dealer is usually in a better position to prevent the violation of the securitieslaws. Of course, the courts will also want to take other circumstances into account, such as the egregiousness ofthe violation, its duration, the agent’s experience with the company, evidence of lax application of safeguardsand the like.

Id. Similarly, in G.A. Thompson, the court observed that whether the controlling person has done enough toprevent the violation depends on what he could have done in such circumstances. 636 F.2d 945.

4) Fact-Intensive Inquiry

As with control, evaluating the good faith defense is fact-intensive. See Loftus C. Carson, The Liability ofControlling Persons Under the Federal Securities Act, 72 Notre Dame L. Rev. 263, 307 (1997). Facts

necessary to show non-inducement are also relevant to good faith. In determining scienter and inducement,important factors include the defendant’s involvement in preparing the documents, his sophistication, expertise,access to information, position in the corporation, procedures in place to prevent securities violations, and thereasonableness of relying on professionals or other officers. Id.


The extended statute of limitations under the Sarbanes-Oxley Act may apply to claims under Section 20(a). DeBenedictis v. Merrill Lynch & Co., 492 F.3d 209, 215 (3d Cir. 2007) (finding inquiry notice triggered bywidespread publication of articles concerning plaintiff’s situation).

B. Respondeat Superior Liability

1. Respondeat Superior Available

Sections 15 and 20 are not exclusive remedies. A majority of circuits now hold that the doctrine of respondeatsuperior permits the imposition of secondary liability for violations of the federal securities laws independent ofSections 15 and 20(a). See, e.g., In re Villa, 261 F.3d 1148 (11th Cir. 2001); Hollinger v. Titan Capital Corp.,914 F.2d 1564, 1576 (9th Cir. 1990); In re Atl. Fin. Mgmt., Inc., 784 F.2d 29 (1st Cir. 1986); Commerford v.Olson, 794 F.2d 1319, 1322-23 (8th Cir. 1986); Sharp v. Coopers & Lybrand, 649 F.2d 175, 181-82 (3d Cir.1981); Henricksen v. Henricksen, 640 F.2d 880, 887 (7th Cir. 1981); Marbury Mgmt., Inc. v. Kohn, 629 F.2d705, 716 (2d Cir. 1980); Paul F. Newton & Co. v. Tex. Commerce Bank, 630 F.2d 1111, 1118 (5th Cir. 1980);Holloway v. Howerdd, 536 F.2d 690, 695 (6th Cir. 1976); Carras v. Burns, 516 F.2d 251, 259 (4th Cir. 1975);Kerbs v. Fall River Indus., Inc., 502 F.2d 731, 740-41 (10th Cir. 1974); Rivera v. Clark Melvin Sec. Corp., 59F. Supp. 2d 280, 295 (D.P.R. 1999); Dougherty v. Mieczkowski, 661 F. Supp. 267, 279 (D. Del. 1987).

a. Application of Respondeat Superior To Corporations

While respondeat superior is often applied in the context of broker-dealers, courts have extended the applicationof respondeat superior to corporations as well. In re Brocade Sec. Litig., No. C 05-02042 CRB, 2008 U.S. Dist.LEXIS 38885, at *10-11 (N.D. Cal. May 13, 2008) (granting partial summary judgment as to company’sliability through respondeat superior for actions taken by CEO where he was “necessarily” motivated, at least inpart, by a purpose to serve the company); In re McKesson HBOC, Inc. Sec. Litig., 126 F. Supp. 2d 1248, 1277(N.D. Cal. 2000) (finding company potentially liable for alleged fraud committed by Chairman of the Board ofDirectors); In re Centennial Techs. Litig., 52 F. Supp. 2d 178, 185-86 (D. Mass. 1999) (finding corporation maybe held vicariously liable for acts of its CEO); Atl. Fin., 784 F.2d at 29; Kerbs, 502 F.2d at 731; see also ZurichCapital Markets Inc. v. Coglianese, 383 F. Supp. 2d 1041 (N.D. Ill. 2005) (finding a promoter could be aprimary violator, and therefore the promoter’s conduct could be attributed to the company); Seolas v. Bilzerian,951 F. Supp. 978, 983 (D. Utah 1997); In re Network Equip. Tech., Inc., 762 F. Supp. 1359, 1366 (N.D. Cal.1991) (explaining respondeat superior may be applied to corporations and corporate insiders). But cf. In reGlobal Crossing Sec. Litig., No. 02 Civ 910(GEL), 2005 U.S. Dist. LEXIS 16228 (S.D.N.Y Nov. 7, 2005)(holding respondeat superior is not applicable to a corporation where the corporation’s employees were actingas independent directors sitting on a different company’s board).

b. Respondeat Superior After Stoneridge

A court in the Southern District of New York has held that the Stoneridge decision does not foreclose commonlaw theories of secondary liability, including respondeat superior, for Exchange Act claims. In re ParmalatSec. Litig., 594 F. Supp. 2d 444 (S.D.N.Y. 2009). The court found that Stoneridge did not specifically deal with

the question of vicarious liability for Exchange Act violations, and refused to extend Stoneridge becauseforeclosing common law vicarious liability for secondary actors “would undermine the ability of defraudedinvestors to obtain meaningful compensation,” as recovery would be limited against the corporations thatemployed “individual malefactors.” Id. at 451.

c. Third Circuit View

While the Third Circuit typically views respondeat superior as supplanted by Sections 15 and 20(a), it hascarved out an exception that allows application of respondeat superior liability to brokers and accountants undera “special duty” doctrine.

In Rochez Bros., Inc. v. Rhoades, 527 F.2d 880 (3d Cir. 1975), the Third Circuit held that secondary liability ina federal securities case may not be established on the principles of respondeat superior. However, the courtnoted that:

We are not faced with the type of relationship that prevails in the broker-dealer cases where a stringentduty to supervise employees does exist. This duty is imposed to protect the investing public and makebrokers aware of the special responsibility they owe to their customers.

Id. at 884-86. In Sharp v. Coopers & Lybrand, 649 F.2d 175, 185 (3d Cir. 1981), the Third Circuit extendedthis exception to accountants, concluding that when an opinion letter is used to influence investors, theaccounting firm owes a duty to the investing public to exercise stringent supervision of its employees. Failingto perform this duty will expose it to liability for violations of Rule 10b-5 under the doctrine of respondeatsuperior.

C. Aiding And Abetting Liability

1. No Aiding And Abetting Liability In Private Suits

The Supreme Court eliminated the private cause of action for aiding and abetting under Rule 10b-5 in CentralBank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). In so holding, the Courtinvalidated a rich – sometimes conflicting – body of lower court case law. The Supreme Court’s rationale forits constriction of secondary liability was three-fold.

Reliance Requirement. The Court reasoned that, were it to recognize a cause of action for aiding and abettingunder Section 10(b), it would thereby “impose 10b-5 aiding and abetting liability when at least one elementcritical for recovery under 10b-5 is absent: reliance.” Id. at 1449.

Statutory Construction. The Court noted that Congress has not created a general civil aiding and abetting tortliability statute, but has instead taken a statute-by-statute approach to such liability. Accordingly, the Courtfound no general presumption favoring aiding and abetting causes of action. The Court then relied on the factthat none of the express private causes of action in the federal securities laws imposes liability on aiders andabettors. The Court concluded that Congress did not intend to attach aiding and abetting liability to a private10b-5 cause of action. Id. at 1447-48.

Narrow Construction of Word “Indirectly” in Section 10(b). Plaintiffs argued that aiders and abettors used oremployed manipulative or deceptive devices “indirectly,” and thus fell within the scope of Section 10(b). TheCourt rejected plaintiffs’ argument; it found that the text of Section 10(b), making it “unlawful for any person,directly or indirectly, … [t]o use or employ, in connection with the purchase or sale of any security …, anymanipulative or deceptive device or contrivance,” did not create a cause of action for aiding and abetting. Id. at1448.

2. Impact Of Central Bank

a. Expansion Of Primary Liability Allegations

After Central Bank, plaintiffs have sought to recast defendants who were traditionally the object of aiding andabetting claims – including lawyers and accountants – as primary violators of 10b-5. As noted above,Section 10(b) brings within its scope any person who “directly or indirectly” engages in its proscribedactivities. Current law leaves unclear the definition of an “indirect” primary violation. Recent decisions offersome guidance but prescribe two divergent standards: the “bright-line” test and the “substantial participation”test.

1) Bright-Line

The Second Circuit dismissed a case against an auditor who had privately approved a press release thatcontained false and misleading statements. Wright v. Ernst & Young LLP, 152 F.3d 169 (2d Cir. 1998). Inadopting a “bright-line” test for liability under Rule 10b-5, the court held the auditor must actually make themisstatement, or the statement must be attributed to the auditor, in order to be a primary violator of the Rule. Id. at 175; see also Shapiro v. Cantor, 123 F.3d 717, 720 (2d Cir. 1997) (“[I]f Central Bank is to have any realmeaning, a defendant must actually make a false or misleading statement in order to be held liable underSection 10(b). Anything short of such conduct is merely aiding and abetting, and no matter how substantial thataid may be it is not enough to trigger liability.”) (quoting In re MTC Elec. Tech. S’holders Litig., 898 F. Supp.974, 987 (E.D.N.Y. 1995)); S.E.C. v. KPMG, LLP, 412 F. Supp. 2d 349 (S.D.N.Y. 2006) (concerning auditengagement partners who were responsible for misstatements in audit opinions); S.E.C. v. Lucent Tech., 363 F.Supp. 2d 708 (D.N.J. 2005) (applying the “bright-line” test and refusing to hold the company’s CFO liablebecause the material misstatements or omissions were not attributable to her); In re Kendall Square ResearchCorp. Sec. Litig., 868 F. Supp. 26 (D. Mass. 1994) (explaining accountants are not primarily liable for allegedreview and approval of financial statements or prospectuses because only “those who make a materialmisstatement or omission or commit a manipulative act” are subject to primary liability). But see Adam v.Silicon Valley Bancshares, 884 F. Supp. 1398 (N.D. Cal. 1995) (explaining an accounting firm can be primarilyliable under Section 10(b) for its role in drafting and editing SEC letters); In re ZZZZ Best Sec. Litig., 864 F.Supp. 960, 968-69 (C.D. Cal. 1994) (finding that an accounting firm can be primarily liable under Section 10(b)for alleged misrepresentations made by the “primary wrongdoer”).

Several circuits have held that an attorney is not liable to third parties for legal work unless the attorney hasprepared a signed opinion for third party use. Kline v. First W. Gov’t Sec., Inc., 24 F.3d 480, 490-91 (3d Cir.1994) (holding that plaintiffs had stated a claim against an attorney under Section 10(b) where the attorney haddrafted an opinion letter upon which investors could be expected to rely); Renovitch v. Kaufman, 905 F.2d 1040(7th Cir. 1990) (dismissing aider and abettor claim where the attorney did not prepare the investment brochureand there was insufficient evidence of scienter); Abell v. Potomac Ins. Co., 858 F.2d 1104 (5th Cir. 1988)(holding that bond counsel was not liable merely by allowing its name to be included in the final offeringstatement where it never signed any of the documents); Pacific Inv. Mgmt. Co. LLC v. Mayer Brown LLC, 603F.3d 144 (2d Cir. 2010) (bright-line test precludes liability for lawyer who allegedly created false statement thatwas not attributed to him); Affco Inv. 2001 LLC v. Proskauer Rose LLP, 2010 U.S. App. LEXIS 22105 at * 20-22. (5th Cir. Oct. 27, 2010( (following reasoning of Pac. Inv. v. Mayer Brown requirement of explicitattribution to show reliance); Barker v. Henderson, Franklin, Starnes & Holt, 797 F.2d 490, 493 (7th Cir. 1986)(refusing to impose liability against law firm that assisted charitable foundation in a bond offering by preparingdrafts of documents where law firm name did not appear on documents); Cronin v. Midwestern Okla. Dev.Auth., 619 F.2d 856, 862 (10th Cir. 1980) (suggesting that courts could apply liability to attorney whoordinarily issues an opinion letter that comes attached to disclosure); S.E.C. v. Spectrum, Ltd., 489 F.2d 535 (2dCir. 1973) (holding lawyer liable under Rule 10b-5 because he signed an opinion letter).

2) Substantial Participation

This test is less stringent and allows primary liability to be imposed where there is “substantial participation orintricate involvement” by the secondary party in the preparation of fraudulent statements “even though thatparticipation might not lead to the actor’s making the actual statements.” Howard v. Everex Sys., Inc., 228 F.3d1057, 1061 n.5 (9th Cir. 2000); see also McGann v. Ernst & Young, 102 F.3d 390 (9th Cir. 1996) (findingaccountants alleged to have provided fraudulent audit report for inclusion in 10-K can be held primarily liablefor acting “in connection with” the purchase or sale of securities); In re Software Toolworks Inc., 50 F.3d 615,628 n.3, 629 (9th Cir. 1994) (explaining accountant may be a primary violator under Section 10(b) where he orshe reviews and plays a significant role in drafting statements); In re Van der Moolen Holding N.V. Sec. Litig.,405 F. Supp. 2d 388, 401-403 (S.D.N.Y. 2005) (holding a subsidiary may be liable under section 10(b), eventhough the plaintiffs did not allege any facts demonstrating that the subsidiary had participated in any way inthe drafting, producing, reviewing and/or disseminating of the alleged misstatements); In re Lernout & HauspieSec. Litig., F. Supp. 2d 161, 173 (D. Mass. 2003) (explaining primary liability can apply to “any person whosubstantially participates in a manipulative or deceptive scheme . . even if a material misstatement by anotherperson creates the nexus between the scheme and the securities market”); McNamara v. Bre-X Minerals Ltd.,57 F. Supp. 2d 396, 426 (E.D. Tex. 1999) (finding defendants who played a significant role in preparing falsestatement liable as primary violators); Cashman v. Coopers & Lybrand, 877 F. Supp. 425, 432-34 (N.D. Ill.1995) (finding primary liability established against accountants who were “centrally involved” in drafting);Vosgerichian v. Commodore Int’l, 862 F. Supp. 1371 (E.D. Pa. 1994) (holding that accounting firm could beliable for drafting clean audit opinion issued to investors).

b. Application To SEC Enforcement Actions

The Court in Central Bank did not discuss whether the SEC could maintain an enforcement action for aidingand abetting under Section 10(b). Recognizing that logic dictates application of Central Bank to SECenforcement actions, the SEC announced on May 6, 1994 that it was dropping all aiding and abetting suits. Seealso Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 200 (1994) (Stevens, J.,dissenting) (“The majority leaves little doubt that the Exchange Act does not even permit the SEC to pursueaiders and abettors in civil enforcement actions under Section 10(b) and Rule 10b-5.”). However, in theReform Act, Congress included an amendment to Section 20 of the Exchange Act, Section 104(f), specificallyauthorizing the SEC to bring actions against any person who “knowingly provides substantial assistance toanother person” in violation of the Exchange Act or rules or regulations issued under it. 15 U.S.C. § 78t. TheAct left open the question whether the aiding and abetting provision applied retroactively.

In S.E.C. v. Fehn, 97 F.3d 1276 (9th Cir. 1996), the Ninth Circuit found that the aiding and abetting provisioncould be applied retroactively under the facts of the case. The court held that although the Reform Act does notexpressly make Section 104 applicable to conduct and events that preceded its enactment, because Fehn’sappeal implicated only the SEC’s injunctive authority under the Reform Act, not that portion of Section 104authorizing the SEC to seek monetary penalties, retroactive application of Section 104 existed in that case.

More recently, in Howard v. S.E.C., 376 F.3d 1136 (D.C. Cir. 2004), the court held that in the context of anaction by the SEC for a civil monetary penalty, “extreme recklessness” is sufficient to satisfy the scienterrequirement for aiding and abetting. Such extreme recklessness may be found “if the alleged aider and abettorencountered ‘red flags,’ or ‘suspicious events creating reasons for doubt’ that should have alerted him to theimproper conduct of the primary violator.” Id. at 1142-43; see also Graham v. S.E.C., 222 F.3d 994 (D.C. Cir.2000).

Further, in S.E.C. v. Papa, 555 F.3d 31 (8th Cir. 2009), the court held that aiding and abetting liability under theExchange Act was not satisfied by a fiduciary trust company’s employees’ failure to disclose allegedlywrongful transactions and accounting adjustments by signing two annual audit letters. Because the

nondisclosures did not cause the transactions or the resulting losses, the court could not find that thenondisclosure created liability for aiding and abetting. Id. at 38.

c. Effect On Conspiracy Claims

In Dinsmore v. Squadron, Ellenoff, Plesent, Sheinfeld & Sorkin, 135 F.3d 837 (2d Cir. 1998), the SecondCircuit held that no conspiracy liability attached under Section 10(b) after Central Bank – “where therequirements for primary liability are not independently met, they may not be satisfied based solely on one’sparticipation in a conspiracy in which other parties have committed a primary violation.” Id. at 843. TheSecond Circuit reversed the district court, which had granted plaintiffs leave to plead a Section 10(b) claimagainst a law firm on a conspiracy theory, In re Towers Fin. Corp. Noteholders Litig., 936 F. Supp. 126, 127(S.D.N.Y. 1996), and which had then upheld that complaint against the firm’s motion to dismiss, Dinsmore v.Squadron, Ellenoff, Plesent, Sheinfeld & Sorkin, 945 F. Supp. 84 (S.D.N.Y. 1996), rev’d, 135 F.3d 837 (2d Cir.1998). The law firm was alleged to have made material misstatements in an offer of rescission to shareholdersand to the SEC in the course of representing Towers Financial Corporation during the SEC’s investigations intoTowers. However, the firm was not alleged to have had a role in preparing or disseminating any of thefraudulent offering materials at issue. The Second Circuit rejected conspiracy liability under Section 10(b) forthe same reasons that the Supreme Court had rejected aiding and abetting liability, observing that “recognitionof a cause of action for conspiracy would not only conflict with the reasoning of the Supreme Court in CentralBank, but would largely undo the effect of that decision itself, inasmuch as many aiding and abetting claimswould simply be repleaded as conspiracy claims.” Id.; see also Glaser v. Enzo Biochem Inc., No. 03-2188,2005 U.S. App. LEXIS 4598 (4th Cir. Mar. 21, 2005) (holding the rationale of Central Bank, with respect toaiding and abetting, applies equally to civil conspiracy even after the post-Central Bank enactment of 15 U.S.C.§ 78t(e), which authorizes criminal prosecution of persons who aid and abet securities law violations); In reGlenFed, Inc., Sec. Litig., 60 F.3d 591, 592 (9th Cir. 1995) (holding that Central Bank barred conspiracy claimsunder Section 10(b)); Stack v. Lobo, CIV. No. 95-20049 SW, 1995 WL 241448, at *10 (N.D. Cal. Apr. 20,1995) (rejecting plaintiffs’ conspiracy claim because where there are “no primary violations pled withparticularity, any secondary liability claims must fail as well”).

Blurring the Distinction Between Primary and Secondary Liability. In S.E.C. v. First Jersey Sec., Inc., 101F.3d 1450 (2d Cir. 1996), the Second Circuit found primary liability from facts showing a defendant’s “hands-on involvement in the pertinent decisions” and relied on the same facts to hold the defendant liable as a controlperson under Section 20(a). Id. at 1471-73. Subsequently, however, the Second Circuit restricted primaryliability under Section 10(b) to defendants who have made “a material misstatement or omission indicating anintent to deceive or defraud in connection with the purchase or sale of a security.” Shapiro v. Cantor, 123 F.3d717, 720-21 (2d Cir. 1997). The court in In re Silicon Graphics Inc., Sec. Litig., 970 F. Supp. 746 (N.D. Cal.1997), construed the reach of primary liability differently, holding that “each defendant is liable for perpetratinga fraudulent scheme only to the extent that he is also found liable for insider trading or making false ormisleading statements or as a control person.” Id. at 762; see also In re Dynegy, Inc. Sec. Litig., 339 F. Supp.2d 804 (S.D. Tex. 2004) (holding company’s bank to be aider and abettor and not subject to primary liabilityeven though plaintiff alleged that bank provided misleading language company used in an SEC filing becausethe bank’s acts did not “coincide” with the preparation of the financial statements at issue).

d. Effect On Group Pleading Doctrine

Claims against defendants who are not alleged to have made material misstatements may nevertheless survive amotion to dismiss upon application of the “group pleading presumption.” Noting the restrictions placed byCentral Bank on attempts to hold non-speaking defendants liable for the statements of others, the court inPowers v. Eichen nonetheless upheld a complaint against defendants who were not alleged to have mademisstatements themselves but who could be charged with those statements at the pleading stage under the“group pleading presumption.” 977 F. Supp. 1031 (S.D. Cal. 1997). Application of the presumption requires

analysis of both the statement at issue and the allegations against each defendant who is to be charged with thatstatement at the pleading stage. The complaint must plead facts demonstrating (1) that the statement at issue is“group-published” information (e.g., a prospectus, registration statement, annual report, or press release), and(2) that the defendant charged with the statement “either participated in the day-to-day corporate activities, orhad a special relationship with [the] corporation, such as participation in preparing or communicating groupinformation at particular times.” Id. at 1040 (quoting In re GlenFed, Inc., Sec. Litig., 60 F.3d 591, 593 (9th Cir.1995)). But see Anixter v. Home-Stake Prod. Co., 77 F.3d 1215, 1226 & n.10 (10th Cir. 1996) (explaining“reading the language of Section 10(b) and 10b-5 through the lens of Central Bank … [defendants] mustthemselves make a false or misleading statement” and cases which allow liability to attach “without requiring arepresentation to be made by [a] defendant, and reformulate the ‘substantial assistance’ element of aiding andabetting liability into primary liability . . . do not comport with Central Bank.”); In re Royal Ahold N.V. Sec. &ERISA Litig., 351 F. Supp. 2d 334, 371 (D. Md. 2005) (following the 10th Circuit’s standard for primaryliability in Anixter requiring a defendant be alleged to have made a misrepresentation which he knew or shouldhave known would be communicated to investors).

Some courts have questioned whether the group pleading doctrine, which originated largely in the NinthCircuit, survived the Reform Act. See, e.g., Branca v. Paymentech, Inc., No. CIV. A. 3:97-CV-2507-L, 2000WL 145083, at *8 (N.D. Tex. Feb. 8, 2000) (noting inherent tension between the Reform Act and the grouppleading doctrine); Marra v. Tel-Save Holdings, Inc., CIV. A. 98-3391, 1999 WL 317103, at *5 (E.D. Pa.May 18, 1999) (same); Allison v. Brooktree Corp., 999 F. Supp. 1342, 1350 (S.D. Cal. 1998) (finding that “thecontinued vitality of the judicially created group-published doctrine is suspect since the Reform Act specificallyrequires that the untrue statements” be set forth with particularity against each defendant). For detaileddiscussion on group pleading in a post Reform Act setting, see Section I.C.5.b. supra.

e. Reliance

Central Bank may also have a spill-over effect on the 10b-5 reliance presumption, increasing plaintiffs’pleading and proof requirements. The Court relied in part on the reliance requirement to bar aiding and abettingclaims:

Our reasoning is confirmed by the fact that [plaintiffs] would impose 10b-5 aiding and abetting liabilitywhen at least one element critical for recovery under 10b-5 is absent: reliance. A plaintiff must showreliance on the defendant’s misstatement or omission to recover under 10b-5. Were we to allow theaiding and abetting action proposed in this case, the defendant could be liable without any showing thatthe plaintiff relied upon the aider and abettor’s statements or actions.… Allowing plaintiffs to circumventthe reliance requirement would disregard the careful limits on 10b-5 recovery mandated by our earliercases.

Central Bank, 511 U.S. at 180 (citation omitted). This statement may serve to refocus attention on, and therebyheighten, the reliance pleading and proof requirements.

D. Scheme Liability

Although the Supreme Court held in Central Bank that Rule 10b-5 does not reach those who only aid or abet aviolation of §10(b), secondary actors in the securities markets are not necessarily “free from liability under theSecurities Acts.” 511 U.S. 164. As the Supreme Court cautioned, “[a]ny person or entity, including a lawyer,accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) onwhich a seller of securities relies may be liable as a primary violator under 10b-5.” Id. at 191.

In an attempt to sidestep the exacting standards that many courts developed to determine what constitutes a“primary violation” under Rule 10b-5(b), plaintiffs increasingly relied on Rule 10b-5(a) and (c) to hold

secondary actors accountable for their role in alleged fraud. By premising claims against secondary actors ontheories of “scheme liability” under Rules 10b-5(a) and (c), which prohibit the employment of a “device,scheme, or artifice to defraud,” and an “act, practice or course of business which operates or would operate as afraud or deceit,” plaintiffs hoped to avoid the need to allege a misstatement or omission of material fact. Onecourt had actually required that class action plaintiffs plead “scheme liability” to avoid dismissal. See Robert N.Clemens Trust v. Morgan Stanley DW, Inc., 485 F.3d 840, 850 (6th Cir. 2007) (finding that in order to plead asa class and satisfy the Reform Act, plaintiffs should plead facts demonstrating a “scheme to defraud”).

Although courts seem to agree that “scheme liability” is analytically distinct from the more familiar“misrepresentations and omissions of material fact” rubric proscribed by subsection (b) of Rule 10b-5, courtsdiffer on the availability and contours of scheme liability against the backdrop of Central Bank’s proscriptionagainst aiding and abetting liability in private Section 10(b) litigation.

In 2008, the United States Supreme Court decided Stoneridge Investment Partners, LLC v. Scientific-Atlanta,Inc., 128 S.Ct. 761 (2008), which squarely addressed – and rejected – claims of “scheme liability.” InStoneridge, shareholders of a cable television provider invoked Rule 10b-5 to allege that equipment vendors,who entered into sham transactions knowing that the cable provider would account for them improperly toinflate operating revenues, did not merely aid and abet the issuer’s fraud, but rather committed a primaryviolation of Rule 10b-5. Id. at 766-67. After analyzing Central Bank, the Supreme Court ruled that, forprimary liability under 10(b) to apply, a secondary actor must satisfy all the elements of 10(b). Id. at 769. TheSupreme Court rejected as “erroneous” any suggestion by other appellate courts that “there must be a specificoral or written statement before there could be liability” under federal securities laws. The Court explained,however, that for a plaintiff investor to succeed in a private lawsuit based on deceptive conduct, the investormust also prove reliance to satisfy the requirement of a causal connection between the defendant’s deceptiveconduct and the investor’s injury. In other words, the investor must prove actual reliance on knowledge of atransaction that is later discovered to be deceptive in making the decision to buy or sell the securities.

Alternatively, under the fraud-on-the-market doctrine, the Court recognized that the investors could be entitledto a rebuttable presumption of reliance, but only if the transaction in question becomes public knowledge. TheCourt noted that neither the plaintiff investors nor the investing public in the Stoneridge case had knowledge ofthe vendors’ deceptive conduct (the contracts), and the plaintiff investors therefore could not prove reliance. The Court expressly rejected the argument that reliance on the financial statements that misrepresented thecable company’s revenues provided a sufficient causal link. Although “[c]onduct itself can be deceptive,” theCourt held that Charter’s investors did not rely on the vendors’ acts or statements. Instead, the Court decidedthat the vendors’ “deceptive acts, which were not disclosed to the investing public, are too remote to satisfy therequirement of reliance.” The vendors had no duty to disclose, and their deceptive acts were not communicatedto the public. Id. at 769. The Court therefore rejected the argument that, had the vendors not assisted Charter,Charter’s auditors would not have been fooled and its financial statements would have been more accurate. Id.at 770. Even though the natural and expected consequence of the vendors’ deceptive acts was to renderCharter’s financial statements inaccurate, nothing the vendors did made it “necessary or inevitable” for Charterto record the transactions as it did. Id.

Finally, the Supreme Court deferred to the SEC’s role in enforcement of the securities laws. Because the SEChad the power to bring aiding and abetting claims, the Court was reluctant to expand the private right under10(b) beyond the realm of the securities market and into ordinary business operations. Id.

1. Application Of Stoneridge

Consistent with its decision in Stoneridge, the Supreme Court on January 22, 2008 declined to review a FifthCircuit opinion reversing a district court order certifying a class of Enron investors who asserted federalsecurities law claims against certain investment banks that had engaged in allegedly deceptive transactions withEnron that allowed Enron to misstate its financial condition by taking liabilities off of its books or inflating itsrevenues. The Fifth Circuit concluded that the banks’ transactions with Enron “cannot be deceptive” within the

meaning of federal securities laws because the banks did not have a duty to disclose the transactions to Enron’sshareholders. See Regents of Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir.2007), cert. denied, Regents of Univ. of Cal. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 128 S. Ct. 1120(2008). The Supreme Court therefore left untouched the Fifth Circuit decision, which appears to impose limitson investor lawsuits even to fraudulent transactions in the “investment sphere” as well as to the traditionalcontracts for goods and services that were at issue in Stoneridge. Courts have reached different conclusionsregarding the scope of Section 10(b) liability in light of the Supreme Court’s decision in Stoneridge. ComparePugh v. Tribune Co., 521 F.3d 686, 696-97 (7th Cir. 2008) (applying Stoneridge and concluding individualdefendants who participated in a fraudulent scheme, inflating circulation numbers of a newspaper, but who hadno role in preparing or disseminating the newspaper company’s financial statements, could not be liable forviolation of Section 10(b)) and Katz v. Image Innovations Holdings, Inc., 542 F. Supp. 2d 269, 272-73(S.D.N.Y. 2008) (holding allegations insufficient under Stoneridge because complaint did not allege howshareholders relied upon particular defendants’ actions) and Affco Inv., LLC v. KPMG, LLP., No. H-07-3379,2009 WL 3248052, at *4 (S.D.Tex. Sept. 28, 2009) (Applying Stoneridge in dismissing plaintiffs’ 10b-5 claimfor lack of reliance where law firm never made statements directly to plaintiffs prior to their investmentdecision), with In re Bristol Myers Squibb Co. Sec. Litig., No. 07 CIV. 5867 (PAC)., 2008 WL 3884384(S.D.N.Y. Aug. 20, 2008) (denying defendants’ motion to dismiss securities fraud action challenging adequacyof public disclosures concerning attempts to settle patent litigation; holding that allegations were adequate tosatisfy requirements of 10(b) and Stoneridge with respect to one defendant, even though he made no publicstatements, because investors relied on his good faith in negotiating settlement for company and the misconductand deceptive acts were communicated to the public through disclosure of amended settlement’s terms andsecret oral agreement) and In re Parmalat Sec. Litig., 594 F. Supp. 2d. 444, 450-51 (S.D.N.Y. 2009) (denyingmotion for summary judgment on grounds that the Supreme Court’s decision in Stoneridge did not foreclosevicarious liability for a principal based on the acts of its agent).

2. Pre-Stoneridge Scheme Liability Decisions

Decisions addressing scheme liability issued prior to Stoneridge remain informative and may provide insight asto how the same courts will apply the Stoneridge decision.

a. Eighth Circuit

In rejecting the plaintiffs’ claims under Rule 10b-5(a) and (c) in In re Charter Commc’ns Inc. Sec. Litig., 443F.3d 987 (8th Cir. 2006), the Eighth Circuit (in the decision affirmed in Stoneridge) emphasized the statutorylanguage of Section 10(b), which prohibits the use of a “manipulative or deceptive device or contrivance” inconnection with the purchase or sale of a security, and concluded that “any defendant who does not make oraffirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage inmanipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable underSection 10(b) or any subpart of Rule 10b-5.” Id. at 992. The court reasoned that “to impose liability forsecurities fraud on one party to an arm’s length business transaction in goods or services other than securitiesbecause that party knew or should have known that the other party would use the transaction to misleadinvestors in its stock would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings.” ID at 992-93

b. Ninth Circuit

The Ninth Circuit, on the other hand, held that a defendant could be found liable “as a primary violator ofSection 10(b) for participation in a ‘scheme to defraud’ if the defendant “engaged in conduct that had theprincipal purpose and effect of creating a false appearance of fact in furtherance of the scheme.” Simpson v.AOL Time Warner Inc., 452 F.3d 1040, 1048 (9th Cir. 2006), vacated by Simpson v. Homestore.com, Inc., 519F.3d 1041 (9th Cir. Mar 26, 2008). In that case, Homestore.com, the issuer of the securities, entered into barter,

round-trip and triangular transactions to fabricate revenue. Plaintiffs alleged that the company’s businesspartners were involved in those “sham transactions” as part of a scheme to defraud and sought to hold themliable, even though the third-party business partners did not make any statements. Id. at 1042-44.

The court emphasized that it is not enough “that a transaction in which a defendant was involved had adeceptive purpose and effect” if the defendant’s own conduct “contributing to the transaction or overallscheme” did not have a deceptive purpose and effect. The court found that the element of using or employing adeceptive device was not adequately alleged because it could not find that the transactions engaged in werecompletely illegitimate or in themselves created a false appearance. Id. at 1050. However, the Ninth Circuit’sdecision was significant because it accepted a theory of liability that would apply to active participation in afraudulent scheme by someone who does not make a misstatement of omission, or engage in a manipulativesecurities trade. Although the Ninth Circuit has not yet addressed it, Simpson is unlikely to survive Stoneridgeon that point.

c. District Courts

District courts had also reached different conclusions on how 10-b(5)(a) and (c) should be applied, prior to theStoneridge decision. For instance, in In re Dynegy Sec. Litig., the Southern District of Texas rejected an effortby plaintiffs to assert scheme liability claims against a bank that allegedly “structured, funded and executed twomajor series of transactions to hide off Dynegy’s balance sheet hundreds of millions of dollars in debt, andartificially inflate Dynegy’s reported net income and cash flows.” 339 F. Supp. 2d 804, 913-916 (S.D. Tex.2004). The Court held that the claim was not actionable under Rule 10b-5(a) and (c) because the plaintiffs didnot allege any facts showing that the bank’s alleged manipulative and deceptive acts coincided with the sales ofthe issuer’s securities. Further, the bank only helped set up the transactions and did not take part in Dynegy’salleged improper reporting of the transactions on its financial statements. “[P]laintiffs cannot invokesubsections (a) and (c) of Rule 10b-5 to circumvent Central Bank’s limitations on liability for a secondaryactor’s involvement in the preparation of false and misleading statements.” Id. at 915

Another court in the same district, however, embraced scheme liability in litigation arising out of the collapse ofEnron. The test adopted by the district judge focused on whether the conduct alleged had the principal purposeand effect of deceiving investors: “[I]f a third party enters a legitimate transaction with a corporation where itknows that the corporation will overstate revenue generated by that transaction, the third party is merely aidingand abetting; in contrast, if the third party and the corporation engage in a transaction whose principal purposeand effect is to create a false appearance of revenues, intended to deceive investors in that corporation’s stockthe third party may be a primary violator.” In re Enron Corp. Sec. Derivative & ERISA Litig., 439 F. Supp. 2d692, 715 (S.D. Tex. 2006).


A. The Uniform Standards Act: Limiting State Court Claims

1. Impetus For The Uniform Standards Act

On November 3, 1998, President Clinton signed into law the Securities Litigation Uniform Standards Act(“Uniform Standards Act” or “SLUSA”). This bill gives federal courts exclusive jurisdiction over certainsecurities class actions. The impetus for the bill was twofold: the ongoing abuses of private securities fraudlawsuits and the failure of the Reform Act to stem those abuses. In 1995, Congress’ stated intention in enactingthe Reform Act was to significantly alter securities litigation by adopting a heightened pleading standard,creating a “safe-harbor” for companies, and among other things, establishing a discovery stay pending adecision on a defendant’s motion to dismiss. However, plaintiffs counsel recognized that state laws required nosuch heightened standards and began filing record numbers of securities actions in state courts in an effort toavoid the more stringent procedural and substantive requirements for private securities actions in federal courtsimposed under the Reform Act. H.R. Conf. Rep. No. 105-803, p. 14-15 (1998). See also Lander v. HartfordLife, 251 F.3d 101, 108 (2d Cir. 2001). In response, Congress enacted SLUSA, which designates the federalcourts as the exclusive venue for nearly all such claims. See Green v. Ameritrade, Inc., 279 F.3d 590 (8th Cir.2002). As then-Representative Christopher Cox stated on October 13, 1998, in a press release, “[t]he legislationwe passed today will close a loophole that has permitted fraudulent ‘strike suits’ to continue in state courts.”

2. Background On The Uniform Standards Act

a. Exclusive Federal Jurisdiction And Preemption Of State Securities Law For MostShareholder Class Actions

The Uniform Standards Act makes federal court the exclusive jurisdiction, and federal claims the exclusiveclaims, permitted for large-scale shareholder class actions where a private party alleges: (a) an untrue statementor omission in connection with the purchase or sale of a covered security; or (b) that the defendant used amanipulative or deceptive device in connection with such a transaction. 15 U.S.C. § 77p(b); 15 U.S.C.§ 78bb(f); see also Abada v. Charles Schwab & Co., Inc., 68 F. Supp. 2d 1160, 1163-69 (S.D. Cal. 1999),vacated, 127 F. Supp. 2d 1101 (S.D. Cal. 2000) (holding class action involving state law claims regarding on-line brokerage account services was preempted by the Uniform Standards Act because: (1) Congresscompletely preempted this area; (2) ”in connection with the purchase or sale of” securities includesarrangements between a broker and its customers; and (3) the Uniform Standards Act is not limited totransactions involving the issuer or an affiliate of the issuer).

b. In Connection With

Although the Second Circuit previously held that the meaning of “in connection with” under SLUSA “iscoterminous with the meaning of the nearly identical language” of Section 10(b) and Rule 10b-5, Dabit v.


Merrill Lynch, Pierce, Fenner & Smith, Inc., 395 F.3d 25, 28 (2d Cir. 2005), the Supreme Court reversed theholding. See Merrill Lynch v. Dabit, 547 U.S. 71 (2006). The Court held that the purchaser-seller “distinctionis irrelevant; the identity of the purchaser does not determine whether the complaint alleges fraud ‘in connectionwith the purchase or sale’ of securities.” Id. at 89. Thus, the purchaser-seller rule of Blue Chip Stamps v.Manor Drugstores, 421 U.S. 723 (1975), does not limit SLUSA so that only purchasers and sellers are blockedfrom state court.

c. Strong Preemption

In fact, SLUSA’s preemptive power is so strong that it may effectively bar certain types of claims altogether. In LaSala v. Bordier et Cie & Dominick Co., AG, a district court in New Jersey held that SLUSA preempts stateaiding and abetting claims where a third party allegedly made actionable misstatements and omissions eventhough the plaintiff had no federal securities remedy because aiding and abetting claims are barred by CentralBank, 452 F. Supp. 2d 575 (D.N.J. 2006), vacated, LaSala v. Bordier et Cie, 519 F.3d 121 (3rd Cir. 2008). Seealso In re Lord Abbett Mut. Funds Fee Litig., 553 F.3d 248, 254 (3rd Cir. 2003) (holding that the inclusion of aSLUSA pre-empted state law claim in a complaint that also alleges non-SLUSA pre-empted claims does notrequire dismissal of the entire action).

d. Retroactive Application of SLUSA

Most courts that have considered whether the Uniform Standards Act is applicable to conduct predating theenactment of SLUSA have held that it is. See, e.g., Blaz v. Belfer, 368 F.3d 501 (5th Cir. 2004) (holding thatretroactive application of SLUSA to pre-enactment conduct was permissible because SLUSA only governsprocedural requirements for filing certain state law securities claims, or secondary conduct, and not the primaryconduct which is the subject of those claims); Prof’l Mgmt. Assoc., Inc. Employees’ Profit Sharing Plan v.KPMG, LLC, 335 F.3d 800, 803-804 (8th Cir. 2003) (finding that no retroactivity analysis was required becauseSLUSA “simply establishes a procedural rule”).

e. Shareholder Actions Brought In State Court Are Removable To Federal Court

Any state-court shareholder class action that satisfies the definitional requirements of the Uniform StandardsAct is removable to federal court. 15 U.S.C. § 77p(c); 15 U.S.C. § 77v(a); 15 U.S.C. § 78bb(f)(2). Defendantshave 30 days from receipt of notice of filing of the complaint to file notice of removal to the federal districtcourt where the action is pending, and to notify the parties and state court of the pending removal. 28 U.S.C.§ 1446. This fairly unusual procedure allows removal of a preempted suit, permitting federal instead of statejudges to dismiss these suits. See 144 Cong. Rec. S4778-03, at *S4797 (stating that without the benefit ofremoval authority corporations could face liability under federal securities laws in fifty states, thus underminingthe Reform Act).

Moreover, because jurisdiction is determined at the time of removal, subsequent pleading amendments do noteliminate jurisdiction. See Behlen v. Merrill Lynch, 311 F.3d 1087, 1095 (11th Cir. 2002), cert. denied, 123 S.Ct. 2583 (2003) (holding that the district court had the discretion to retain jurisdiction over the amendedcomplaint provided that the allegations gave rise to subject matter jurisdiction at the time of removal).

f. Reviewability of Remand Order

The United States Supreme Court held in Kircher v. Putnam Funds Trust, 126 S. Ct. 2145 (2006), that an orderremanding a case removed under SLUSA is not appealable to a federal circuit court, even if the order is clearlyerroneous. See also Abada v. Charles Schwab & Co., Inc., 300 F.3d 1112 (9th Cir. 2002) (explaining that

because the remand was nondiscretionary and was based on lack of subject matter jurisdiction, there was nobasis for appellate review under 28 U.S.C. § 1447(d)).

g. Federal Courts Can Issue Stays Of State Court Actions

The Uniform Standards Act also specifically gives federal courts the power to stay any private action in statecourt “as necessary in aid of its jurisdiction, or to protect or effectuate its judgments.” 15 U.S.C. § 77z-1(b)(4);15 U.S.C. § 78u-4(b)(3)(D). But see In re Transcrypt Int’l Sec. Litig., 57 F. Supp. 2d 836 (D. Neb. 1999)(refusing to stay state court discovery in individual non-class action case).

The power of federal courts to stay private actions in state courts extends to certain shareholder derivativeactions and is not limited to securities fraud actions. See In re Cardinal Health Inc. Sec. Litig., 365 F. Supp. 2d866, 873-74 (S.D. Ohio 2005) (“[T]he plain language of the [the statute is] more persuasive than its legislativehistory. Had Congress intended to limit this provision to securities fraud actions, it could have done so . . . thiscourt finds the provision, as applied to state court derivative actions, does not require a showing that the stateplaintiff intended to circumvent the PSLRA.”). Actions that are exclusively derivative fall outside the statute,however, as discussed infra.

Courts have expressed differing views on whether the discovery stay provision of SLUSA extends to actionsbrought under Section 220 of the Delaware General Corporations Code, which allows shareholders to demandcompany books and records for inspection. See City of Austin Police Ret. Sys. v. ITT Educ. Servs., Inc., No.1:04-cv-0380, 2005 U.S. Dist. LEXIS 1646, at *16-17 (S.D. Ind. Feb. 2, 2005) (“In enacting the discovery stayprovision of SLUSA, Congress chose broad language that can be adapted to a variety of state law procedures . .. [the] Section 220 action is a discovery proceeding for the purposes of [SLUSA].”). But see Cohen v. El PasoCorp., No. CIV. A. 551-N 2004, WL 2340046 (Del. Ch. Oct. 18, 2004) (holding that neither the PSLRA nor theSLUSA prevent a state court from considering a books and records demand under Section 220, merely becauseone of the parties to the state action is protected by a PSLRA automatic discovery stay in an unrelated federalsecurities action); Kaufman v. Computer Assocs. Int’l, Inc., No. Civ. A 699-N, 2005 WL 3470589, at *4 (Del.Ch. Dec. 13, 2005) (denying a motion to stay a Section 220 books and records action where a derivative actionencompassing substantially the same allegations was pending in another jurisdiction, and finding it significantthat the documents requested constituted “a relatively discrete set of papers” that had already been provided tothe government in the past).

3. Requirements For Removal

The pleading itself must contain the basis for removing the complaint under the Uniform Standards Act. SeeDesmond v. BankAmerica Corp., 120 F. Supp. 2d 1201, 1203-204 (N.D. Cal. 2000); see also U.S. Mortgage,Inc. v. Jensen, 494 F.3d 833, 843 (9th Cir. 2007) (holding “SLUSA does not prohibit amendment of thecomplaint after removal” and allowing the possibility of remand back to state court). The Uniform StandardsAct requires that the removing party prove (1) the purchase or sale of a “covered security;” (2) in connectionwith that purchase or sale, defendants misrepresented or omitted a material fact; (3) the class action sought to beremoved is a “covered class action;” and (4) the class action complaint is based on state law claims. SeeKenneth Rothschild Trust v. Morgan Stanley Dean Witter, 199 F. Supp. 2d 993, 997-98 (C.D. Cal. 2002). Seealso Segal v. Fifth Third Bank, N.A., 581 F.3d 305, 310-11 (6th Cir. 2009) (requiring courts to look behind thewords used in the complaint to determine whether the substantive allegations are of “misrepresentations,material omissions and manipulation” “in connection with the purchase or sale of a security.” A plaintiffcannot “avoid [SLUSA’s] application through artful pleading that removes the covered words from thecomplaint but leaves in the covered concepts.”); Proctor v. Vishay Intertech., Inc., 584 F.3d 1208, 1222 n. 13(9th Cir. 2009) (approving of Segal and citing several other cases for similar proposition).

a. Misrepresentation Or Omission Must Be “In Connection With” Purchase Or Sale

Of Covered Security

To be removable, the complaint must allege misrepresentations or omissions “in connection with” a purchase orsale of a covered security. See, e.g., Instituto de Prevision Militar v. Merrill Lynch, 546 F.3d 1340, 1349-50(11th Cir. 2008) (allegations that the investment fund stole rather than invested plaintiffs’ money and that fraudinduced plaintiffs to invest met the “in connection with the purchase or sale” requirement); Kingdom 5-KR-41,Ltd. v. Star Cruise PLC., No. 01 CIV. 2946(DLC), 2004 WL 444554, at *3-4 (S.D.N.Y. Mar. 10, 2004)(holding state action for unjust enrichment was sufficiently “in connection with” the sale or purchase of asecurity to justify SLUSA preemption); McCullagh v. Merrill Lynch & Co., No. 01 CIV. 7322 (DAB), 2002WL 362774, at *4 (S.D.N.Y. Mar. 6, 2002) (finding investment advice tainted by brokerage firm’s policyrequiring employees to issue buy recommendations was a misrepresentation in connection with the purchase orsale of a covered security); Korinsky v. Salomon Smith Barney, Inc., No. 01 CIV. 6085 (SWK), 2002 WL27775, at *5 (S.D.N.Y. Jan. 10, 2002) (holding misrepresentations and omissions were in connection with thepurchase or sale of a covered security where each member of the class was a person who purchased shares ofcommon stock because of allegedly misleading “buy” rating issued that day); Cf. Green v. Ameritrade, Inc.,120 F. Supp. 2d 795, 799 (D. Neb. 2000), aff’d, 279 F.3d 590 (8th Cir. 2002) (holding action not removablebecause it stated no claims for misrepresentation or omission in connection with the purchase or sale of asecurity); Gordon v. Buntrock, No. 00 CV 303, 2000 WL 556763, at *3-4 (N.D. Ill. Apr. 28, 2000) (holdingcause of action seeking lost opportunity and benefit of the bargain damages but not damages for trading lossescaused by misrepresentations was not “in connection with trades” and not covered by the Act); Burns v.Prudential Sec., Inc., 116 F. Supp. 2d 917, 923 (N.D. Ohio 2000) (holding complaint alleging breach ofcontract, breach of fiduciary duty, conversion, and negligence against employer of broker who performedunauthorized trading did not state claim “in connection with” purchase or sales); Proctor v. Vishay Intertech,Inc., 584 F.3d 1208, 1222 (9th Cir. 2009) (finding accountant’s alleged misrepresentation made beforeannouncement of tender offer, which was actual inducement to hand over shares, satisfied the “in connectionwith” element).

In Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 126 S. Ct. 1503 (2006), the Supreme Court resolved asplit between the Second and Seventh Circuits and found that SLUSA preemption applies to class actionsalleging fraudulent inducement to retain securities, ending the viability of “holding claims filed in state court ifthey otherwise fall within the scope of SLUSA pre-emption.” The Court vacated a Second Circuit decisionwhich had held that Congress intended SLUSA to apply only to traditional purchaser-seller claims meeting thestanding requirements of Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975) and not to claimsbrought by anyone other than a purchaser or seller. See Dabit v. Merrill Lynch, Pierce, Fenner, & Smith, Inc.,395 F.3d 25, 28 (2d Cir. 2005); Siepel v. Bank of Am., N.A., 239 F.R.D. 558, 569 (E.D. Mo. 2006) (holding thatSLUSA preempts state law claims despite the fact that Plaintiffs are beneficiaries, and not purchasers, sellers, orholders, of the financial accounts at issue).

In Dabit, a broker filed a class action under state law alleging that his brokerage breached a fiduciary duty to itsclients by disseminating misleading analyst research. Because of the misleading information, the clients andbrokers both continued to hold their stocks long beyond the point they would have sold had they known thetruth. Dabit, 126 S. Ct. at 1507. The Supreme Court held that Blue Chip Stamps defined the scope of a privateright of action under Rule 10b-5 but it did not define the words “in connection with the purchase or sale.” Id. at1512. The Court noted that the Second Circuit’s more restrictive interpretation of SLUSA was notunreasonable, but stated that its prior decisions regarding the meaning of the phrase in the context of Rule 10b-5had encouraged broad interpretation. Id. at 1513. Likewise, Congress intended a broad interpretation ofSLUSA: “It would be odd, to say the least, if SLUSA exempted that particularly troublesome subset of classactions from its pre-emptive sweep.” Id. at 1514. Thus, for the purposes of SLUSA preemption, the identity ofthe plaintiff as a buyer or seller was irrelevant in determining whether the complaint alleged fraud “inconnection with the purchase or sale of securities.” Id. at 1515.

Finally, courts have held that consideration for stock does not have to be cash to meet the “purchase or sale”requirement of SLUSA. See Sofonia v. Principal Life Ins. Co., 378 F. Supp. 2d 1124 (S.D. Iowa 2005) (holdingthat although the policyholders did not sell any security interests, and their mutual funds were not covered

securities, their acquisition of stock in the demutualization process, when they merged into a publicly-heldcorporation, qualifies as a “purchase” of securities under SLUSA).

b. Covered Securities

In order to be subject to the removal and dismissal provisions of SLUSA, an action must involve a “coveredsecurity.” 15 U.S.C. § 77p(c). SLUSA defines “covered security” as a security that satisfies the standards for acovered security specified in paragraph (1) or (2) of 15 U.S.C. § 77r(b), at the time during which it is allegedthat the misrepresentation, omission, or manipulative or deceptive conduct occurred (except that “coveredsecurity” does not include any debt security that is exempt from registration pursuant to rules issued by theSecurities and Exchange Commission under 15 U.S.C. § 77d(2)). 15 U.S.C. § 77p(f)(3); 15 U.S.C. § 78bb(f)(5)(E). Only those actions pertaining to the purchase or sale of the securities defined as “covered securities” bySLUSA are preempted. See U.S. Mortgage, Inc. v. Jensen, 494 F.3d 833, 844-45 (9th Cir. 2007) (holding thatwhether or not the debt instruments named in the complaint are “covered securities,” SLUSA applied becausethe harm arose from misrepresentations that coincided with the purchase or sale of public shares, which were“covered securities”).

The following cases held that a particular security or category of security was a “covered security” within themeaning of SLUSA: In Kenneth Rothschild Trust v. Morgan Stanley Dean Witter, 199 F. Supp. 2d 993, 997-98(C.D. Cal. 2002), (holding that shares in a money market fund are covered securities within the meaning ofSLUSA); Herndon Equitable Variable Life Ins. Co., 325 F.3d 1252, 1254 (11th Cir. 2003) (variable annuitiesare covered securities); Patenaude v. Equitable Life Assurance Soc’y of U.S., 290 F.3d 1020, 1025 (9th Cir.2002) (same); Lander v. Hartford Life & Annuity Ins. Co., 251 F.3d 101 (2d Cir. 2001) (same); In re LutheranBhd. Variable Ins. Prod. Co. Sales Practices Litig., 105 F. Supp. 2d 1037 (D. Minn. 2000) (variable lifeinsurance policies are covered securities); Lasley v. New Eng. Variable Life Ins. Co., 126 F. Supp. 2d 1236(N.D. Cal. 1999) (same); see also Falkowski v. Imation Corp., 309 F.3d 1123, 1126 (9th Cir. 2002) (employeestock options are covered securities); Cordova v. Lehman Brothers, Inc., 413 F. Supp. 2d 1309, 1316 (S.D. Fla.2006) (retirement trusts are covered securities).

A de-listed stock can constitute a covered security. See Cape Ann Investors LLC v. Lepone, 296 F. Supp. 2d 4,10 (D. Mass. 2003) (finding that a covered security under SLUSA is one that is traded on a national exchange atthe time of the alleged misrepresentation, not at the time the security was purchased). Cf. Madden v. Deloitte &Touche, LLP, 118 Fed. Appx. 150 (9th Cir. 2004) (rejecting argument that the common stock issued pursuant toa merger agreement was not a “covered security” under SLUSA because the shares were not listed onNASDAQ until after the alleged misrepresentation occurred).

c. Covered Class Actions

The Uniform Standards Act provides for removal of only certain covered class actions brought in state court tothe federal district court for the district in which the action is pending. The Act defines a covered “class action”as a single lawsuit in which (a) damages are sought on behalf of more than 50 persons or prospective classmembers, or (b) one or more named parties seeks to recover damages on a representative basis on behalf ofthemselves and other unnamed parties similarly situated. 15 U.S.C. § 77p(f)(2); 15 U.S.C. § 78bb(f)(5)(B).

The Uniform Standards Act also defines a covered “class action” as a “group of lawsuits filed in or pending inthe same court” in which (a) damages are sought on behalf of more than 50 persons or prospective classmembers, and (b) the “lawsuits are joined, consolidated, or otherwise proceed as a single action.” 15 U.S.C.§ 78bb(f)(5)(B) (emphasis added). See In re Worldcom, Inc. Sec. Litig., 308 F. Supp. 2d 236 (S.D.N.Y. 2004)(holding that ten identical claims of securities fraud, filed in state court and removed to federal court as relatedto a bankruptcy proceeding, were a “group of lawsuits” and constituted a “covered class action” under SLUSA);see also Amorosa v. Ernst & Young, LLP, 2009 WL 4434943, at *23 (S.D.N.Y. Nov. 30, 2009) (holding thatan action need not have been formally joined or consolidated with other actions in order to be a “covered class

action” subject to SLUSA’s preemption provision).

If a corporation, investment company, pension plan, partnership, or other entity is a plaintiff, each counts asonly one person for purposes of the Uniform Standards Act. 15 U.S.C. § 77p(f)(2)(C); 15 U.S.C. § 78bb(f)(5)(D). Courts differ on whether a trust constitutes “one person” for the purposes of defining a covered classaction. Compare Lasala v. Bordier et Cie, 519 F.3d 121, 132-34 (3d Cir. 2008) (holding a trust created in largepart to pursue claims on behalf of over 6,000 individuals should be counted as a single entity for the purposes ofthe application of SLUSA); with Cape Ann Investors, 296 F. Supp. 2d at 10 (finding that Trust representingshareholders of issuer did not fall within the Act’s definition of a unitary entity because the primary purpose ofthe Trust was to “prosecut[e] the causes of action contributed to it” and thus Trust constituted a covered class). In a similar context but with respect to the “single lawsuit” requirement, the Court in Smith v. Arthur AndersenLLP, 421 F.3d 989 (9th Cir. 2005), held that SLUSA did not apply because the plaintiff Trustee was not“established for the purpose of participating in the action” and thus the Trustee’s action was not a “singlelawsuit” barred by SLUSA.

1) Actions Seeking Damages

In order to qualify as a “covered class action” subject to removal and dismissal under SLUSA, the plaintiff mustbe seeking “damages.” See Zoren v. Genesis Energy, L.P., 195 F. Supp. 2d 598 (D. Del. 2002) (dismissing apartnership unitholder’s securities class action, which had been removed from state court, where the prayer fordamages had been dropped from the complaint after the time of removal); Rubery v. Radian Group, Inc., Civ.No. 07-1068, 2007 WL 1575211, at *2 (D. Penn. May 30, 2007) (“Plaintiff’s demand for a ‘constructive trust’is tantamount to a demand for ‘damages.’”); Feitelberg v. Merrill Lynch & Co., Inc., 234 F. Supp. 2d 1043(N.D. Cal.. 2002) (despite fact that plaintiffs sought remand on basis that disgorgement and restitution are not“damages” under 15 U.S.C. § 78bb(f)(5), court found that under federal law, these monetary remedies fallwithin the type of actions preempted by SLUSA).

2) Presence Of Uncovered Claims

Courts are divided over SLUSA’s effect on complaints that include a mixture of preempted and non-preemptedclaims. Compare Greaves v. McAuley, Fed. Sec. Rep. (CCH) ¶ 92,414 (N.D. Ga. Feb. 7, 2003) (holding thatbecause the court lacked jurisdiction over the claims affected by the Delaware carve-out, the entire action wasremanded) and In re Lord Abbett Mut. Funds Fee Litig., 463 F. Supp. 2d 505 (D.N.J. 2006) (concluding thatSLUSA does not preempt particular “claims” or “counts” but rather preempts “actions” under 15 U.S.C. §78bb(f)(1), suggesting that if any claims alleged in a covered class action are preempted, the entire action mustbe dismissed) with Falkowski v. Imation Corp., 309 F.3d 1123 (9th Cir. 2002), as amended by 320 F.3d 905(9th Cir. 2003) (finding fraud claim preempted; breach of contract claim permitted to proceed), and Gray v.Seaboard Sec., Inc., 241 F. Supp. 2d 2213 (N.D.N.Y. 2003) (considering SLUSA preemption as to each claim). See also Proctor v. Vishay Intertech., Inc., 584 F.3d 1208, 1228 (9th Cir. 2009) (holding that although removalwas not wrongful, remand of nonprecluded claims to state court is required).

3) 1933 Act Claims In State Court

The Uniform Standards Act amended Section 22(a), 15 U.S.C. § 77v(a), of the 1933 Act (the “nonremovabilityprovision” that applied to Sections 11 and 15 claims), to allow the removal of “covered class actions” arisingunder the Act:

The district courts of the United States and the United States courts of any Territory shallhave jurisdiction of offenses and violations under [the 1933 Act] and under the rules and

regulations promulgated by the Commission in respect thereto, and, concurrent with theState and Territorial courts except as provided in [15 U.S.C. § 77p] with respect to coveredclass actions. . . .

Except as provided in [15 U.S.C. § 77p(c)], no case arising under this subchapter and broughtin any State court of competent jurisdiction shall be removed to any court of the UnitedStates.

15 U.S.C. § 77v(a).

The first reported decision to consider whether SLUSA allows the removal of 1933 Act claims filed in statecourt was In re Waste Mgmt., Inc. Sec. Litig., 194 F. Supp. 2d 590 (S.D. Tex. 2002), which held that suchclaims were not removable. Several courts have followed Waste Mgmt. in holding that 1933 Act claims are notremovable under SLUSA. In Nauheim v. Interpublic Group of Cos., Inc., No. 02-C-9211, 2003 WL 1888843(N.D. Ill. April 16, 2003), the court explained that SLUSA’s removal provision only provides for removal ofcovered class actions that are “based upon the statutory or common law of any state.” Id. at *3 (citing 15U.S.C. § 77p(b)). Actions under the 1933 Act, by contrast, are based upon federal law. Id.; see also BerndBildstein IRRA v. Lazard Ltd., No. 05 CV 3388 RJDRML, 2006 WL 2375472 (E.D.N.Y. Aug. 15, 2006)(holding Securities Act claims are not removable under SLUSA); In re Tyco Int’l, Ltd., 322 F. Supp. 2d 116(D.N.H. 2004) (remanding to state court because “[n]either the text nor the legislative history of SLUSAsupport the view that cases that are based exclusively on the Securities Act [of 1933] are removable under§ 77p(c)”).

But, there are several cases that have disagreed with Waste Mgmt., holding that claims brought under the 1933Act are removable under the Uniform Standards Act. See, e.g., ; Cal. Pub. Employees’ Ret. Sys. v. WorldCom,Inc., 368 F.3d 86 (2d Cir. 2004) (holding that individual claims filed under the Securities Act, generallynonremovable claims under section 22(a), can be removed to federal court if they relate to bankruptcyproceedings); Brody v. Homestore, Inc., 240 F. Supp. 2d 1122, 1123 (C.D. Cal. 2003); see also Harold S.Bloomenthal, 3C Sec. & Fed. Corp. Law § 16:161 (2d ed. Nov. 2002) (“It is apparent that Congress intended torestrict the concurrent jurisdiction of the states in this area, and whether or not it used appropriate language todo so effect must be given to the amendment of Section 77zz.”) and Proctor v. Vishay Intertech., LLC, 584 F.3d1208, 1212, n.1 (9th Cir. 2009) (suggesting that SLUSA applies equally to ‘33 and ‘34 Acts).

Moreover, if a class action has nationwide impact, removal may be available. The Southern District of NewYork held that the broad removal authority in the Class Action Fairness Act (CAFA) supersedes the SecuritiesAct’s anti-removal provision. New Jersey Carpenters Vacation Fund v. Harborview Mortgage Loan Trust2006-4, 581 F. Supp. 2d 581, 587 (S.D.N.Y. 2008) (quoting Estate of Pew v. Cardarelli, 527 F.3d 25, 32 (2dCir. 2008) (“[r]eview of SULSA and CAFA confirms an overall design to assure that the federal courts areavailable for all securities cases that have national impact (including those that involve securities traded onnational exchange), without impairing the ability of state courts to decide cases of chiefly local import or thatconcern traditional statute regulation of the state’s corporate creatures.”)). The court examined the legislativehistory and noted that the CAFA sponsors “repeatedly emphasized the breadth of CAFA, while insisting thateach exception must be construed narrowly, such that cases with nationwide impact are to be heard in federalcourt.” Id. at 584-85. The Court held even though plaintiffs limited their claims to those under the SecuritiesAct in order to avoid removal, removal was available under CAFA as the claims stemmed from the mortgage-backed securities crises, “an issue of national, if not global, importance.” Id. at 585.

d. Scienter Pleading Requirement

Although SLUSA contains no express requirement that scienter be alleged, some courts for various reasonshave found that in order to qualify as a “covered class action” subject to removal and dismissal under SLUSA,the plaintiff’s complaint must expressly or impliedly allege “scienter” on the part of the defendant. See, e.g.,Magyery v. Transamerica Fin. Advisors, Inc., 315 F. Supp. 2d 954 (N.D. Ind. 2004) (noting that the parties had

agreed that the broker did not intend to breach the contract, but rather made the trades in question out of agenuine desire to save the client’s money, and concluding that there could be no claim of scienter and thus nopre-emption); Denton v. H & R Block Fin. Advisors, Fed. Sec. L. Rep. (CCH) ¶ 91,618 (N.D. Ill. Oct. 4, 2001)(finding financial duty claim sufficiently alleged deception to be preempted).

But, the majority of courts to address this issue have agreed that state claims need not contain an expressscienter element to be preempted. In In re Enron Corp. Sec., Derivatives & ERISA Litig., 284 F. Supp. 2d 511,642 (S.D. Tex. 2003), the district court explained that if the plaintiff can avoid SLUSA’s preemption effect bymerely omitting scienter allegations, SLUSA would be totally eviscerated; that is, if in fact the claims allegemisrepresentations or omissions or use of manipulative or deceptive devices in connection with the purchase orsale of securities and otherwise come within the purview of SLUSA, artful avoidance of those terms or scienterlanguage will not save them from preemption. See also Anderson v. Merrill Lynch Pierce Fenner & Smith,Inc., 521 F.3d 1278, 1287 (10th Cir. 2008) (holding a class action is covered under SLUSA although claimsarose under state law not requiring scienter and reliance); In re Worldcom, Inc., No. 02 Civ. 4816 DLC, 2003WL 21385870 (S.D.N.Y. June 17, 2003) (explaining that while negligence is not actionable under § 10(b),SLUSA bars more than simply state law claims requiring scienter).

The Third Circuit recently confirmed that a claim under foreign, as opposed to state, law is not preempted bySLUSA. Lasala, 519 F.3d at 138-43.

4. Exclusions Under The Uniform Standards Act

Four general categories of actions are preserved by SLUSA, including exclusively derivative actions, actions toenforce contractual agreements between issuers and indenture trustees, actions by states or their subdivisions,and certain actions under the state law of an issuer’s state of incorporation.

a. Derivative Actions Excluded

Actions that are exclusively derivative in nature are excluded from the definition of “covered class actions,”whereas three other categories of actions are explicitly “preserved” by SLUSA. 15 U.S.C. § 77p(f)(2)(B); 15U.S.C. § 78bb(f)(5)(C).

Under the plain meaning of the statute, if plaintiff labels the claim derivative, the court will consider it notpreempted. For instance, in Arlia v. Blankenship, 234 F. Supp. 2d 606, 612-13 (S.D. W. Va. 2002), thecomplaint asserted a derivative claim for breach of fiduciary duty, including a misappropriation theory ofinsider trading. Defendants argued that the complaint essentially asserted a class action claim for insidertrading which could not recover for harm to the corporation, but only to shareholders. Ultimately, the courtheld that the plain meaning of the statute exempted the claim under the “Delaware carve-out,” discussed infra,despite the fact that West Virginia law may not recognize a derivative cause of action for insider trading.

b. Actions Brought By A State

“State actions” are another category of preserved actions. SLUSA provides that “[n]otwithstanding any otherprovision of this section, nothing in this section may be construed to preclude a State or political subdivisionthereof or a State pension plan from bringing an action involving a covered security on its own behalf, or as amember of a class comprised solely of other States, political subdivisions, or State pension plans that are namedplaintiffs, and that have authorized participation, in such action.” 15 U.S.C. § 77p(d)(2); 15 U.S.C. § 78bb(f)(3)(B).

c. Trustee Actions

Also preserved are actions to enforce contractual agreements between issuers and indenture trustees. Specifically, SLUSA provides that covered class actions that “seek to enforce a contractual agreement betweenan issuer and an indenture trustee” can be brought in federal or state court “by a party to the agreement or asuccessor to such party.” 15 U.S.C. § 77p(d)(3); 15 U.S.C. § 78bb(f)(3)(C).

d. “Delaware Carve-Out”

Notwithstanding SLUSA’s broad limitation on securities class actions, SLUSA also contains a savings clause,known as the “Delaware carve-out,” which preserves certain “covered class actions.” 15 U.S.C. § 77p(d)(1)(B);15 U.S.C. § 78bb(f)(3)(A)(ii). This exception applies to certain class actions brought under the law of the statein which a corporation or other entity was incorporated or organized. To qualify for this exception, the actionmust involve (1) the purchase or sale of securities by the issuer or an affiliate of the issuer exclusively from orto holders of equity securities of the issuer; or (2) any recommendation, position, or other communication withrespect to the sale of securities of the issuer that (a) is made by or on behalf of the issuer or an affiliate or theissuer to holders of equity securities or the issuer; and (b) concerns decisions of those equity-holders withrespect to voting their securities, acting in response to a tender or exchange offer, or exercising dissenters’ orappraisal rights. 15 U.S.C. § 77p(d)(1)(A); 15 U.S.C. § 78bb(f)(3)(A)(i).

Several cases have interpreted the scope of the “Delaware carve-out.” See City of Ann Arbor Employees’ Ret.Sys. v. Gecht, No. C-06-7453 EMC, 2007 WL 760568 (N.D. Cal. Mar. 9, 2007) (holding that the secondprovision of the Delaware carve-out is not limited to misrepresentations made in connection with proposedmergers or acquisitions and finding that a proxy statement requesting shareholder approval to increase thenumber of shares of common stock authorized for issuance constituted a communication “with respect to” thesale of securities, thereby falling within the scope of the second carve-out provision); Lewis v. Termeer, 445 F.Supp. 2d 366 (S.D.N.Y. 2006) (holding Delaware carve-out applies where most plaintiffs tendered their stockto issuer but some sold to other buyers); Alessi v. Beracha, 244 F. Supp. 2d 354 (D. Del. 2003) (rejecting anarrow reading of “tender or exchange offer,” and finding that where gravamen of claim was breach of duty ofdisclosure, Congress intended matters to be entrusted to Delaware state court); Greaves v. McAuley, No. CIV A1:03-CV-0207-B, 2003 WL 21277274 (N.D. Ga. Feb. 7, 2003) (holding that majority of plaintiff’s claims wereexcluded from SLUSA under the Delaware carve-out because they involved communications to shareholdersunder the law of the state of incorporation concerning decisions whether or not to vote for the merger);Lalondriz v. USA Networks, Inc., 54 F. Supp. 2d 352, 353-54 (S.D.N.Y. 1999) (remanding class action forbreach of fiduciary duty); Derdiger v. Tallman, 75 F. Supp. 2d 322 (D. Del. 1999); Malone v. Brincat, 722 A.2d5 (Del. 1998) (holding that federal securities law did not preclude a state suit for breach of duty claims, citingthe “Delaware carve-out” of the Uniform Standards Act); see also Pace v. Bidzos, No. C 07-3742PJH, 2007WL 2908283, at *2-3 (N.D. Cal. Oct. 3, 2007) (finding action concerning a proxy statement seekingauthorization for the issuance of more stock options fell within prong “(II)” of the Delaware carve-out fromSLUSA, 15 U.S.C. § 78bb(f)(3)(A)(ii)(II), which exempts class actions that concern equity holders with respectto voting of their securities); Ind. Elec. Workers Pension Trust Fund v. Millard, No. 07 CIV. 172 JGK, 2007WL 2141697, at *5-9 (S.D.N.Y July 25, 2007) (remanding complaint to state court as claims that defendantsbreached fiduciary duties under Delaware law by making misrepresentations and failing to disclose materialfacts about an options backdating scheme fell within the Delaware carve-out; the carve out applied because thecomplaint alleged there were misrepresentations in a proxy statement sent to shareholders and because theproxy sought shareholder approval of an increase in the number of shares authorized for stock option grants—which were communications “with respect to the sale of securities”); Madden v. Cowen & Co., 576 F.3d 957,970 (9th Cir. 2009) (holding that the Delaware carve-out “allows a shareholder to bring a covered class actionunder state law against any ‘issuer’ that has made certain communications regarding the sale of its ‘securities,’and that these securities need not be … ‘covered securit[ies]’”).

1) Venue Limitation

There is legislative history suggesting that the Delaware carve-out contains a venue restriction such that for thecarve-out to apply, the suit must be brought in the courts of the state of incorporation. See H.R. Conf. Rep. No.105-803, at 13-14, n. 2 (1998); S. Rep. No. 105-182, at 6 (1998). Yet, the only courts to address this particularissue have concluded that SLUSA contains no limitation that preserved actions can be maintained only in thestate of incorporation. See Rubery v. Radian Group, Inc., Civ. No. 07-1068, 2007 WL 1575211, at *4 (D. Pa.May 30, 2007) (holding that absence of a venue provision in SLUSA demonstrates that Congress chose not torestrict venue); DeCristofaro v. The May Dep’t Stores Co., No. 4:05CV526-DJS, 2005 WL 1528260 (E.D. Mo.June 28, 2005) (holding that the statute contains no limitation that preserved actions can only be maintained inthe state of incorporation, and finding nothing susceptible to clarification or interpretation by either the HouseConference or Senate Banking Committee Reports); Gibson v. PS Holdings, Inc., No. 00-CV-0372 W(RBB),2000 WL 777818 (S.D. Cal. June 14, 2000) (explaining that nothing in the language of “Delaware carve-out”suggests that Congress intended to restrict the venue of preserved class actions to the issuer’s state ofincorporation).

2) Remand Of Improperly Removed Actions Required

If following removal from state court under either 15 U.S.C. § 77p(c) or 15 U.S.C. § 78bb(f)(2), a federal courtdetermines that the action is preserved under this savings clause, the federal court must remand the action tostate court. 15 U.S.C. § 77p(d)(4); 15 U.S.C. § 78bb(f)(3)(D).

In Superior Partners v. Chang, 471 F. Supp. 2d 750, 757-58 (S.D. Tex. 2007), the court held that SLUSArequired cases to be evaluated as a whole and remanded the entire case to state court under the “Delawarecarve-out” even though the case included some claims that would otherwise be preempted by SLUSA. Thecourt concluded that it must determine if an exception preserves the jurisdiction of state courts and, if remand isappropriate, remand the entire lawsuit even if some claims are preempted by SLUSA. Id. at 758; see also Rubinv. Reinhard, No. 08cv1820-WQH-JMA, March 29, 2009 (granting plaintiff’s motion to remand action to statecourt after removal because the class was not a covered class action subject to removal under SLUSA because itsought only equitable injunctive relief and not damages).

5. Practical Effect Of The Uniform Standards Act

Enactment of the Uniform Standards Act significantly curtailed state court shareholder actions. Some plaintiffs,however, have filed state court shareholder derivative suits that mimic parallel federal class actions, oftenclaiming that their derivative suit is evidence of a breach of fiduciary duty by the board in subjecting thecompany to liability in the class action. These cases are truly “derivative” of the class actions and rely on afinding of damages in the class actions for liability.

Plaintiffs have also attempted to use these state derivative actions as an end-run around the Reform Actdiscovery stay in their federal class actions. The Uniform Standards Act specifically provides federal courtswith the ability to prevent discovery from proceeding in any state action that is filed in an attempt to avoid thefederally-mandated discovery stay.

It is uncertain how the Uniform Standards Act impacts and/or potentially dictates the applicable statute oflimitations in federal court. In all likelihood, a state statute of limitations (typically longer) for securities claimsis pre-empted. Congress engaged in a discussion concerning whether, in some instances, a state statute oflimitations might apply to certain claims removed from state to federal court under the Uniform Standards Act. The Senate attempted to pass an amendment that would allow plaintiffs to import their state’s statute oflimitations, but the amendment failed. See 144 Cong. Rec. S4778-03, *S4804-06.

B. Securities Fraud Claims

1. Individual Actions In State Court

The Uniform Standards Act only preempts covered class actions brought under state law with 50 or moreplaintiffs. 15 U.S.C. § 77p(f); 15 U.S.C. § 78bb(f)(5). Thus, an individual or entity (or small group ofindividuals or entities) can still bring securities fraud actions pursuant to state law, and in so doing can avoidthe procedural protections of the Reform Act and capitalize upon advantageous substantive provisions of stateBlue Sky laws. Such actions are typically brought by institutional investors who sustained large losses but donot want to assume the responsibility of serving as lead plaintiff in a class action even though they haveincentive to bring an action on an individual basis, yet do not want their fate to hinge on the outcome of a classaction brought by others. Similarly, these plaintiffs can also bring separate individual actions in federal courtalleging state law claims in addition to federal claims.

While the procedural protections of the Reform Act do not apply in individual state law actions, the UniformStandards Act gives federal courts the discretion to stay discovery in any state court proceeding in order toeffectuate their judgments, providing state court defendants with some small amount of procedural cover. 15U.S.C. § 77z-1(b)(4); 15 U.S.C. § 78u-4(b)(3)(D). Defendants can take advantage of this provision, however,only in the event that a parallel federal action subject to the provisions of the Uniform Standards Act is pending.

2. Internal Affairs Doctrine

Courts have long enforced the internal affairs doctrine, under which a corporation’s internal affairs areregulated by the state in which the company is incorporated. However, after the California Court of Appealdecision in Friese v. Superior Court, the internal affairs doctrine no longer protects out-of-state corporationsand their executives from liability under California’s securities laws. 134 Cal. App. 4th 693 (2005). The Courtheld that the choice of law rule embodied in the internal affairs doctrine, as codified in California CorporationsCode Section 2116, did not prevent the plaintiffs from bringing claims against the directors and officers of aDelaware corporation under California’s insider trading laws. Id. at 709. In rejecting the applicability of theinternal affairs doctrine and Section 2116, the Friese decision relies largely on the policy argument that“California also has a legitimate and compelling interest in preserving a business climate free of fraud anddeceptive practices.” Id. at 702 (citing Diamond Multimedia Sys., Inc. v. Sup. Ct., 19 Cal. 4th 1036 (1999)).

3. California Corporations Code Section 25400

a. California’s Blue Sky Laws

California’s Blue Sky laws are codified in the Corporate Securities Law of 1968, located at CaliforniaCorporations Code Sections 25000 et seq. Three statutory schemes exist in those sections, imposing liabilityfor the following securities violations: market manipulation (Sections 25400 and 25500); false and misleadingstatements (Sections 25401 and 25501); and insider trading (Sections 25402 and 25502). Within each of theseschemes, the 25400 provisions establish the violation and the 25500 provisions establish the remedy.

1) Section 25400

Section 25400 was patterned after Section 9(a) of the 1934 Act. The provision prohibits conduct designed tomanipulate stock price. Plaintiffs predominantly rely on Section 25400(d).

Corporations Code Section 25400(d) reads, in relevant part, “[i]t is unlawful for any person, directly orindirectly, in this state … [i]f such a person is a broker-dealer or other person selling or offering for sale orpurchasing or offering to purchase the security, to make … for purpose of inducing the purchase or sale of suchsecurity by others, any statement which was … false or misleading with respect to any material fact, or which

omitted to state any material fact necessary in order to make the statements … not misleading, and which heknew or had reasonable ground to believe was so false or misleading.” Cal. Corp. Code § 25400(d).

In Diamond Multimedia Systems, Inc. v. Superior Court, the California Supreme Court resolved a disputeregarding the meaning of the statutory language “in this state,” which appears in Section 25400. The Court heldthat out-of-state purchasers or sellers of securities may seek relief under Section 25400 where the defendantsengaged in unlawful market manipulation in the state of California. Put simply, so long as the defendant’sillegal conduct occurred within “this state,” a plaintiff will have a cause of action under Section 25400 even ifplaintiff did not purchase or sell a security “in this state.” The “in this state” language defines only where theconduct must occur and does not restrict where the actual transaction must take place. See generally DiamondMultimedia Sys., Inc. v. Sup. Ct., 19 Cal. 4th 1036 (1999).

2) Elements

The elements of a Section 25400(d) claim are (1) plaintiff bought or sold stock; (2) each defendant was a personselling stock or offering to sell stock; (3) each defendant made a statement or omission regarding a material factwhich was false or misleading when made; (4) each defendant made the false statement or omission withknowledge or reasonable grounds to believe it was false or misleading; (5) each defendant made the falsestatement or omission for the purpose of inducing the purchase or sale of securities by others; and (6) eachdefendant’s false statement or omission affected the price of plaintiff’s securities. See Cal. Corp. Code§§ 25400(d), 25500; Mirkin v. Wasserman, 5 Cal. 4th 1082 (1993); People v. Corey, 35 Cal. App. 4th 717(1995); Bowden v. Robinson, 67 Cal. App. 3d 705 (1977).

Requisite Mental State. According to the California Supreme Court, “liability under section 25400 attach[es]only if a person omits a material fact for the purpose of inducing the sale or purchase of the stock withknowledge that the omission was false or misleading.” Diamond Multimedia Sys., 19 Cal. 4th at 1048, n.13.

Materiality. The standard for materiality is the same as under Section 10 of the 1934 Act. Ins. UnderwritersClearing House, Inc. v. Natomas Co., 184 Cal. App. 3d 1520, 1526 (1986) (“A fact is material if there is asubstantial likelihood that, under all circumstances, a reasonable investor would consider it important inreaching an investment decision.”).

3) Reliance

The California Supreme Court has suggested, in dicta, that proving actual reliance to establish liability under25400 is not required. Mirkin v. Wasserman, 5 Cal. 4th 1082, 1102 (1993).

4) Privity

According to dicta in Mirkin, privity is not required under Section 25400. Id. at 1104.

5) Section 25500

The availability and amount of damages in a private Section 25400 claim is governed by Section 25500. Section 25500 provides that “[a]ny person who willfully participates in any act or transaction in violation ofSection 25400 shall be liable to any other person who purchases or sells any security at a price which wasaffected by such act or transaction for the damages sustained by the latter as a result of such act or transaction.”

The court in California Amplifier, Inc. v. RLI Ins. Co., 94 Cal. App. 4th 102, 112 (2001) interpreted the phrase“willfully participates” to limit Section 25500 liability to situations where there is an intent to defraud through aknowingly false statement. “Only persons who willfully, not merely recklessly, violate Section 25400,subdivision (d) can be liable for damages.” Id. In other words, a violation of Section 25400, by itself, is notsufficient to give rise to Section 25500 liability. Moreover, the court interpreted the “in violation of Section25400” requirement to mean that civil liability for damages could not be based on conduct which did not, byitself, also violate Section 25400. Id. at 113.

4. California Business And Professions Code Sections 17200 and 17500

Plaintiffs may attempt to bring a securities action pursuant to Sections 17200 and 17500 of the CaliforniaBusiness and Professions Code (“Unfair Competition Law” or “UCL”). The broad proscriptions of sections17200 and 17500 are designed to protect individuals from unlawful, unfair or fraudulent business practices andfrom statements that are untrue or misleading. See Myers v. Merrill Lynch & Co., No. C-98-3532 WHO, 1999WL 696082 (N.D. Cal. Aug. 23, 1999), aff’d, 249 F.3d 1087 (9th Cir. 2001). Section 17200 defines “unfaircompetition” to “include any unlawful, unfair, or fraudulent business act or practice and unfair deceptive,untrue or misleading advertising.” Cal. Bus. and Prof. Code § 17200.

California law previously authorized any person acting for the general public to sue for relief from unfaircompetition. Bus. & Prof. Code § 17204, as amended by Prop. 64, § 3; see also Comm. On Children’sTelevision, Inc. v. Gen. Foods Corp. (1983) 35 Cal. 3d 197, 211. Cf. Stop Youth Addiction, Inc. v. Lucky Stores,Inc., 17 Cal. 4th 553, 561 (1988). After Proposition 64, which voters approved at the November 2, 2004General Election, a private person has standing to sue only if he or she “has suffered injury in fact and has lostmoney or property as a result of such unfair competition.” Bus. & Prof. Code § 17204, as amended by Prop.64, § 3; see also Bus. & Prof. Code § 17203, as amended by Prop. 64, § 2. By heightening the standingrequirements, the tension between state and federal courts regarding plaintiffs’ standing and ability to form aclass has been eased because it is well-established that federal courts must look to the Article III constitutionaland prudential limitations on standing in order to determine their jurisdiction. See Mangini v. R.J. ReynoldsTobacco Co., 793 F. Supp. 925, 929 (N.D. Cal. 1992); see also Lippitt v. Raymond James Fin. Servs. , Inc., 340F.3d 1033 (9th Cir. 2003).

Whether the UCL even applies to claims for violations of the securities laws is open to considerable doubt. InBowen v. Ziasun Technologies, Inc., 116 Cal. App. 4th 777, 788 (2004), for example, the court describedSection 17200 as a “little FTC Act” and cited cases from 15 other jurisdictions holding that their little FTC Actsdo not apply to securities transactions in concluding that Section 17200 should be viewed in the same way. See,e.g., Spinner Corp. v. Princeville Dev. Corp., 849 F.2d 388 (9th Cir. 1988) (Hawaii law). See also, Williams v.Deutsche Bank Sec., Inc., 2005 U.S. Dist. LEXIS 12121 at * 29-31 (S.D.N.Y. 2005); Scognamillo v. CreditSuisse First Boston LLC, 2005 U.S. Dist. LEXIS 20221 at * 36-37 (N.D. Cal. 2005). Other cases, however,have distinguished or disagreed with Bowen and its progeny. See, e.g., Overstock.com, Inc. v. GradientAnalytics, Inc., 151 Cal. App. 4th 688, 714-16 (2007) (Bowen limited to actual securities transactions and doesnot prevent UCL from applying to allegedly false analyst reports); Benson v. JP Morgan Chase Bank, N.A.,2010 U.S. Dist. LEXIS 37465 at * 19-28 (N.D. Cal. 2010) (UCL applies to aiding and abetting securitiesfraud); Strigliabotti v. Franklin Resources, Inc., 2005 U.S. Dist. LEXIS 9628 at * (N.D. Cal. 2005) (UCLapplies to scheme to overcharge for management of securities); In re Charles Schwab Corp. Sec. Litig., 257F.R.D. 534, 553 (N.D. Cal. 2009) (UCL applies to claim of misrepresenting risk profile of mutual fund assetsand improperly changing fund’s investment policies); see also, Roskind v. Morgan Stanley Dean Witter & Co.,80 Cal. App. 4th 345, 354-55 (2000) (pre-Bowen decision holding that federal securities laws do not preemptUCL).

5. California Civil Code Sections 1709 And 1710

Plaintiffs alleging securities fraud violations often bring additional claims under California law for the tort ofdeceit, California Civil Code Sections 1709 and 1710. Civil Code Section 1709 provides that “one who

willfully deceives another with intent to induce him to alter his position to his injury or risk, is liable for anydamage which he thereby suffers.” Civil Code Section 1710 offers three definitions of deceit that may pertainto securities fraud actions: “(1) the suggestion, as a fact, of that which is not true, by one who does not believeit to be true; (2) the assertion, as a fact, of that which is not true, by one who has no reasonable ground forbelieving it to be true; (3) the suppression of a fact, by one who is bound to disclose it, or who givesinformation of other facts which are likely to mislead for want of communication of that fact.” Cal. Civ. Code§§ 1709-10.

Even though the deceit statutes do not mention “reliance,” plaintiffs must plead and prove they actually reliedon the alleged misrepresentation to prevail on a deceit claim. See Mirkin v. Wasserman, 5 Cal. 4th 1082, 1092(1993). In Mirkin, the California Supreme Court declined to enlarge the scope of the law of deceit by includingthe fraud-on-the market doctrine. Id. at 1101-102.

6. Common Law Fraud And “Holding” Claims

Section 25510 of California’s Corporate Securities Law states “nothing in this chapter shall limit any liabilitywhich may exist by virtue of any other statute or under common law if this law were not in effect.” Cal. Corp.Code § 25510. California courts have thus recognized actions alleging common law fraud in the securitiesfield. See, e.g., Greenfield v. Fritz Cos., Inc., 82 Cal. App. 4th 741 (2000), rev’d sub nom. Small v. Fritz Cos.,30 Cal. 4th 167 (2003).

A plaintiff can recover in a common law securities fraud action if the trier of fact concludes: (1) the defendantmade a misrepresentation; (2) the misrepresentation concerned a matter of fact; (3) the misrepresentation wasmaterial to the shareholder’s decision; (4) the misrepresentation was actually received by the shareholder;(5) the shareholder relied on the misrepresentation; (6) the shareholder’s reliance was justified; and (7) themisrepresentation was the proximate cause of damage to the shareholder. See id.

Unlike the federal and state regulatory schemes that focus on sales or purchases of securities, California courtspermit a plaintiff who simply held his or her shares to bring a common law fraud action. The court inGreenfield, for example, recognized as valid plaintiff’s argument that the defendants made misrepresentationswhich induced him to continue holding shares of the corporation that he otherwise would have sold. Id. Inaddition, the California Supreme Court ruled that a stockholder who held shares in reliance on fraud ormisrepresentation may sue under state law. While acknowledging that the PSLRA and SLUSA limitshareholder actions, the court wrote that it “recognize[s] the danger that shareholders may bring abusive andnonmeritorious suits to force a settlement … but [the court does] not view that danger as justifying outrightdenial of all shareholders’ causes of action.” Small v. Fritz Cos., 30 Cal. 4th 167, 180 (2003). As a practicalmatter, cases like Small are unlikely ever to proceed as class actions, inasmuch as reliance will inevitably be apredominating individual issue. Instead, the plaintiff in Small voluntarily dismissed his case when forced toconcede that he could not allege reliance even on an individual, let alone classwide, basis.

Other states have rejected “holder” cases in their entirety or severely limited them. See, e.g., Starr Found. v.AIG, Inc., 76 A.D. 3d25 (N.Y. App. 2010), and cases cited therein; Holmes v. Grubman, 286 Ga. 636 (2010)(holder claims for common law fraud or negligent misrepresentation available only to those who can proveactual reliance to their detriment on a direct communication); Dloogatch v. Brincat, 396 Ill. App. 842 (2009)(affirming dismissal of holder claim for failure to adequately plead either specific reliance or damage, andnoting that holder claims “present potential for windfall to plaintiffs profiting from fraud-inflated stock prices”).

C. Shareholder Derivative Actions

With increasing frequency, plaintiffs are filing shareholder derivative actions as tag-alongs to securitieslawsuits. Plaintiffs often base these derivative actions on one or both of the following theories: (1) themisconduct alleged in the securities litigation complaint injured not only the shareholders individually but alsocaused a derivative injury to the corporation and shareholders as a whole, and (2) the filing of the securities

lawsuit itself resulted in an injury to the corporation and shareholders as a whole.

1. Definition

A shareholder derivative action is a lawsuit brought by a shareholder on behalf of the corporation seeking torecover corporate losses typically suffered as a result of the corporation’s directors and officers failing to actproperly. See Elf Atochem N. Am., Inc. v. Jaffari, 727 A.2d 286, 293 (Del. 1999) (explaining derivative form ofaction permits an individual shareholder to bring suit to enforce a corporate cause of action against officers,directors, and third parties); Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984) (noting the derivative suit is apotent tool to redress the conduct of a “torpid or unfaithful management”), overruled in part on other groundsby Brehm v. Eisner, 746 A.2d 244 (Del. 2000). The shareholder derivative action developed in equity to enableshareholders to sue in the corporation’s name where those in control of the corporation refused to assert a claimbelonging to it. Aronson, 473 A.2d at 811. A derivative action has two goals: (1) it is a suit by theshareholders to compel the corporation to sue, and (2) it is a suit by the corporation, asserted by theshareholders on its behalf, against those liable to it. Ala. By-Products Corp. v. Cede & Co., 657 A.2d 254, 264-65 (Del. 1995); Brown v. Tenney, 532 N.E. 2d 230, 232 (Ill. 1988) (explaining derivative suit contains twoactions, “one against the directors for failing to sue, the second based upon the right belonging to thecorporation”).

The distinction between direct and derivative claims can be blurry, and the same set of facts may arguably giverise to both types of actions. See Grimes v. Donald, 673 A.2d 1207 (Del. 1996), overruled in part on othergrounds by Brehm, 746 A.2d 244. Generally, a derivative action lies where the injury is to the corporation orshareholders as a whole, such as the destruction or depletion of corporate assets or a reduction in the value ofcorporate stock. See, e.g., Vogel v. Jobs, No. C 06-5208 JF, 2007 WL 3461163, at *3 (N.D. Cal. Nov. 14,2007) (holding that allegations of backdating are properly characterized as derivative where the plaintiffs’injuries are not unique or independent of any harm done to the corporation, and therefore a corporateoverpayment claim could be recognized as both derivative and direct in character, but only where (1) themajority shareholder causes the corporation to issue him “excessive” shares for inadequate compensation, and(2) the effect of the exchange is to simultaneously increase the shareholder’s percentage of outstanding shareswhile decreasing the percentage owned by minority shareholders); Clifton v. Vista Computer Serv., LLC, No. 01CIV. 10206 (JSM), 2002 WL 1585550, at *6 (S.D.N.Y. July 16, 2002) (“Delaware law is clear that whenplaintiff’s injury is that the defendant’s actions reduced the value of their stock and stock options, the remedy isa shareholder derivative action.”). Where the injury is a breach of rights traditionally belonging to theshareholder as an individual or member of the corporation, the injury is non-derivative. In diversity actionsbrought in federal court, state law determines whether the action is direct or derivative. See Sax v. World WidePress, Inc., 809 F.2d 610, 613 (9th Cir. 1987); Galef v. Alexander, 615 F.2d 51, 58 (2d Cir. 1980); see alsoKrinsk v. Chiron Corp., 2009 WL 1654569 (Cal. Ct. App. June 11, 2009) (holding that, because a shareholder’sloss of stock value as a result of corporate mismanagement is deemed to be merely incidental to corporateinjury, such a loss supports only a derivative action, not a direct action). In contrast, for procedural issuesgoverning a derivative action, a federal court sitting in diversity will apply Federal Rule of Civil Procedure 23.1rather than any inconsistent state rules. See, e.g., Kona Enters., Inc. v. Estate of Bishop, 179 F.3d 767, 769 (9thCir. 1999) (reasoning that because Federal Rule 23.1’s continuous share ownership requirement is procedural, itapplies in diversity proceedings).

2. Standing

a. Shareholder Requirements

In order to have standing to bring a derivative suit, a plaintiff must be a shareholder both at the time the actionis filed and at the time of the transaction being challenged. See Cal. Corp. Code § 800(b)(1); Del. Gen. Corp.Law § 327; Kona Enters., Inc. v. Estate of Bishop, 179 F.3d 767, 769-70 (9th Cir. 1999); Ryan v. Gifford, 918A.2d 341, 359 (Del. Ch. 2007) (finding that plaintiff lacked standing to challenge backdated options granted

before he acquired shares, even though backdated grants were made after he became a shareholder). In otherwords, a plaintiff must have both “contemporaneous and continuous” ownership of the company’s stock inorder to have standing to bring a derivative claim. Therefore, a plaintiff cannot bring a suit if he purchasedshares after the transaction occurred. See In re Bank of N.Y. Derivative Litig., 173 F. Supp. 2d 193, 197(S.D.N.Y. 2001), aff’d, 320 F.3d 291 (2d Cir. 2003); Brambles USA, Inc. v. Blocker, 731 F. Supp. 643 (D. Del.1990).

b. Effect of Merger

One result of the continuous ownership requirement is that plaintiffs lose their derivative standing when theysell their stock as part of a merger. See In re Mercury Interactive Corp. Derivative Litig., 487 F. Supp. 2d 1132,1136 (N.D. Cal. 2007) (applying the “continuous ownership” doctrine to find that consolidated plaintiffs losttheir standing after defendant’s cash-out merger and refusing to find equitable “merger exception” to thecontinuous ownership doctrine because no evidence indicated there was fraud in the merger.); In reCountrywide Fin. Corp. Derivative Litig., 581 F. Supp. 2d 650 (D. Del. 2008) (recognizing the established rule“that a shareholder in a derivative lawsuit loses standing post-merger because he can no longer satisfy thecontinuous ownership rule.”) The only exceptions to the continuous ownership rule are: (1) where the mergeritself is the subject of a fraud claim, or (2) where the merger is actually a reorganization which does not affectthe plaintiff’s ownership. Id. at 652.

c. Choice Of Law

The standing issue will normally be decided by the laws of the state in which the company is incorporated, notthe state in which the suit is brought. In early 2008, California’s Supreme Court held that California, likeDelaware, requires both contemporaneous and continuous ownership as prerequisites for standing to bring aderivative suit. See Grosset v. Wenaas, 175 P.3d 1184 (Cal. 2008); see also In re Mercury Interactive Corp.Derivative Litig., No. 1-05-CV-050710, at *3-4 (Cal. Super. Ct., Feb. 5, 2007) (holding that a determination ofstanding to sue in a derivative action is decided by the laws of the state of incorporation and that a cash buy-outof shareholders deprived shareholder plaintiffs of standing to bring a derivative suit under Delaware’s“continuous ownership” doctrine).

d. Fair And Adequate Representation

Federal Rule of Civil Procedure 23.1 provides that a plaintiff must fairly and adequately represent the interestsof the corporation. See Salovaara v. Jackson Nat’l Life Ins. Co., 66 F. Supp. 2d 593, 602-3 (D.N.J. 1999), aff’d,246 F.3d 289 (3d Cir. 2001). In In re JPMorgan Chase & Co. S’holder Derivative Litig., No. 08 CIV. 974(DLC)., 2008 WL 4298588 (S.D.N.Y. Sept. 19, 2008), the court granted the defendants’ motion to dismiss afterfinding that the lead plaintiff was a “professional plaintiff” who could not be relied on to protect the interest ofother shareholders. The court held that the requirement of fair and adequate representation in the derivativecontext is analogous to the requirement for a representative party in a class action and expressed concern thatthe lead plaintiff had “lent his name as a favor to his friend and colleague” in many previous lawsuits. Id. at *7-12

e. Security

A minority of states, including California and New York, require the plaintiff to post a security in those caseswhere the plaintiff owns less than a specified percent or number of shares of stock in the corporation. See N.Y.Bus. Corp. Law § 627; Cal. Corp. Code § 800(d); see also In re Westinghouse Sec. Litig., 832 F. Supp. 989,1002 (W.D. Pa. 1993). The security generally covers litigation expenses the corporation may incur, including

attorneys’ fees.

3. Demand Requirement

Before bringing a derivative suit, the shareholder must first make a demand on the board that the board bringsuit itself. Under Federal Rule of Civil Procedure 23.1(b)(3), a derivative plaintiff must allege withparticularity “any effort by the plaintiff to obtain the desired action from the directors or comparableauthority … and the reasons for not obtaining the action or not making the effort.” See also Cal. Corp. Code§ 800(b)(2); Del. Ch. Ct. R. 23.1. Pre-suit demand requirements and the demand futility exceptions aregoverned by the law of the state of incorporation. Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 108-109(1991); see also Henik v. LaBranche, 433 F.2d 372, 377 (S.D.N.Y. 2006).

The demand requirement is not merely a “technical pleading hurdle” but is based on the “fundamental tenet ofAmerican corporate law that places the responsibility for making decisions in the hands of the board ofdirectors” rather than with individual shareholders. Johnson v. Hui, 752 F. Supp. 909, 911 (N.D. Cal. 1990). The purpose of the requirement is to “encourage intracorporate resolution of disputes and to protect themanagerial freedom of those to whom the responsibility of running the business is delegated.” Shields v.Singleton, 15 Cal. App. 4th 1611, 1619 (1993); see also Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 101(1991) (“The purpose of requiring a precomplaint demand is to protect directors’ prerogative to take overlitigation or to oppose it.”); Garber v. Lego, 11 F.3d 1197, 1201 (3d Cir. 1993) (explaining that the decision tobring a lawsuit or refrain from litigating a claim on behalf of the corporation is a decision concerning themanagement of the corporation and consequently is the responsibility of the directors); Spiegel v. Buntrock, 571A.2d 767, 773 (Del. 1990) (“The purpose of pre-suit demand is to assure that the stockholder affords thecorporation the opportunity to address an alleged wrong without litigation, to decide whether to invest theresources of the corporation in litigation, and to control any litigation which does occur.”).

4. Pleading Demand Futility

a. Burden

Plaintiff bears the burden of alleging that demand would be futile. In re Abbott Labs. Deriv. S’holders Litig.,141 F. Supp. 2d 946, 950 (N.D. Ill. 2001), rev’d on other grounds, 325 F.3d 795 (7th Cir. 2003) (dismissingcomplaint for failure to plead demand futility in part because while the “complaint alleges that the auditcommittee should have uncovered certain problems” it fails to “specify what was reported to them or how theywould have discovered those problems”); In re Baxter Int’l, Inc. S’holders Litig., 654 A.2d 1268, 1269-71 (Del.1995) (filing a complaint that “does not plead with particularity what obvious danger signs were ignored orwhat additional measures the directors should have taken” does not excuse the demand requirement where thecomplaint alleges that defendants violated their fiduciary duties to exercise reasonable care in the oversight andsupervision of corporate affairs and management).

Demand can only be excused in the exceptional case where a plaintiff pleads concrete facts “with particularity”to demonstrate that tendering a demand would have been “futile.” Del. Ch. Ct. R. 23.1; see also Cal. Corp.Code § 800(b)(2); In re Computer Scis. Corp. Derivative Litig., No. CV 06-05288 MRP, 2007 WL 2274951, at*7-8 (C.D. Cal. July 24, 2007) (finding that complaint was insufficient where it failed to plead particularizedfacts showing how each individual director was interested); In re Pfizer Inc. Derivative Sec. Litig., 503 F. Supp.2d 680, 685 (S.D.N.Y. 2007) (finding that directors did not have a “substantial likelihood” of being liablebecause company’s charter exempted directors from personal liability); see, e.g., Kalin v. Xanboo, Inc., No. 04-CV-5931 (KMK), 2007 WL 273546, at *14-16 (S.D.N.Y. Jan. 16, 2007) (holding that merely informing theboard of the intention to bring a derivative action, followed by a refusal by the board to take such action, doesnot fulfill the demand requirement); In re CNET Networks, Inc. S’holder Derivative Litig., 483 F. Supp. 2d 947,965 (N.D. Cal. 2007) (holding that mere membership on a compensation committee does not establish that themembers knew the true grant date of a backdated option).

In Brehm, the Delaware Supreme Court reaffirmed plaintiff must plead particularized facts to make the showingof demand futility, not “conclusory statements or mere notice pleading.” Brehm v. Eisner, 746 A.2d 244, 254(Del. 2000); see also Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984), overruled in part on other grounds byBrehm, 746 A.2d at 244 (demand will be excused as futile only where (1) the facts alleged with particularitycreate a reasonable doubt that the directors’ action was entitled to the protection of the business judgment ruleand (2) the stockholder alleges with particularity that demand would be futile); Ryan v. Gifford, 918 A.2d 341,354-56 (Del. Ch. 2007) (finding demand futility in an options backdating case under the second prong of theAronson test because one half of the board members served on the compensation committee that approved eachtransaction. The court also found demand to be futile under Rales because approval of backdating of optionsqualifies as one of those “rare cases [in which] a transaction may be so egregious” that board approval cannotmeet the business judgment rule test).

Courts consider demand futile where the directors are incapable of making an impartial decision because ofpersonal interest or bias or cannot properly exercise their business judgment in determining whether to bring thelitigation. Rales v. Blasband, 634 A.2d 927, 932 (Del. 1993). See, e.g. In re Zoran Corp. Derivative Litig., 511F. Supp. 2d 986 (N.D. Cal. 2007) (holding that demand on the board was futile because all board membersreceived backdated stock options and because the directors might have been forced to disgorge their profitsfrom the backdated options or face legal exposure, they were interested and demand was futile). See id. at1002-03, 1008-09.; In re Countrywide Fin. Corp. Derivative Litig., 554 F. Supp. 2d 1044, 1081-82 (C.D. Cal.2008) (applying Rales and finding demand futility based on the fact that the board had oversight responsibilitiesand failed to exercise them, thereby supporting a finding that they were “interested” due to potential liability). But see In re MIPS Tech., Inc. Derivative Litig., No. C06-06699RMW, 2008 WL 131915 (N.D. Cal. Jan. 11,2008) (following Beam v. Stewart, 845 A.2d 1040, 1048-49 (Del. 2004)), and finding directors’ membership onaudit and compensation committee, without more, was insufficient to adequately plead demand futility in astock options backdating case); In re Infosonics Derivative Litig., No. 06CV1336 BTM, 2007 WL 2572276, at*7-8 (S.D. Cal. Sept. 4, 2007) (finding Maryland law’s stricter requirements for establishing demand futilitywere not satisfied because plaintiffs “have not come forward with specific facts demonstrating that when facedwith a demand, the directors would not act in the best interests of InfoSonics,” and noting even though themajority of directors approved or participated in the backdating, they could seek the advice of a speciallitigation committee or even accede to the demand); In re VeriSign Derivative Litig., No. C 06-4165 PJH, 2007WL 2705221, at *11-14 (N.D. Cal. Sept. 14, 2007) (finding that plaintiffs failed to plead demand futility withparticularity because executives’ receipt of benefits from backdated options did not show that the board wasinterested under the Rales test, and rejecting plaintiffs’ argument that demand would have been futile becausethe board was “hopelessly conflicted” by its participation in the backdating).

In addition, the Ninth Circuit recently held that “before a demand letter can properly invoke a duty…to takeaction…the board is entitled to know with specificity the identity of the person making the demand.” Potter v.Hughes, 546 F.3d 1051, 1057-58 (9th Cir. 2008). Affirming the dismissal of a complaint for failure to meet thedemand requirement where the demand was anonymous, the court explained that “the identity of thecomplaining shareholder may shed light on the veracity or significance of the facts alleged in the demand letter,and the Board might properly take a different course of action depending on the shareholder’s identity.” Id.

b. Must Be Pled Without The Benefits Of Discovery

Plaintiffs are not entitled to discovery to assist them in complying with particularized pleading requirements. See Scattered Corp. v. Chi. Stock Exch., Inc., 701 A.2d 70, 77 (Del. 1997), overruled in part on other groundsby Brehm v. Eisner, 746 A.2d 244 (Del. 2000); see also Gonzales Turul v. Rogatol Distrib., Inc., 951 F.2d 1, 3(1st Cir. 1991) (“[S]hareholder may not plead in general terms, hoping that, by discovery or otherwise, [s]hecan later establish a case.”); Teachers Ret. Sys. v. Welch, 244 A.D.2d 231, 232 (N.Y. App. Div. 1997). Toallow a plaintiff shareholder discovery before the plaintiff survives a motion to dismiss would be a completeabrogation of the requirement that the plaintiff plead particularized facts. See Levine v. Smith, 591 A.2d 194,210 (Del. 1991), overruled in part on other grounds by Brehm, 746 A.2d 244. But see In re Merck & Co. Sec.,

Derivative & ERISA Litig., 493 F.3d 393, 402 (3d Cir. 2007) (“The general rule that discovery may not be usedto supplement demand futility allegations has no applicability in a case where the parties voluntarily agree topermit discovery to go forward on the one area that has particular import for the motion to dismiss.”); In re PSE& G S’holder Litig., 718 A.2d 254, 261 (N.J. Super. Ct. Ch. Div. 1998), aff’d, 801 A.2d 295 (N.J. 2002)(limited discovery permitted on very narrow issue of what steps directors took to inform themselves ofshareholder demand and reasonableness of its decision); Brehm, 746 A.2d at 249 (holding plaintiffs may meettheir pleading burden by relying on “the tools at hand,” external sources of information, such as media reportsand corporate regulatory filings). Shareholder-plaintiffs may also invoke their inspection rights to obtain pre-demand access to corporate books and records.

5. Standard For Board Action

Delaware Courts have used two tests for evaluating the sufficiency of a plaintiff’s allegations of demandfutility. The Aronson test applies where the complaint challenges board action which has allegedly resulted inharm to the company. In cases challenging board inaction such as allegations of inadequate supervision, theRales test applies.

a. Challenges To Board Action

Under the predominant Aronson test, the court must analyze “whether under the particularized facts alleged, areasonable doubt is created that: (1) the directors are disinterested and independent [or] (2) that challengedtransaction was otherwise the product of a valid exercise of business judgment.” Aronson v. Lewis, 473 A.2d805, 814 (Del. 1984), overruled in part on other grounds by Brehm, 746 A.2d 244; In re Linear Tech. Corp.Derivative Litig., No C-06-3290 MMC, 2006 WL 3533024, at *3 (N.D. Cal. Dec. 7, 2006) (merely citingsuspiciously timed option grants is insufficient to demonstrate that directors are disinterested and lackindependence for purposes of showing demand futility in stock option backdating cases).

b. Challenges To Board Inaction

The other test, the Rales test, applies in situations in which no affirmative board action is challenged, but thecomplaint alleges a failure to act or oversee or inadequate internal controls. Because no affirmative act exists toafford the presumption of the business judgment rule, the court considers only the disinterestedness of theboard. See Rales v. Blasband, 634 A.2d 927, 933 (Del. 1993). In such instances, Delaware courts apply onlythe first prong of the Aronson standard and evaluate “whether or not the particularized factual allegations of aderivative stockholder complaint create[s] a reasonable doubt that, as of the time the complaint is filed, theboard of directors could have properly exercised its independent and disinterested business judgment inresponding to a demand.” Id.; Compare Ryan v. Gifford, 918 A.2d 341, 352-353 (Del. Ch. 2007) (holding theAronson test applied even though allegations at issue were of board inaction, because a committee of the boardconsisting of half of the board actively approved stock grants) with In re Finisar Corp. Derivative Litig., No. C-06-07660 RMW, 2008 WL 131867 (N.D. Cal. Jan. 11, 2008) (following Ryan, but ultimately applying Ralesbecause only three of the company’s seven directors were on the compensation committee during the allegedbackdating).

6. Responding To The Demand

Once a demand is made, the amount of time the corporation has to make a decision will “vary in directproportion to the complexity of the technological, quantitative, and legal issues raised by the demand.” Allisonex rel. Gen. Motors Corp. v. Gen. Motors Corp., 604 F. Supp. 1106, 1117-18 (D. Del.), aff’d, 782 F.2d 1026(3d Cir. 1985); see also Stallworth v. AmSouth Bank, 709 So. 2d 458, 463 (Ala. 1997) (holding shareholdermust allow board sufficient time to act once presented with the demand). The board has the option of bringing

suit, resolving the dispute through alternative methods, or rejecting the demand. Harhen v. Brown, 730 N.E.2d859, 865 (Mass. 2000). However, the board cannot remain neutral; the board must make a decision. Spiegel v.Buntrock, 571 A.2d 767, 767 (Del. 1990).

a. Acceptance Of Demand

If the board accepts the demand, the board takes control of the litigation and “places the resources of thecorporation, including its information, personnel, funds and counsel behind the suit.” Daily Income Fund, Inc.v. Fox, 464 U.S. 523, 533 (1984).

b. Rejection Of Demand

If the board believes the suit is not in the best interest of the corporation, the board may reject the demand. After the board rejects the demand, the shareholder must show that the rejection was wrongful beforeproceeding. See Stepak v. Addison, 20 F.3d 398 (11th Cir. 1994); Miller v. Thomas, 656 N.E.2d 89 (Ill. 1995). The board’s decision is evaluated under the business judgment rule. See Mount Moriah Cemetery ex rel. Dun &Bradstreet Corp. v. Moritz, No. CIV. A. 11431, 1991 WL 50149, at *3 (Del. Ch. Apr. 4 1991), aff’d, 599 A.2d413 (Del. 1991) (“[T]he business judgment rule is used in reviewing a board’s refusal to act pursuant to astockholder demand.”). Therefore, the shareholder has the burden “to rebut the [business judgment rule]presumption by introducing either evidence of director self-interest, if not self-dealing, or that the directorseither lacked good faith or failed to exercise due care.” Williams v. Grier, 671 A.2d 1368, 1376 (Del. 1996). But see Levine v. Smith, 591 A.2d 194, 212 (Del. 1991) (finding that by making a demand, plaintiffs concedethe independence and disinterestedness of the board). The board’s decision is given great deference. SeeParamount Commc’ns, Inc. v. QVS Network, Inc., 637 A.2d 34, 45 (Del. 1994). In general, successful plaintiffscounter the board’s rejection of the demand by showing that the business judgment rule does not apply becausethe board lacked good faith, due care or independence, or was under the influence of an improper party.

c. Demand Deferred

The Ninth Circuit has upheld a district court decision allowing the corporation to defer final response to ashareholder demand if responding to the demand could subject the company to additional liability. In Furmanv. Walton, 320 Fed. Appx. 638, 2009 WL 784261 (9th Cir. 2009), the shareholder plaintiff demanded that theboard investigate certain employment practices that formed the base of a class action lawsuit against thecompany. The board determined that investigating the claims prior to the conclusion of the class action couldconstitute harmful admissions, potentially exposing the company to a multi-million dollar judgment. The NinthCircuit, agreeing with the district court, held that this was a rational business decision, afforded the protectionsof the business judgment rule, and allowed the company to postpone its response to the demand. Id.

7. Special Litigation Committees

The board may delegate the responsibility for investigating the demand to a special litigation committee. Oncethe investigation is complete, the committee must make a report and recommendation to the board. Seminarisv. Landa, 662 A.2d 1350 (Del. 1995). By establishing a special litigation committee, the board may beconceding its lack of independence. See Abbey v. Computer & Commc’ns Tech. Corp., 457 A.2d 368 (Del.1983). Cf. Spiegel v. Buntrock, 571 A.2d 767 (Del. 1990) (explaining delegating decision to a special litigationcommittee does not ipso facto waive board’s right to challenge plaintiff’s allegations); Peller v. Southern Co.,911 F.2d 1532 (11th Cir. 1990); Seminaris, 662 A.2d at 1350.

Most courts hold that a special litigation committee may terminate pending derivative litigation even when theplaintiff has been excused from making a demand. See Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981);

Auerbach v. Bennett, 393 N.E.2d 994 (N.Y. 1979). However, to do so effectively, the committee must have theauthority to make a binding decision itself without full board approval. In re Par Pharm., Inc. Derivative Litig.,750 F. Supp. 641, 646 (S.D.N.Y. 1990). As such, a special litigation committee should have full authority tomake decisions on behalf of the board. Toward that end, the members of the committee should all beindependent and disinterested. Lewis v. Fuqua, 502 A.2d 962, 966 (Del. 1985). Further, the committeemembers ought not to be closely affiliated with potential defendants. Id. Finally, while one-membercommittees are sometimes permissible, a special litigation committee should generally have two or moremembers. The members should be qualified to deal with the complexity of the issues involved.

The committee should also hire independent counsel to advise and assist in the litigation. See In re Par Pharm.,750 F. Supp. at 647. However, where there is evidence that the board was grossly negligent or unreasonable inits selection of independent counsel, the directors’ decision to refuse the shareholder’s demand will not beafforded the protection of the business judgment rule. See Stepak v. Addison, 20 F.3d 398, 406 (11th Cir. 1994)(pleading that a conflicted law firm unduly influenced a board’s decision raised a reasonable doubt that theboard’s decision was informed and protected by the business judgment rule).

A SLC’s decision to terminate the litigation will likely be evaluated based on the totality of the circumstances. Recently, the Northern District of California denied a special litigation committee’s motion to terminate aderivative lawsuit in a stock option backdating case, based on an evaluation of “the totality of thecircumstances, including the size of the SLC, questions surrounding its independence, and the depth of focus ofits inquiry.” In re KLA-Tencor Corp., No. 06-03445, at *8 (N.D. Cal. Dec. 12, 2008) (slip op.). The court alsorejected the proposed settlements with certain former officers and directors, noting that “the size of thesettlement that resulted from the SLC’s investigation is a mere fraction of the overall damages that KLAsuffered as a result of Defendants’ backdating activities.” Id.

D. California Corporations Code Section 1101: The All-Holders Rule


California Corporations Code Section 1101 provides in relevant part that in a merger “[e]ach share of the sameclass or series of any constituent corporation … shall, unless all shareholders of the class or series of consent . .. be treated equally with respect to any distribution of cash, rights, securities, or other property.” Cal. Corp.Code § 1101(e).

2. Inapplicability Of Tender Offers

Section 1101 appears in the chapter entitled “Merger” and its plain focus is on the consideration received for“shares in a merger.” “Merger” is a very precise legal term: the combination of “any two or morecorporations … into one of those corporations.” Cal. Corp. Code § 1100. A “merger” is not a “tender offer”and Section 1101 does not regulate tender offers. Further, tender offers are governed by federal securities laws,while mergers are governed by state corporation laws. See Kramer v. Time Warner, Inc., 937 F.2d 767, 779 (2dCir. 1991).


Section 1101 does not provide for a private right of action for a violation of its terms. See Moradi-Shalal v.Fireman’s Fund Ins. Cos., 46 Cal. 3d 287, 305 (1988) (a private right of action can be inferred only if a strictlegislative intent analysis supports one); Crusader Ins. Co. v. Scottsdale Ins. Co., 54 Cal. App. 4th 121, 132-34(1997) (“If the Legislature had intended to create a private right to sue, one would reasonably have expectedthat the Legislature simply would have directly imposed such liability in clear, understandable, unmistakableterms, as it has done in numerous other statutes.”); Vikco Ins. Servs., Inc. v. Ohio Indem. Co., 70 Cal. App. 4th55, 62 (1999) (“Adoption of a regulatory statute does not automatically create a private right to sue for damages

resulting from violations of the statute.”).


A. The Power Of The SEC

1. Broad Investigatory Powers

Congress has vested the SEC with broad authority to conduct investigations into possible violations of thefederal securities laws and to demand production of evidence relevant to such investigations. See, e.g, 15U.S.C. §§ 77s(b), 78u(a), (b). This authority includes the power to subpoena witnesses, administer oaths, andcompel the production of books and records. Subpoenas issued by the Commission are not self-enforcing. See,e.g., 15 U.S.C. §§ 77v(b), 78u(c). Persons may be criminally liable under section 78u(c)(2), however, forfailure to comply with an SEC subpoena unless they possess “an objectively reasonable good-faith ground” toprovide the “just cause” necessary to exclude compliance. S.E.C. v. Huff, 664 F. Supp. 2d 1288, 1294–95 (S.D.Fl. 2009).

In October 2008, the SEC made its Enforcement Manual available on its website. The 122-page document containsimportant guidance for the Enforcement staff on a variety of investigatory issues ranging from opening informalinquiries and formal investigations, commencing the Wells process, requesting document production and issuingsubpoenas, asserting privileges and protections, and cooperating with other agencies in parallel investigations. Themanual is a useful resource for private attorneys practicing in the enforcement area and, where appropriate, is cross-referenced in this guide.

2. Enforcement Actions: Key Statutory Provisions

a. Securities Act Of 1933

The Securities Act of 1933 has two basic objectives: (1) require that investors receive financial and othersignificant information concerning securities offered for public sale; and (2) prohibit deceit, misrepresentations,and other fraud in the sale of securities. A primary means of accomplishing these goals is the disclosure ofimportant financial information through the registration of securities.

The 1933 Act also works to prevent fraud through the inclusion of an anti-fraud provision, Section 17(a), whichprohibits both fraud with scienter, §17(a)(2) and (3), and non-scienter fraud, §17(a)(1). These provisions arecommonly employed by the Commission against fraudulent sellers.

The 1933 Act also enables the Commission to seek injunctions. However, before the Commission can initiatean investigation under this Act, it must appear “to the Commission, either upon complaint or otherwise, that theprovisions of [the Act or Rule] have been or are about to be violated.” 1933 Act § 20(a), (b).

b. Securities Exchange Act Of 1934


The 1934 Act both created the SEC and empowered it with broad authority over all aspects of the securitiesindustry, including the power to regulate brokerage firms, transfer agents, and clearing agencies, and to overseethe nation’s securities self-regulatory organizations (SROs). The Act also identifies and prohibits certain typesof conduct in the markets and provides the Commission with disciplinary powers over regulated entities and thepeople associated with them. Under this Act, the SEC requires periodic reporting—in the form of quarterly,annual, and other periodic reports, or 10-Q’s, 10-K’s, and 8-K’s, respectively—of information by companieswith publicly traded securities. See Exchange Act §13.

The Exchange Act further permits the Commission, in its discretion, to investigate persons suspected ofviolating (or seeking to violate) the Act or any rule issued under the Act, § 21(a)(1), and to publish informationconcerning any violations. Id. The Commission may also prescribe “rules and regulations” to aid in theenforcement of other provisions. Id.

1) Section 10(b): Anti-fraud

As with Section 17(a) of the 1933 Act, Section 10(b) of the 1934 Act—and particularly Rule 10b-5,promulgated thereunder—explicitly prohibits any party from employing “in connection with the purchase orsale of any security . . . any manipulative or deceptive device.” This provision enables the Commission to takeaction against any party—buyer or seller—who has committed fraud.

2) Section 13: “Books And Records” And Internal Controls

Section 13 of the 1934 Act requires every issuer of registered securities to file periodic reports with the SEC Most of these reports must be signed by the officers of the registered company and often form the basis forliability.

3) Section 15: Broker-Dealer Regulation And Enforcement

The Exchange Act is the basic provision of the federal securities laws prohibiting brokers and dealers fromengaging in manipulative, deceptive, or other fraudulent devices or contrivances. See Exchange Act § 15(c)(1).

c. Investment Company Act Of 1940

This Act regulates the organization of companies (including mutual funds) that invest and trade in securities andwhose own securities are offered to the investing public. In short, the Act works to minimize conflicts ofinterest that arise as part these trading companies’ complex operations. To do so, it requires investmentcompanies to disclose their financial condition and investment policies to investors both when the stock is firstsold, and thereafter on a regular basis. They must also disclose their investment objective, company structure,and operating plans. Notably, the 1940 Act does not give the Commission the power to directly supervise theinvestment decisions or activities of these companies or judge the merits of their investments, but it does affordthe Commission the power to investigate whether a person has violated or is about to violate the Act or theRules promulgated thereunder. See § 42(a).

d. Investment Advisers Act Of 1940

The Investment Advisers Act regulates the firms or individual practitioners compensated for advising othersabout securities investments. Such investment advisers must register with the SEC and conform to regulations

designed to protect investors. Again, as with the Investment Company Act, the Commission has the power toinvestigate anytime it appears “either upon complaint or otherwise, that the provision of [the Act or any Rulethereunder] have been or are about to be violated.” See § 209(a).

e. Sarbanes-Oxley Act Of 2002

Adopted in 2002, the Public Accounting Reform and Investor Protection Act, commonly known as theSarbanes-Oxley Act, sets forth a number of sweeping reforms designed to enhance corporate responsibility,greatly expand required financial disclosures, and combat corporate and accounting fraud. The Act also createdthe Public Company Accounting Oversight Board (“PCAOB”), a private organization (operating under theCommission’s oversight) with the power to register, set audit standards for, and inspect and conductdisciplinary proceedings against public accounting firms that audit the financial statements of registeredcompanies. Section 408 of the Act also requires the SEC to review periodic filings by public companies at leastonce every three years.

In 2006, a non-profit public interest organization brought an action challenging the constitutionality of thePCAOB, arguing that the creation of the Board violated the Appointments Clause, separation of powers, andnon-delegation principles. The PCAOB’s constitutionality was upheld by the D.C. Circuit in 2008. See FreeEnterprise Fund v. Public Co. Accounting Oversight Bd., 537 F.3d 667 (D.C. Cir. 2008).

In Levy v. Sterling Holding Co., 2008 WL 4415135 (3rd Cir. Oct. 1, 2008), the Third Circuit affirmed summaryjudgment in favor of defendants in a shareholder derivative suit for disgorgement of short-swing profits. Thecourt held that retroactive application of the new S.E.C. Rules 16b-3 and 16b-7 is permissible because the newrule is a clarification of a previous version and applying it does not have an impermissible retroactive effect.

B. The Initiation And Escalation Of An SEC Investigation

1. Sources Of An SEC Investigation

SEC investigations may spring from any of a large number of different sources. Often, investigations grow out ofexaminations by the Staff of periodic filings made with the Commission. Another common source of investigationsis market surveillance conducted by the Staff and SROs. Complaints from members of the public, includingcompetitors of issuers and their current or former employees, are yet another common source of SEC investigations. Since the fall of Enron, the financial press has become a potent source of leads for the SEC, as business journalistsnow conduct aggressive investigations even before the Staff is aware of certain conduct. Likewise, tips by internalwhistleblowers have prompted many investigations, including by complainants who thereafter bring parallellitigation under the whistleblower provisions of Sarbanes-Oxley. Whistleblower complaints are likely to escalate inlight of the “bounties” made available by Dodd-Frank. Finally, referrals from other government agencies are also acommon source of SEC investigations. See Securities and Exchange Commission, Division of Enforcement,ENFORCEMENT MANUAL § 2.2 at 8-13 (Oct. 6, 2008) (describing the sources of complaints, tips, and referrals receivedby the SEC and the guidelines for processing this information).

2. Informal Inquiries

SEC proceedings usually begin as “informal investigations” or “informal inquiries.” At the informal inquiry stage,the SEC’s Staff has not yet sought the authority to issue subpoenas for compelling documents and testimony. Instead, it usually asks witnesses to give testimony and provide documents voluntarily. It also may investigate atarget without giving notice that an inquiry exists. Courts have upheld the Staff’s ability to conduct an informalinquiry without giving notice. See, e.g., RNR Enters., Inc. v. S.E.C., 122 F.3d 93, 98 (2d Cir. 1997) (holding that dueprocess does not require that target be named); Wells v. S.E.C., 113 F.3d 1230 (2d Cir. 1997) (same); Gold v. S.E.C.,48 F.3d 987, 991 (7th Cir. 1995) (same); see also Securities and Exchange Commission, Division of Enforcement,

ENFORCEMENT MANUAL § 2.3.1, 2.3.2 at 13-19 (Oct. 6, 2008) (describing SEC procedures for commencing,conducting, and closing matters under inquiry).

a. Guidelines Governing Informal Inquiries

17 C.F.R. § 202.5(a) provides the SEC with the power to conduct an informal inquiry in private. Only veryrarely will the SEC disclose the pendency of an informal inquiry, which means that private plaintiffs may bekept at bay as long as an inquiry remains informal (and as long as the subject of the informal inquiry is notrequired to be disclosed by other disclosure rules).

b. Document And Testimonial Discovery In Informal Inquiries

In connection with an informal inquiry, the Staff nearly always requests a voluntary production of documents. Indeed, an informal inquiry very often commences with a letter attaching a request for documents. Suchrequests can be just as broad in scope as requests in private litigation. Given that informal inquiries are oftenexploratory fact-finding exercises focused on several areas of reported or suspected misconduct, the Staff’sdocument requests are often broader and less specific than those of private plaintiffs.

It is also not unusual for the Staff to request creation of various documents or compendiums of information anddata. For example, the Staff may request the submission of a chronology of events, complete with the identitiesof participants at any meetings. Given the materiality of newly created “summary” documents in potentialprivate litigation, the preparation of such documents must be handled with care.

After document production has commenced and the Staff has begun its document review, the Staff willcommonly request interviews and/or testimony from witnesses. This is particularly true if the Staff perceives ahigh degree of cooperation with an informal inquiry. If the prospective witness can persuade the SEC that atranscript would disadvantage him or the Staff, the Staff may sometimes agree to conduct its interviews bytelephone or without a transcript. Given the always looming specter of subsequent private litigation,proceeding in this manner has clear advantages.

As long as an inquiry remains informal, the Staff does not technically have the authority to administer oaths orrequire affirmations. However, some subjects of an informal inquiry, in an effort to fully cooperate with theStaff and avoid escalation of the inquiry, will voluntarily consent to be placed under oath and will testify on therecord. That said, no person may make a false statement to a federal official, whether under oath or not. 18U.S.C. § 1001. Once the witness is placed under oath, false testimony will be subject to additional punishmentunder federal perjury laws. 18 U.S.C. § 1621.

c. Conclusion Of An Informal Inquiry

An informal inquiry may conclude in numerous ways. Where documents and testimony provided to the Staffdo not indicate a securities violation, the subject of an informal inquiry may simply never hear from the Staffagain regarding the inquiry. This sort of “die on the vine” conclusion may also be possible if, under thecircumstances, it is questionable whether any violation occurred and if the subject of the inquiry acted in acooperative and credible manner. Generally, if the Staff decides that it will not pursue the inquiry beyond theinformal stage, the subject of the inquiry will not receive any formal notification.

At the other end of the spectrum, an informal inquiry may conclude because the Staff becomes convinced,without the need for examining additional evidence, that a securities violation occurred. In such a case, theStaff may decide to “skip” the formal investigation stage altogether, and may recommend to the Commissionthat the Commission commence an administrative proceeding against alleged violators or file a complaint infederal court seeking injunctive relief. The Staff may also refer the suspected violation to the Department of

Justice for initiation of criminal proceedings against alleged violators. In the post-Enron environment, it isbecoming somewhat more common for the Staff to skip directly from an informal inquiry to an administrative,injunctive, or criminal proceeding. However, it is still probably the case that, where the Staff decides to movebeyond the informal inquiry stage, it will not generally do so by seeking immediate authority to bring a legalaction, but will instead seek to obtain from the Commission a formal order of investigation. 17 C.F.R. § 202.5(b).

3. Formal Investigations

The Staff may escalate an informal inquiry into a formal investigation if it believes that a subpoena is necessary toobtain needed documents or testimony from the subject of the investigation or from third parties that will not orcannot voluntarily comply with an informal request for information. This often occurs where the subject of aninquiry is uncooperative. See Securities and Exchange Commission, Division of Enforcement, ENFORCEMENTMANUAL § 2.3.3, 2.3.4 at 19-22 (Oct. 6, 2008) (describing SEC procedures for commencing and conducting formalinvestigations).

a. Formal Order Of Investigation

The Staff cannot initiate a formal investigation—and enjoy the concomitant powers to issues subpoenas andrequire oaths—until the Commission issues a formal order of investigation. See, e.g., Securities Act § 20(a);Exchange Act § 21(a)(1); Advisers Act § 209(a); Investment Company Act § 42(a). A formal order ofinvestigation will issue if the Commission believes that a violation of the federal securities laws is occurring orhas occurred. Most importantly, a formal order will often describe—albeit vaguely—the general subject matterof the formal investigation. This may provide the target of an investigation with the first written indication ofthe nature a suspected violation.

A formal order of investigation gives the Staff broad investigative powers. See Securities Act § 19(b), 15U.S.C. § 77s; Exchange Act § 21(b), 15 U.S.C. § 78u(2); Advisers Act § 209(b), 15 U.S.C. § 80b-9(b);Investment Company Act § 42(b), 15 U.S.C. § 80a-42(b). These powers are not limited to attorneys; theyextend to other Staff members, including accountants, investigators, and others – all of whom may issuesubpoenas, take testimony, and examine witnesses.

In 2009, the SEC Chairman officially repealed a pilot project that required enforcement staff to seekpreauthorization from the Commission before negotiating any civil money penalties. The investigatory staffhave also regained their ability to obtain subpoenas with the authorization of a single commissioner, rather thanthe entire Commission. With these streamlined procedures, the SEC hopes to better address its heavierworkload and increased pressure to find and litigate abuses.

In considering whether to issue a formal order of investigation, the Commission will review a memorandumprepared by the Staff called an “action memorandum” or “action memo,” which sets forth a statement of factsknown and suspected, the specific securities laws that may have been violated, the reason for the Staff’s requestfor a formal order, and the proposed form of the order. As a practical matter, the Commission almost alwaysgrants a Staff request for an order. The subject of the formal order is entitled to no notice and no opportunity tobe heard prior to issuance of the order. Occasionally, the subject of a proposed formal order will submit to theCommission an opposition to the issuance of a formal order, but such submissions are almost never effective inpreventing issuance of an order.

b. Contents Of A Formal Order

A formal order is a brief document—three or four pages long—indicating suspected statutory and regulatoryviolations. A formal order will not provide much (if any) detail regarding the Staff’s evidence or the bases for

the Staff’s legal theories. The order will generally contain four sections: (1) the Public Official Files section,which refers to information contained in the Commission’s public files; (2) the Staff Report section, whichpresents, in a highly conclusory form, the facts then known to the Staff, as well as the securities laws that theStaff suspects have been or are being violated; (3) the Purpose and Order section will list the violations thatmay have occurred or are occurring; and (4) the Authorized Staff section will list the members of the Staff whoare authorized to administer oaths and to issue subpoenas. Despite the limited information within a formalorder, counsel should always request a copy from a senior official of the Staff – generally an assistant directorwithin Enforcement, an assistant regional director of a regional office, or a district administrator of a districtoffice. See 17 C.F.R. § 203.7(a).

c. Guidelines Governing Formal Inquiries

As with informal inquiries, formal investigations will remain non-public in almost all cases. 17 C.F.R. § 203.5. The Staff may, however, share information with other governmental agencies. If asked for informationregarding a suspected investigation, the Staff will neither confirm nor deny the existence of an investigation. Nevertheless, counsel should recognize that it is not unprecedented for the existence of a formal investigation tobe leaked by persons within the subject entity, and thus it may be appropriate to develop a response plan inanticipation of such a leak. Furthermore, if it becomes apparent that an investigation is likely to result in somesort of action, a duty to disclose may arise under some circumstances.

Pursuant to the SEC’s Rules Relating to Investigations, witnesses in formal investigations receive a number ofprocedural protections. 17 C.F.R. § 203.7(a)-(c). Among the more important protections are a witness’s rightto review the formal order, to review a transcript of his or her own testimony, and to be accompanied bycounsel while giving testimony. Courts have upheld the Commission’s right to deny a request to purchase acopy of a witness’s testimony. See, e.g., S.E.C. v. Sprecher, 594 F.2d 317 (2d Cir. 1979); Commercial CapitalCorp. v. S.E.C., 360 F.2d 856 (7th Cir. 1966).

When witnesses give testimony, the Staff remains in control of the record, and may choose to go “off therecord” at any time. United States v. Lieberman, 608 F.2d 889, 892 (1st Cir. 1979). Where an attorneyrepresents multiple parties in an investigation, the Staff generally will not take a position on a potentialconflict. If counsel purports to represent dozens or more present and former employees, officers, and/ordirectors of a corporate client, however, counsel should be prepared to address the Staff’s questions regardingthe nature of such broad representation. This is especially true where counsel takes the position that the Staffmust contact counsel prior to contacting any current or former corporate agents.

Rule 7(b) of the Commission’s Rules Relating to Investigations states that “all witnesses shall be sequestered,and unless permitted in the discretion of the officer conducting the investigation, no witness or the counselaccompanying any such witness shall be permitted to be present during the examination of any other witnesscalled in such proceeding.” 17 C.F.R. § 203.7(b). It is virtually unheard of for the Staff to enforce this rulewhere, as is common, counsel represents multiple witnesses in a formal investigation. The relative rarity withwhich the Staff enforces Rule 7(b) may arise from due process concerns. See S.E.C. v. Higashi, 359 F.2d 550,553 (9th Cir. 1966) (holding sequestration rule not enforceable where witness would be deprived “of theservices of the attorney most familiar with the source of his vulnerability”); S.E.C. v. Csapo, 533 F.2d 7, 11(D.C. Cir. 1976) (holding sequestration rule not enforceable where no “concrete evidence” exists that multiplerepresentation of witnesses would “obstruct and impede” investigation).

The subject of an SEC investigation is entitled to the same testimonial privileges as during a judicialproceeding, including Fourth and Fifth amendment protections against unreasonable searches and self-incrimination. See, e.g., McMann v. S.E.C., 87 F.2d 377, 379 (2d Cir. 1937). The attorney-client privilegelikewise exists in connection with an SEC investigation.

d. Conclusion Of A Formal Inquiry

The Staff may conclude a formal investigation by either determining that no action is appropriate or byrecommending to the Commission that enforcement proceedings commence. If the Staff recommends noaction, the Staff generally will inform the subject of the investigation that the investigation will not result inenforcement. See U.S. Securities and Exchange Commission, Procedures Relating to the Commencement ofEnforcement Proceedings and Termination of Staff Investigations, Sec. Act Rel. No. 5,310, 1972 WL 18218, at*3 (Sept. 27, 1972); Sec. Reg. & L. Rep. (BNA) No. 19, vol. 27, at 708 (May 12, 1995).

Counsel should note that receiving a notice from the Staff that no action will be taken is not an exoneration anddoes not indicate that the Staff has found no evidence or legal basis upon which to bring a charge. Rather, sucha notice means only that the Staff has decided, for the time being, to recommend no enforcement action.

On the other hand, if the Staff believes that the investigation should result in enforcement action, it will draft anaction memorandum to the Commission recommending that the Commission take action against certainidentified persons. The recommendation will set forth the evidentiary and legal grounds supporting thepurported violations and will recommend a course of action, a remedy, and an overall rationale for pursuingaction. Finally, the Staff will also forward to the Commission any Wells submission (discussed below)provided by the proposed respondents or defendants.

4. Wells Notice And Submission

Where the Staff believes that it will recommend to the Commission that charges be brought against the subject of aninvestigation, the Staff will usually issue a “Wells notice.” A Wells notice, which will generally issue near the endof a formal investigation, invites persons involved in an investigation to present a statement to the Commissionsetting forth their interests and positions — a “Wells Submission.” See Sec. Act Rel. No. 5,310, 1972 WL 18218(Sept. 27, 1972); Sec. Act Rel. No. 5,320, 1972 WL 18228 (Oct. 12, 1972). The Wells notice itself is often a usefuldocument, containing the proposed enforcement recommendation. In follow up meetings after a Wells notice isissued, the Staff will generally provide information pertaining to the legal theories and evidence upon which it isrelying. Upon receipt of a Wells notice, counsel must consider whether the existence of the investigation must bedisclosed to the subject, if it has not been already. See Securities and Exchange Commission, Division ofEnforcement, ENFORCEMENT MANUAL § 2.4 at 23-29 (Oct. 6, 2008) (describing the Wells Notice process).

a. No Right To Receive A Wells Notice

The Wells submission practice is exactly that – a practice or custom that is not required under law. No courthas held that the subjects of SEC investigations have a due process right to receive a Wells notice (or thesubsequent opportunity to make a Wells Submission). However, the Staff usually provides a Wells noticeunless it is concerned that the subject entity will dissipate assets or destroy documents, or where some othercircumstance makes immediate action more appropriate. S.E.C. v. Nat’l Student Mktg. Corp., 538 F.2d 404 (D.C. Cir. 1976).

b. Whether To Make A Wells Submission

Most potential respondents and defendants choose to make a Wells submission, perhaps because the Staff andthe Commissioners appear to evaluate these submissions with care. After evaluating a Wells submission, theStaff may very well alter its recommendations to the Commission, including dropping certain individuals fromor reducing the severity of the proposed action. Moreover, because a Wells submission accompanies the Staff’srecommendation to the Commission, the submission may have a positive and direct impact on the Commissionitself, in addition to its potential positive impact on the Staff’s recommendation itself.

Subjects of SEC investigations do not always choose to make a Wells Submission. Several factors andcircumstances may cause a subject to forego a submission. For example, a subject may become reasonably

certain during an investigation that the Staff would recommend vigorous action against the subject regardlessand a Wells Submission would only provide the Staff with an outline of the subject’s defenses in a futureadministrative or court proceeding.

Because the Staff believes that anything within a Wells submission constitutes an admission in futureproceedings, a subject may be unwilling to take factual positions in a Wells submission if it believes thesubmission has little chance to persuade the Staff or the Commission. At least one court has held that a Wellssubmission is not an offer of compromise and thus is admissible in a subsequent court proceeding. See In reInitial Pub. Offering Sec. Litig., No. 21 MC92, 2004 WL 60290 (S.D.N.Y. Jan. 12, 2004).

Moreover, where the facts underlying an investigation are especially problematic, counsel should consider thata Wells submission may be provided to the Department of Justice in a parallel or subsequent grand jury inquiryor criminal prosecution. False statements in a Wells submission may trigger the felony provisions of 18 U.S.C.§ 1001.

c. Content Of A Wells Submission

A Wells statement is essentially a legal brief—complete with appendices—that highlights the factual, legal, andtheoretical impediments that an action by the Commission would face. The Commission prefers concisesubmissions, generally of forty pages or less. See Arthur Levitt, Remarks on Private Litigation Under theFederal Securities Laws at the Securities Regulation Institute Conference (Jan. 26, 1996). The Commissionalso accepts brief videotaped statements by counsel (accompanied by a transcript), although these are far lesscommon.

The Commission has stated that the most helpful Wells submissions address questions of law and policy, ratherthan arguing factual matters. See Sec. Act Rel. No. 5,310, 1972 WL 18218, at *1 (Sept. 27, 1972). Nevertheless, subjects often submit Wells briefs that rely heavily on factual arguments or discuss the burdens ofproof that will be applicable in an administrative or injunctive proceedings.

Whatever the content of a Wells submission, counsel must submit it in a timely manner. In general, the Staffwill grant counsel one month to submit a statement. Depending on the circumstances of a given case, the Staffmay grant an extension. Counsel should plan to adhere to the one-month deadline and may sometimes beginwork on a Wells submission before receiving a Wells notice.

5. Internal Investigations

It can be in a company’s interest to respond to notice of an SEC investigation by instituting an internal investigation. At a company’s request, the Staff will defer its investigation pending the completion of the internal investigation,provided the company agrees to forward the results of its investigation to the Staff. A company can greatly expediteresolution of the Staff investigation, and thereby avoid the cost and disruption of a Staff investigation, by utilizingthis process.

A company that launches an internal investigation may also curry favor with the Staff by showing itswillingness to cooperate. The Commission and the Staff often consider such cooperation in determining whatremedy, if any, to impose. Under the Commission’s Rule 21(a) report on Seaboard Corp., Exchange Act Rel.No. 44969 (Oct. 23, 2001), the company’s cooperation — along with other factors such as the remedialmeasures taken and the size of the loss to the investing public — worked to persuade the Commission to refrainfrom initiating an enforcement action. More often, the Commission will bring a less forceful enforcementaction than it might have otherwise. See, e.g., In re Premiere Fin. Bancorp, Inc., Exchange Act. Rel. No.52370, Admin. Proc, File No. 3-12027 (Aug. 31, 2005) (imposing a cease-and-desist order without civilpenalties against a bank that made false and misleading statements in SEC filings but also conducted swiftinternal investigation that resulted in staff changes and new audit and oversight functions).

Unfortunately, even where the Commission rewards a subject for voluntarily conducting and sharing the resultsof an internal investigation, the subject may face increased liability if deemed to have waived potentiallyapplicable privileges. See, e.g., In re Royal Ahold N.V. Sec. & ERISA Litig., 230 F.R.D. 433 (D. Md. 2005). InRoyal Ahold, defendants sought to avoid production of hundreds of interview memos prepared during thecourse of an internal investigation on the theory that they were protected as attorney work-product. The courtheld that the memoranda were discoverable, despite Royal Ahold’s confidentiality agreement with theCommission, “to the extent that Royal Ahold offensively [] disclosed information pertaining to its internalinvestigation in order to improve its position with investors, financial institutions, and the regulatory agencies,it also implicitly has waived its right to assert work-product privilege as to the underlying memorandasupporting its disclosures.” Id. at 437; see also United States v. Bergonzi, 216 F.R.D. 487 (N.D. Cal. 2003).

6. Action By The Commission

Where an action has been investigated by the Staff and recommended to the Commission, the Staff’s opinionand recommendations are consolidated in an “action memo” to the Commission. This memo sets forth arecommended course of action—enforcement, litigation, no-action or settlement—that the Commission willusually adopt.

The action memo marks the beginning of the Commission process: a two-to three-month period ofconsideration that determines the fate of the investigation. The Commission conducts a closed meeting toconsider the Staff’s suggestions and then chooses whether to either fully adopt the Staff’s position or proceedon a course of its own.

The Commission does not usually consider a settlement proposed by the Staff until it is signed by the subject(to ensure that the settlement offer is legitimate). If the Commission chooses to adopt the proposed settlement,it presents the subject with a boilerplate consent judgment. See Securities and Exchange Commission, Divisionof Enforcement, ENFORCEMENT MANUAL § 2.5 at 29-33 (Oct. 6, 2008) (describing SEC procedures for issuingenforcement recommendations).

7. Litigating Against The Commission

Upon the recommendation of the Staff or at its own choosing, the Commission may decide to initiate civillitigation or an administrative proceeding against the subject of an investigation. Further, while theCommission does not have the power to bring a criminal suit, the Staff may refer the matter to the Departmentof Justice or state and local authorities for prosecution.

Administrative proceedings are typically litigated by Enforcement Division Staff from one of the Commission’sregional offices. In civil litigation enforcement action, the Staff member primarily responsible for theinvestigation will be coupled with a member from the Enforcement Division’s “Trial Unit” and the two willpursue the Commission’s claims together. For more complicated cases involving accounting or financial fraud,additional Staff members may be brought on board. Litigation will then be initiated, typically in federal court.

C. Disclosing An SEC Investigation

1. Nondisclosure By The SEC

The SEC’s formal investigative proceedings are normally conducted privately, see S.E.C. Rules Related toInvestigations, 17 C.F.R. § 203, Rule 5, to avoid unwarranted injury to the reputations of the persons beinginvestigated; S.E.C. v. Harrison, 80 F. Supp. 226, 229 (D.D.C. 1948) (“[It is] a well recognized principle ofadministrative law that investigations ought to be so conducted that harmful publicity will not be used in lieu ofsanctions provided by law.”). Section 21 of the 1934 Act does authorize the Commission to publishinformation concerning violations it uncovers during the course of its investigations. Courts have sustained the

Commission’s right to investigate subjects privately and publicly. See Woolley v. United States, 97 F.2d 258(9th Cir. 1938).

2. Disclosure By The Company Under Investigation

While it usually runs in the favor of a party under SEC investigation to refrain from disclosing the nature of aninvestigation—if for no reason other than to keep the plaintiff’s bar at bay until the investigation is concluded—where the investigation (or matter being investigated) is material, the party must disclose it or potentially faceadditional penalties and litigation. The materiality of an investigation depends on a number of factors,including: (1) whether the investigation will materially affect the company’s performance and prospects; (2) thelikelihood that the investigation will result in an enforcement action; and (3) the likely impact the potentialenforcement action on the company. Additionally, whether determined to be material or not, the existence of aninvestigation must not be falsely denied by corporate officials.

Under Section 21(a) of the Exchange Act, even where an SEC investigation is not material, some parties maychoose to publicly disclose their actions “as part of the process of resolving their involvement in theinvestigation.” Traditionally, such disclosure has been cast as a form of cooperation that is rewarded withlower sanctions if further proceedings commence.

D. Commission Enforcement Actions

The Commission is empowered to bring a wide variety of enforcement actions against both companies andindividuals. It should be remembered that, when filing a complaint, the Commission is not subject to theheightened pleading requirement of the PSLRA. See, e.g., S.E.C. v. Prater, 296 F. Supp. 2d 210, 215 (D. Conn.2003) (“Since actions brought by the SEC are not considered ‘private litigation,’ the standard imposed in thePSLRA for pleading scienter does not apply to the SEC”); S.E.C. v. Berry, 580 F. Supp. 2d 911, 920-21 (N.D.Cal. May 7, 2008) (same). Further, the Commission is not subject to the automatic stay provision under 11U.S.C. § 362(b). See S.E.C. v. Applegate, 2006 WL 1005302 (N.D. Ohio Apr. 13, 2006).

While there is no heightened pleading standard for the SEC, the complaint must still contain some allegationsof scienter. See S.E.C. v. Espuelas, 579 F. Supp. 2d. 461, 481 (S.D.N.Y. 2008) (“The paucity of the SEC’sallegations of scienter . . . particularly telling when one considers the fact that the Complaint was filed after 17depositions . . . . Had the SEC gathered any evidence upon which it could have alleged the Defendants’ recklessor knowing involvement with the CFO in the improper accounting . . . surely it should have found its way intothe complaint.”)

1. Types Of Cases

In 2008, the SEC brought 671 enforcement actions, the second-highest number of enforcement actions inagency history. Insider trading and market manipulation cases increased more than 25 percent and 45 percentrespectively over 2007. The Commission continued to pursue a number of stock options backdating cases,charging eight public companies and 27 executives. SEC Announces Fiscal 2008 Enforcement Results, U.S.Securities & Exchange Commission, Oct. 22, 2008.

a. Accounting And Financial Fraud

The Commission regularly pursues corporate accounting fraud under Section 17(a) of the Securities Act andSections 10(b) and 13(a) of the Exchange Act. In S.E.C. v. Time Warner, Civil Action No. 05-CV-00578(D.D.C. Mar. 13, 2005), for example, the Commission charged that Time Warner had materially overstatedinternet advertising revenue through the use of so-called “round-trip” transactions. Without admitting ordenying the Commission’s allegations, Time Warner consented to (a) the entry of a judgment ordering it to

comply with a cease-and-desist order, (b) pay $300 million in civil penalties, which the Commission requestedbe distributed to harmed investors, (c) restate its historical financial results by approximately $500 million, and (d) engage an independent examiner to determine whether the company’s historical accounting for certaintransactions was in conformity with GAAP.

Likewise, in S.E.C. v. Adelphia Communications Corp., No. 02-CV-5776 (S.D.N.Y.), the Commission filed suitto prosecute one of the “most extensive financial frauds ever to take place at a public company.” See LitigationRelease No. 17627 (July 24, 2002), available at http://www.sec.gov/litigation/litreleases/lr17627.htm. In itscomplaint, the Commission alleged that Adelphia fraudulently excluded billions of dollars in liabilities from itsconsolidated financial statements—hiding them in off-balance sheet affiliates—and that it otherwise falsifiedoperations statistics to inflate Adelphia’s earnings. In 2005, the parties reached settlement, with insiderdefendants agreeing to disgorge over $1.5 billion in assets that they derived from the accounting fraud, and thecorporation agreeing to pay $715 million into a victim fund. See Commission Release No. 2005-63 (Apr. 25,2005).

b. False And Misleading Statements

The Commission also pursues claims of false and misleading statements in violation of Section 17 of theSecurities Act, Section 10(b) of the Exchange Act, and Rule 10b-5. See, e.g., S.E.C. v. Lucent Techs. Inc., 363F. Supp. 2d 708 (D.N.J. 2005); S.E.C. v. First Jersey Sec., Inc., 101 F.3d 1450 (2d Cir. 1996); S.E.C. v. Adoni,60 F. Supp. 2d 401, 405 (D.N.J. 1999).

c. Insider Trading

Similarly, the Commission pursues any number of insider trading cases. See, e.g., United States v. Evans, 486F.3d 315, 323-24 (7th Cir. 2007) (holding that tipper acquittal did not foreclose tippee conviction if tippeerelied on tipper breach, because elements of tipper and tippee liability differ); S.E.C. v. Ginsburg, 362 F.3d1292 (11th Cir. 2004) (affirming the district court where pattern of tipper phone calls and timing of tippeetrades indicated insider trading); S.E.C. v. Yun, 327 F.3d 1263 (11th Cir. 2003) (holding that to prevail underthe classical theory of insider-trading liability, plaintiff must show tipper was not merely reckless, but intendedto benefit personally from the disclosure of confidential information to tippee); S.E.C. v. Heron, No. 06-674,2007 WL 2916196, at *5 (E.D. Pa. Oct. 5, 2007) (upholding bar on evidence of company’s trading blackoutperiods because of potential unfair prejudice to defendant if allegedly illegal trades occurred during blackoutperiod); S.E.C. v. Franco, 253 F. Supp. 2d 720 (S.D.N.Y. 2003) (finding the Commission sufficiently statedclaim against a trust where it alleged trust directors traded on nonpublic information acquired as corporateinsiders); S.E.C. v. Schwinger, No. 07-CV-01047 (D.D.C.), Litig. Rel. No. 20152 (June 13, 2007) (noting thatSchwinger agreed to a $41,021 settlement with the SEC regarding insider trading allegations).

d. Market Manipulation

Market manipulation consists of intentional or willful conduct designed to deceive or defraud investors bycontrolling or artificially affecting the price of securities. The Commission often pursues claims against suchactivities under Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act. In S.E.C. v.Cavanagh, No. 98 CIV. 1818 (DLC), 2004 U.S. Dist. LEXIS 13372, at *83 (S.D.N.Y. July 15, 2004), forexample, the court held that defendants engaged in “classic market manipulation” when they merged a shellcompany with a small unsuccessful operating company, sold stock bearing no restrictive legend in anunregistered transaction, took control of virtually the entire market float, created a false impression of interest inthe stock, filed an untimely, incomplete, and misleading registration statement, issued a false press release, anddrove the stock price up in a “pump and dump” scheme from which they pocketed millions of dollars. See alsoS.E.C. v. Parnes, No. 01 Civ. 0763 (LLS)(THK), 2001 U.S. Dist. LEXIS 21722 (S.D.N.Y. Dec. 21, 2001).

e. Mutual Fund Cases – Market Timing/Late Trading

Mutual fund market timing is a form of arbitrage activity that takes advantage of small short-term fluctuationsin mutual fund prices. Though not illegal, the practice can nonetheless potentially harm investors by increasingtrading and brokerage costs, as well as tax liabilities, and is therefore closely regulated. See Final MarketTiming Rule, 69 Fed. Reg. at 22,300; see also S.E.C. v. PIMCO Advisors Fund Mgmt. LLC, 341 F. Supp. 2d454 (S.D.N.Y. 2004) (explaining market timing generally); In re Mass. Fin. Servs. Co., Investment CompanyAct Rel. No. 26,347 (Feb. 5, 2004) (announcing that Massachusetts Financial Services Co. would agree to pay$175 million in disgorgement and $50 million in penalties related in part to misleading disclosures concerningmarket timing).

f. Options Backdating

Options grant employees a right to purchase their company’s stock at a future date based on a pre-set priceknown as the “exercise” or “strike” price. Usually, an option’s exercise price is set at the market price of thestock on the day the option is granted, at which point the option has no intrinsic value. Backdating of stockoptions involves setting the exercise price lower than the stock’s current market price by choosing an earlierdate when the stock price was lower. In late 2006, the Commission targeted well over 100 companies ininvestigations into improper backdating of option grants. The Commission continues to scrutinize thispractice. See Speech by Linda Thomsen, Director of SEC Division of Enforcement, Options Back-dating, TheEnforcement Perspective, Oct. 30, 2006, transcript.

As of 2007, the SEC had brought a substantial number of backdating cases, some of which included parallelcriminal investigations. See S.E.C. v. Brocade Commc’ns Sys., Inc., No. 07-2821 (N.D. Cal.), Litig. Rel. No.20137 (May 31, 2007) (reporting that Brocade—the first criminal case filed in connection with backdating, seeSection VII, supra—agreed to a $7 million settlement with the SEC regarding an option backdatinginvestigation); S.E.C. v. Mercury Interactive, LLC, No. 07-2822 (N.D. Cal.), Litig. Rel. No. 20136 (May 31,2007) (reporting that Mercury agreed to a $28 million settlement with the SEC regarding an option backdatinginvestigation).

The cases that have been resolved in 2006 reflected a continuing emphasis on corporate cooperation. Forexample, in a backdating investigation of Apple, Inc., the SEC did not pursue an enforcement action based onApple’s “swift, extensive and extraordinary” cooperation, which included prompt self-reporting, an independentinternal investigation, sharing of the results of that investigation with the government, and implementation ofnew controls designed to prevent a recurrence of the unlawful conduct. See S.E.C. Charges Former AppleGeneral Counsel for Illegal Stock Options Backdating, Apr. 24, 2007, available athttp://www.sec.gov/news/press/2007/2007-70.htm.

g. Foreign Payments

The Foreign Corrupt Practices Act (“FCPA”), 15 U.S.C. §§ 78dd-1 et seq., prohibits payments to foreignofficials to “obtain or retain business.” The Commission is responsible for enforcing the FCPA with regard toany company listed on the United States securities exchanges. One can incur FCPA liability without beingaware of the boundaries of the law. See United States v. Kay, 513 F.3d 432 (5th Cir. 2007) (noting thatalthough the FCPA contains imprecise language, it is not complex and suffices to put people of “commonintelligence” on notice of what is forbidden).

On March 1, 2005, the Commission filed S.E.C. v. The Titan Corp., Civil Action No. 05-0411 (D.D.C.),alleging that Titan had (a) made over $3.5 million in illegal payments to an agent in Africa to garner favor for atelecommunications project the company was undertaking there, and (b) published a proxy statement containingan explicit representation that “neither Company nor any of its Subsidiaries, nor any director, officer, agent or

employee of the Company or any of its Subsidiaries, ha[d] . . . taken any action which would cause theCompany or any of its Subsidiaries to be in violation of the Foreign Corrupt Practices Act of 1977.” The latterclaim, the Commission argued, opened Titan to “potential liability under Exchange Act Sections 10(b) and14(a), and Rules 10b-5 and 14a-9 thereunder, for publication of false or misleading material disclosuresregarding material contractual provisions such as representations.” Without admitting or denying theallegations in the complaint, Titan consented to the entry of a final judgment permanently enjoining it fromviolating Sections 30A, 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5) of the Exchange Act.

In United States v. Kozeny, 2008 WL 4658807, at *3 (S.D.N.Y. Oct. 21, 2008), the court issued one of the firstdecisions on the FCPA’s local-law affirmative defense, which permits payments to a foreign official if thepayments are “lawful under the written laws and regulations” of the official’s country. The court held that thelocal-law defense does not apply to situations in which a person cannot be prosecuted in a foreign country dueto a technicality (e.g., time-barred) or because a provision in the foreign law “relieves” the person of criminalresponsibility. Id. In other words, if the payment itself is illegal in the foreign country, the local-law defensecannot be used even if the practice in that country is to forgive the offense. Id.

FCPA enforcement has become a “high priority.” In 2007, at least 38 DOJ and SEC enforcement actions werebrought, a significant jump from the five cases brought in 2005. The SEC and the Department of Justice havebrought more cases in recent years than all of the previous years added together. The focus on FCPA cases inthe Obama administration will likely continue, especially where DOJ and SEC authorities have pledged thatauthorities are “working more effectively with foreign authorities around the world” to investigate FCPA cases.

Further, recent cases involving Siemens, Halliburton and KBR were unprecedented in the amount of fines anddisgorgements, both civil and criminal, that were obtained. SEC officials have stated that violations by largecompanies involving large profits require equally large fines to serve a deterrence purpose. The SEC does takeinto account criminal penalties imposed by the DOJ, however, when determining its settlement amounts.

h. Regulation FD

In S.E.C. v. Siebel Systems, Inc., 384 F. Supp. 2d 694 (S.D.N.Y. 2005), the Commission brought and lost itsfirst action over the agency’s fair-disclosure rule, or Regulation FD. See 17 C.F.R. § 43.100. The Commissionargued that Siebel executives violated Regulation FD by disclosing information to large investors at an invite-only dinner party, but not to the public at large (through the filing of an 8-K) within the 24-hour time framecontemplated by the regulation. Siebel, 384 F. Supp. 2d at 697. The court disagreed, finding that the allegedlyoffending statements had either already been disclosed or were sufficiently forward-looking as to not beconsidered material. Id. at 701-08.

In October 2010, the SEC settled an enforcement action against the CEO and CFO of Office Depot charging therespondents with selectively conveying to analysts that the company would not meet analysts’ estimates. SEC.Lit. Rel. No. 21703 (Oct. 21, 2010).

i. Ponzi Schemes, Investment Schemes And A Renewed Focus On Enforcement

Over the last two years, the SEC has moved away from filing options backdating complaints and insteadfocused its enforcement efforts on cases of fraud brought to light, at least in part, by the global financial crisis. For example, in December 2008, the SEC filed a complaint against financier Bernard Madoff and hisinvestment firm for running a $50 billion Ponzi scheme. See SEC Charges Bernard L. Madoff for Multi-BillionDollar Ponzi Scheme, Press Rel. No. 2008-293, Dec. 11, 2008. Mr. Madoff’s Ponzi scheme was discoveredonly after he confessed his misdeeds to colleagues and turned himself in to the authorities. The SEC has beensubject to much criticism for its failure to detect the fraud, despite multiple complaints about Madoff’s fundsfrom the public. In February 2009, the SEC filed a complaint against Robert Allen Stanford and three of hiscompanies for orchestrating a fraudulent $8 billion investment scheme. See SEC Charges R. Allen Stanford,

Stanford International Bank for Multi-Billion Dollar Investment Scheme, Press Release No. 2009-26, Feb. 17,2009. The appointment of a former prosecutor, Robert Khuzami, to head the SEC’s Enforcement Divisionsignals a strong future emphasis on vigorously pursuing cases of securities fraud and closer coordinationbetween the SEC and criminal authorities. See Robert Khuzami Named S.E.C. Director of Enforcement, PressRel. No. 2009-31, Feb. 19, 2009.

j. “Implied Representation” Theory

In SEC v. Tambone, 597 F.3d 436 (1st Cir. 2010), the en banc court rejected the SEC’s attempt to chargeemployees of an underwriter who made no misstatements with 10b-5 liability on an “implied representation”theory for using the misstatements of others to sell securities. The SEC based its theory on the claim thatunderwriters have a “special duty” to conduct an investigation sufficient to provide a reasonable basis forbelieving that prospectus statements are true and complete. The court relied on the “make a statement”language of Section 10(b) in concluding that the “use or employ” language of the statute does not extendliability to securities professionals who do not themselves make any statement. The court also noted that theimplied representation theory would impose a “free-standing and unconditional duty to disclose” on securitiesprofessionals without the showing of fiduciary duty required by cases like Chiarella v. U.S., 445 U.S. 222(1980).

2. Remedies

Under the 1933 and 1934 Acts, as well as the Securities Enforcement Remedies & Penny Stock Reform Act of 1990,104 Stat. 931, the Commission may seek a number of penalties from the courts to ensure compliance withregulations.

a. Injunctive Actions

Section 20(b) of the Securities Act gives the Commission authority to bring an action to enjoin any personengaged in or about to engage in any act or practice that violates any provision of the Act. 15 U.S.C. § 77t(b).

In some instances, defendants (without admitting the alleged violations) may consent to the entry of theinjunction. Defendants may contest a preliminary or final injunction, however, by arguing that they have notviolated the Act and/or that any further violation is improbable. A district court must then decide, among otherthings, whether “a reasonable likelihood of further violation in the future” exists, warranting an injunction. SeeS.E.C. v. Commonwealth Chem. Sec., 574 F.2d 90 (2d Cir. 1978); see also S.E.C. v. Save the World Air, No.01cv11586, 2005 WL 3077514, at *15 (S.D.N.Y. Nov. 15, 2005) (granting motion for permanent injunctionbecause defendant CEO “persists in his refusal to admit that he has engaged in any wrongful activities,” causing“plainly a substantial risk that he will continue to flout this nation’s securities laws….”). But see S.E.C. v.DiBella, No. 3:04-CV-1342 (EEB), slip op. at 37 (D. Conn. Mar. 13, 2008) (declining to impose a permanentinjunction, despite finding that defendant acted with scienter, because of the drastic nature of a permanentinjunction, the defendant’s single violation, the passage of 10 years since his misconduct, and the lack ofevidence, apart from his continued assertions of no wrongdoing, indicating a likelihood of future violations).

Even where the SEC and the defendant(s) have agreed on and proposed a consent injunction to the court as aresolution of an SEC enforcement action, the court may reject the proposal. S.E.C. v. Bank of Am. Corp., 653F. Supp. 2d 507, 509–10 (S.D.N.Y. 2009) (rejecting proposed consent judgment that provided for an injunctionagainst future false statements in proxy solicitations and a 33 million dollar fine paid by the corporation to theSEC because failed to identify or punish the wrongdoers and only further penalized the shareholders).

1) Preliminary Injunction

To succeed on its motion for a preliminary injunction, the Commission must show probable success at trial. S.E.C. v. Frank, 388 F.2d 486 (2d Cir. 1968); S.E.C. v. Bremont, 954 F. Supp. 726 (S.D.N.Y. 1997). Uponmaking this showing, the Commission may seek injunctive relief tailored specifically to the violationcommitted, including but not limited to the appointment of a receiver, S.E.C. v. Fifth Ave. Coach Lines, 289 F.Supp. 3 (S.D.N.Y 1968), the appointment of a trustee to oversee the redistribution of ill-gotten profits, S.E.C. v.Tex. Gulf Sulphur Co., 446 F.2d 1301 (2d Cir. 1971), and the appointment of a “special agent” to supervise thedefendant’s compliance with the law, S.E.C. v. Besinger, 552 F.2d 15 (1st Cir. 1977). Once an injunction hasbeen entered, the doctrine of collateral estoppel bars the defendant from relitigating the underlying issue in asubsequent private damage action based on the same course of conduct. See Parklane Hosiery Co. v. Shore,439 U.S. 322 (1979).

2) Final Injunction

Defendants are ultimately entitled to a trial on the merits before a court may issue a final injunction. S.E.C. v.N. Am. Research & Dev. Corp., 59 F.R.D. 111 (S.D.N.Y. 1972) (rejecting SEC’s attempt to by-pass a hearingon the merits by following the preliminary injunction with a motion for summary judgment).

b. Civil Penalties

The Commission may seek a monetary penalty against any person in violation of the federal securities laws or aCommission cease-and-desist order. See Securities Act, § 20(d); Exchange Act §§ 21B, 21C; InvestmentAdvisers Act § 209(e); Investment Company Act § 42(e). Such fines can be as large as three times the profitgained or loss avoided as a result of a trade made “while in possession of material, non-public information.” Exchange Act §21A. Moreover, under current Commission policy, a defendant must agree to seek no taxbenefit or insurance benefit for a penalty payment.

There are six factors that the Commission considers to determine whether a fine is in the public interest: (1)whether the act in question involves “fraud, deceit, manipulation, or deliberate or reckless disregard of aregulatory requirement”; (2) resulting harm to other persons; (3) extent of unjust enrichment; (4) degree ofrecidivism; (5) the need to “deter such persons and other persons from committing such acts or omissions”; and(6) other considerations as justice may require. 1934 Act § 21B(c); Investment Company Act § 9(d);Investment Advisor’s Act § 203(i).

The Commission can also assess penalties on corporations. It considers two factors in determining theappropriateness of such a penalty: (1) the presence or absence of a direct benefit to the corporation from theviolation and (2) the degree to which the penalty will recompense or further harm the injured shareholders. Commission Rel. No. 2006-04 (Jan. 4, 2006) (listing the principles the Commission will use in imposingfinancial penalties). See also Litigation Release No. 19520, 2006 WL 20378 (Jan. 4, 2006) (announcing thatMcAfee agreed to a settlement that included a $50 million penalty); In re Applix, Inc., Release Nos. 8651,53059, 33-8651, 34-53049, AE-2359, 2006 WL 20379 (Jan. 4, 2006) (announcing a settlement that did notinclude a civil penalty).

In early 2006, the Commission issued its corporate penalties statement, which signaled that the Commissionwould take a more lenient approach toward penalties against issuers. In 2007, then-Chairman Cox announced anew pilot policy requiring Staff to obtain settlement authority from the Commission before negotiating withissuers regarding penalties. In February 2009, however, newly-appointed Chair of the Commission MarySchapiro indicated that this policy will no longer be enforced. The SEC hopes that by ending the pilot policy itwill expedite its enforcement efforts.

c. Disgorgement

In addition to a fine, the Commission may also seek disgorgement, “directing defendant to return the fullamount of profits derived from a violation.” See H.R. Rep. No. 101-616, 101st Cong., 2d Sess. 22 (1990); seealso S.E.C. v. J.T. Wallenbrock & Assocs., 440 F.3d 1109, 1114 (9th Cir. 2006) (affirming disgorgement orderentered by district court for $253.2 million and rejecting defendants’ request to offset expenses against amountordered disgorged); S.E.C. v. Jones, 476 F. Supp. 2d 374, 385-86 (S.D.N.Y. 2007) (holding that disgorgementremedy requires fact-finding by the district court to determine the amount of money acquired throughwrongdoing and an order compelling the wrongdoer to pay that amount plus interest to the court); S.E.C. v.Applegate, No. 1:05CV2363, 2006 WL 1005302 (N.D. Ohio Apr. 13, 2006) (holding that disgorgement is “notan equivalent to ordinary money damages, but rather is an equitable remedy sought in furtherance of the SEC’spolice powers” exempt from automatic stay pursuant to 11 U.S.C. § 362(b)(4)).

Section 304 of the Sarbanes Oxley Act also provides for the forfeiture of bonuses and profits received by theCEO and CFO when they fail to comply with securities law reporting requirements. 15 U.S.C. § 7243(a)(1). This section is limited to certain situations, however:

· Section 304 applies only where an accounting restatement actually was filed. S.E.C. v. Shanahan, 2008WL 5211909, at *5 (E.D. Mo. Dec. 12, 2008).

· The amounts subject to forfeiture are only those received during the twelve-month period following “thefirst public issuance or filing . . . of the financial document embodying such financial reporting requirement.” Id.; see also S.E.C. v. Mercury Interactive, LLC, 2009 WL 2984769, at *5 (N.D. Cal. Sept. 15, 2009) (findingspecifically that forfeiture did not apply to the twelve months following each public filing that violatedreporting requirements, only the first).

· This section applies to backdating only if it occurred on or after July 30, 2002, the date upon which thissection was enacted. Id. Backdating is said to have “occurred” as of the “filing of statements concealing theresulting compensation expenses.” Id. at *5–6.

· Section 304 does not create an implied private right of action for forfeiture. See, e.g., In re DigimarcCorp., 2008 WL 5171347, at *8 (9th Cir. Dec. 11, 2008).

d. Prospective Relief

1) Undertakings

As part of a settlement, the Commission will often require that a company agree to an “undertaking”—aparticularized prospective action—designed to ensure that the company cannot and will not commit the sameviolation again. See, e.g., In re PA Fund Mgmt., Exchange Release No. 50384 (Sept. 15, 2004) (requiringtrading fund defendants to implement written guidelines designed to prevent fund representatives from placingtrades with a broker-dealer based on his promotion or sale of fund shares).

2) Appointment Of Independent Consultant Or Corporate Monitor

Where a company’s activities are particularly egregious or require oversight beyond prospective restrictions, anindependent consultant or corporate monitor may be appointed.

E. Administrative Proceedings

The Commission has the authority to itself adjudicate certain alleged violations of the securities laws after an

administrative hearing on the record. Under the Exchange Act, the Commission has the power to imposeremedial sanctions on broker-dealers, associated persons, municipal securities dealers, government securitiesdealers, and transfer agencies, and to review disciplinary proceedings initiated by a registered clearing agency. 15 U.S.C. §§ 78o(b)(4), (b)(6), B(c), C(c). The Commission also has the responsibility of reviewing a numberof determinations made by SROs, including proceedings in which the SRO imposes disciplinary sanctions onits members and/or persons associated with a member. 15 U.S.C. § 78s(d)(2).

F. Rule 102(e) Proceedings

Under Rule 102(e) of the Commission’s Rules of Practice, the Commission may deny “the privilege ofappearing or practicing before it to any person who is found by the Commission after notice of and opportunityfor hearing” to not possess the requisite qualifications, to have engaged in unethical or improper professionalconduct, or to have willfully violated federal securities laws. Though Rule 102(e) proceedings may beoverturned if the Commission’s disqualification is not based on substantial evidence or is procedurallyimproper, see, e.g., Kivitz v. S.E.C., 475 F.2d 956 (D.C. Cir. 1973), the Commission’s use of these proceedingshas been upheld as a valid exercise of its power to protect the integrity of its own processes. Touche Ross v.S.E.C., 609 F.2d 570 (2d Cir. 1979).

1. Process

a. Conduct Of Hearings

A formal administrative proceeding is initiated by an “order instituting proceedings” issued by the Commission,and is commenced by serving all named respondents. 15 U.S.C. § 78u-2. Notice to respondent must contain(1) the nature of any hearing; (2) the legal authority and jurisdiction under which the hearing is to be held; (3) ashort and plain statement of the matters of fact and law to be considered; and (4) the nature of any relief oraction sought or taken. See SEC Rules of Practice 200(a)(1), (b).

Once initiated, a formal proceeding is usually tried before an Administrative Law Judge (“ALJ”), anindependent Commission employee. S.E.C. Rule of Practice 110. But see 5 U.S.C. § 556(b) (affording theCommission the right to consider a hearing en banc). The proceeding is conducted in manner similar to a non-jury trial, with each of the respondents able to present evidence and testimony and to cross-examine witnesses. Unlike a trial, however, a proceeding before the Commission affords the respondents no right to discovery andproceeds at a much faster pace under looser evidentiary standards. At the proceeding’s conclusion, the ALJfiles an “initial decision” containing findings of fact and conclusions of law.

b. Appeal To The Commission

“The Commission will not review a hearing officer’s ruling prior to its consideration of the entire proceeding inthe absence of extraordinary circumstances.” S.E.C. Rule of Practice 400(c). In other words, once aproceeding has been assigned to an ALJ, all motions, objections, and other filings must be directed to anddecided by the hearing officer until the ALJ issues an initial decision. S.E.C. Rule of Practice 151(c).

After issuance of the ALJ’s initial decision, respondents may file a petition for a Commission review or theCommission may order review on its own initiative. S.E.C. Rules of Practice 360, 410, 411. Respondent’spetition for review must make a “reasonable showing” that the ALJ made prejudicial procedural error or thatthe initial decision was the product of a clearly erroneous finding or conclusion of law or fact. S.E.C. Rule ofPractice 411(b)(2).

Review may proceed only as to those issues specified in the petition or otherwise raised at the Commission’sdiscretion. S.E.C. Rule of Practice 411. The parties may file exceptions and briefs with the Commission, and

oral argument is granted at the written request of any party unless circumstances make it “impracticable orinadvisable.” S.E.C. Rule of Practice 451. Ruling on a “preponderance of the evidence,” see Steadman vS.E.C., 450 U.S. 91 (1981), the Commission renders judgment on the basis of submitted materials. It maymodify the initial decision in any way, even increasing the initial sanctions. See Hanly v. S.E.C., 415 F.2d 589(2d Cir. 1969). Absent a petition or order for review, the Commission’s initial decision becomes final. S.E.C.Rule of Practice 360.

c. Appeal To United States Court Of Appeals

Once a final order has been entered, parties may appeal the Commission’s decision to either the United StatesCourt of Appeals for the District of Columbia or the circuit in which the appealing party resides or has itsprincipal place of business. See 1933 Act § 9; 1934 Act § 25.

Parties may not appeal Commission decisions that have been adjudged not to constitute an “order.” “No-action” letters, for example, when directed at a routine matter the SEC considered and chose not to examine, donot constitute an “order” subject to judicial review. Koss v. S.E.C., 364 F. Supp. 1321 (S.D.N.Y. 1973).

2. Sanctions

Sanctions that can be imposed in these proceedings include the SEC’s power to “censure, place limitations onthe activities, functions, or operations, suspend for a period not exceeding 12 months a broker-dealer [orassociated person], or revoke the registration of a broker-dealer” (this includes the possibility of a bar from thatassociation). 15 U.S.C. §§ 780(b)(4) (as to broker-dealer), (b)(6) (as to person associated with broker-dealer). The Commission also has authority under the Investment Advisers Act to impose remedial sanctions oninvestment advisers. 15 U.S.C. § 80b-3(i). Under the Investment Company Act, the Commission may barpersons from serving or acting in the capacity of an employee, officer, director, member of an advisory board,investment adviser to or depositor of, or principal underwriter for a registered investment company. 15 U.S.C.§ 80a-9. It can, in an administrative proceeding, stop order a registration statement under the Securities Act. 15U.S.C. § 77h(d) (stop orders). The Commission does not have comparable stop-order authority with respect toreports filed under the Exchange Act, proxies, or tender offer material. It can initiate an administrativeproceeding in which it may, after notice and opportunity for hearing, enter an order finding a failure to complywith registration, reporting, proxy, or tender offer requirements of the Exchange Act and order compliancetherewith. 15 U.S.C. § 78o(c)(4).

The appropriate remedial sanction depends on which is “in the public interest.” See, e.g., In re Marshall E.Melton & Asset Mgmt. & Research, Inc., Exch. Act. Release No. 48,228, 2003 WL 21729839 (July 25, 2003).

a. Cease And Desist Orders

The Commission has broad authority to administratively enter cease and desist orders that restrain violation orthreatened violation of the securities laws by any person. See 15 U.S.C. §§ 77h-1, 78u-3, 80a-9(f), § 80b-3(k). If the Commission finds “that any person is violating, has violated, or is about to violate any provision” of theSecurities Act, the Exchange Act, the Investment Company Act, the Investment Advisers Act, or any rule orregulation adopted thereunder, it may enter an order directing the respondent “to cease and desist fromcommitting or causing such violation and any future violation.” The order may also be directed against anyperson who was, is, or may become the cause of such violation “due to an act or omission the person knew orshould have known would contribute to such violation.” 15 U.S.C. § 78u-3(a). The order may also direct therespondent to take specific steps “to effect compliance . . . within such time” as the Commission may order. See, e.g., 15 U.S.C. § 78u-3(a). The Commission must initiate such a proceeding by giving the respondentnotice fixing a hearing date not earlier than thirty days or later than sixty days after service of the notice, unlessthe Commission and respondent agree to another date. See, e.g., 15 U.S.C. § 78u-3(b). After the hearing and

prior to or in conjunction with the entry of an order, the Commission must publish its findings.

1) Enforcing A Cease And Desist Order

If a cease and desist order is violated, the Commission can initiate a proceeding in an appropriate federal districtcourt to impose a civil penalty. 15 U.S.C. § 78u(d)(3)(A). The basis for the remedy before the federal court isviolation of the cease and desist order. The Commission does not have to prove the underlying violation thatgave rise to the cease and desist order.

2) Disgorgement And Accounting

In any proceeding where the Commission seeks to impose a cease and desist order, it may enter an orderrequiring an accounting, disgorgement of any profit, and payment of reasonable interest. 15 U.S.C. §§ 77h(c),78t(3). A cease and desist proceeding can be initiated against any person for any violation of federal securitieslaws; the Commission’s authority to require disgorgement and accounting is thus far-reaching.

b. Monetary Penalties

The Commission has the authority to impose a monetary penalty on any securities professional who violates thesecurities laws. The authority to impose such a fine in an administrative proceeding is limited to those areas inwhich the Commission otherwise has authority under the securities laws to impose remedial sanctions. See 15U.S.C. §§ 78u, 80a-9(d), 80b-3(i).

Remedial sanctions can also be imposed against one who has aided, abetted, counseled, commanded, induced orprocured such violation and against a person who “failed reasonably to supervise with a view to preventing . . .another person who commits such a violation, if such other person is subject to his supervision.” See, e.g., 15U.S.C. § 78o(b)(4)(E).

In a proceeding under the Exchange Act or the Investment Advisers Act, the Commission has the authority toimpose remedial sanctions, including censure, a twelve-month suspension, a revocation, or a permanent barfrom serving as an officer or director.

c. Suspension/Permanent Bar

The Commission has the authority to initiate a civil action seeking a bar or suspension against an officer ordirector for violation of the anti-fraud provisions of the Exchange Act § 10(b) and Rule 10b-5 or the SecuritiesAct § 17(a)(1), or if that person “demonstrates substantial unfitness to serve as an officer or director of any suchissuer.” 1933 Act § 20(e), 1934 Act § 21(d); see also PAZ Sec., Inc. v. S.E.C., 494 F.3d 1059 (D.C. Cir. 2007)(holding that the SEC abused its discretion “by failing to address certain mitigating factors the petitioners raisedbefore it and by affirming the severe sanctions imposed upon them by the NASD without first determining[that] those sanctions were remedial rather than punitive”); Rooms v. S.E.C., 444 F.3d 1208 (10th Cir. 2006)(finding that the SEC’s imposition of a permanent bar from the securities business on a broker was not an abuseof discretion); S.E.C. v Patel, 61 F. 3d 137 (2d Cir. 1995) (enumerating factors to be considered when decidingif a party is “substantially unfit to serve,” including the “egregiousness” of the underlying violation and whetherthe defendant was a repeat offender); S.E.C. v. DiBella, 2008 WL 6965807, at *29–31 (D. Conn. Mar. 13, 2008)(declining to impose an officer/director bar, despite finding that defendant acted with scienter, becausedefendant’s misconduct occurred 10 years prior and constituted his first and only violation of securities law).


In addition to parallel civil proceedings brought by the SEC and Self Regulatory Organizations, securities classactions are more and more frequently intertwined with criminal actions. In the wake of securities related scandalssuch as Enron, and in light of the current global economic crisis, criminal enforcement is politically popular. Boththe 1933 Securities Act and the 1934 Exchange Act criminalize willful violations of the Acts’ provisions and therules promulgated under the Acts’ authority. Additionally, criminal charges under the Acts are often accompaniedby charges under the criminal code. These additional criminal charges typically include mail and wire fraud,conspiracy, RICO violations, false statements, perjury and obstruction of justice.

In December 2004, the Director of the SEC’s Division of Enforcement quantified the duality of civil andcriminal enforcement of the securities laws:

In the last two fiscal years, the SEC has brought more than 1,300 civil cases and has obtaineddisgorgement and penalties in excess of $5 billion. These numbers far exceed those of anyother two-year time frame in the Commission’s history. In the same period, the Departmentof Justice has brought criminal cases alleging securities-related misconduct by more than500 defendants.

A. Parallel Civil And Criminal Proceedings

Parallel proceedings exist when separate criminal, civil, or administrative actions involving a common set offacts occur simultaneously or consecutively. In the white collar securities context, this typically means acriminal grand jury investigation or prosecution occurring alongside an (a) SEC action, (b) private civillitigation, or (c) self-regulatory organization action (such as by FINRA). See Securities and ExchangeCommission, Division of Enforcement, ENFORCEMENT MANUAL § 5.1-5.2 at 108-11 (Oct. 6, 2008) (describingSEC procedures for cooperating with criminal authorities and considerations for parallel investigations).

1. Potential Benefits To Defendants

Despite the ominous specter of liability on multiple fronts, the existence of one or more parallel proceedingscan sometimes provide a defendant with tools that are otherwise unavailable.

a. Civil Discovery

Most significantly, the existence of parallel civil proceedings can allow a criminal defendant to use the liberalcivil discovery rules to his or her benefit. If the civil proceedings occur before a criminal trial, for example, thedefendant can gain access to a wide range of discovery tools under Federal Rule of Civil Procedure 26 thatwould be otherwise unavailable, such as interrogatories, depositions, requests for admission, and broaddocument requests. Civil depositions can be particularly useful, since (1) counsel during such depositions oftenhave a different goal than a criminal prosecutor would in eliciting information from the witness and (2) theygive criminal defendants an opportunity to depose government witnesses and cooperatives. In addition, civildocument requests can prompt the early disclosure of any Jencks Act or 18 U.S.C. § 3500 material to a criminal


defendant, if such information is contained in regulators’ files. Robert S. Khuzami, Parallel Criminal and CivilProceedings in Securities Fraud Cases, ABA White Collar Crime 2004, at B-13.

b. Collateral Estoppel And Persuasive Effect Of Civil Victory

Another potential benefit to a parallel proceeding is that favorable results in civil cases can sometimes persuadecriminal prosecutors to drop charges, or not to file charges in the first place. See, e.g., United States v. Rogers,960 F.2d 1501, 1507-10 (10th Cir. 1992) (dismissing an indictment on collateral estoppel grounds to the extentthat it relied on facts decided against the SEC in a prior unsuccessful injunction proceeding). Indeed, SECconsent decrees involving findings of fact and conclusions of law are generally treated as “final judgments onthe merits” for res judicata purposes. United States v. S. Ute Tribe or Band of Indians, 402 U.S. 159 (1971). The reverse can also occur, such as in the McKesson HBOC cases where an SEC action against the company’sformer CFO was voluntarily dismissed after he was acquitted following a criminal trial.

Res judicata and collateral estoppel are not beneficial to parallel proceeding defendants under certaincircumstances. A criminal acquittal, for example, has no res judicata or collateral estoppel force on asubsequent civil or administrative matter. A criminal conviction, however, can be used as evidence against adefendant in later civil proceedings. Marvin G. Pickholz, Securities Crimes § 3:17-18, at 3-40-41 (2001);United States v. Killough, 848 F.2d 1523 (11th Cir. 1988) (permitting government in civil proceedings tointroduce defendants’ guilty pleas from prior criminal investigations of kickback scheme); In re AdelphiaCommc’ns Corp. Sec. & Derivative Litig., No. 03 MD 1529 (LMM), 03-CV-5750, 2006 WL 2463355(S.D.N.Y. Aug. 23, 2006) (ruling on plaintiff’s attempt to use defendants’ criminal conviction as offensivecollateral estoppel); S.E.C. v. Haligiannis, 470 F. Supp. 2d 373, 382 (S.D.N.Y. 2007) (finding that collateralestoppel can be appropriate in securities fraud cases as “the elements necessary to establish civil liability underSection 17(a) and 10(b) are identical to those necessary criminal liability under Section 10(b)”). Also, the SECcan use collateral estoppel to prevent a defendant from relitigating an issue already decided against him in aparallel criminal proceeding. Parklane Hosiery Co., Inc. v. Shore, 439 U.S. 322 (1979).

2. Benefits To The Government, Regulators, And Civil Plaintiffs

Although parallel proceedings can provide defendants with some useful tools, their existence strongly favorsthe government, regulators, and civil plaintiffs. The potential benefits afforded plaintiffs and the governmentare many and can include free flow of information between state and federal prosecutors and the SEC, pretrialseizure or forfeiture of civil defendants’ assets by federal agencies, and an adverse inference is drawn from aninvocation of the Fifth Amendment in civil proceedings. See generally, Marvin G. Pickholz, Securities Crimes§ 3 (2001).

a. SEC Information Gathering And Disclosure

Litigants in parallel proceedings should assume that all information obtained by the SEC will be available tostate and federal prosecutors, as well as other agencies. Accordingly, attorneys need to understand that anydisclosures to the SEC can give rise to potential liability for violations of antitrust regulations; bankingregulations; food, drug, and alcohol laws; EPA regulations; IRS regulations; Energy Department regulations;State Department regulations; labor laws; and federal communications laws. Marvin G. Pickholz, SecuritiesCrimes § 3:5, at 3-12 (2001). As a result, lawyers must be extremely mindful of all representations in SECfilings or responses. See, e.g., S.E.C. v. Merrill Scott & Assocs., 2008 WL 276502 (D. Utah Jan. 30, 2008)(holding that defendant was not entitled to the return of materials he produced pursuant to a protective order inan SEC enforcement action, where the materials were provided by the SEC to the United States Attorney’sOffice, which subsequently provided them to the IRS).

3. Judicial Scrutiny

In light of the increased coordination between SEC investigators and federal prosecutors, courts may be moreinclined to scrutinize the fairness of parallel proceedings. In United States v. Scrushy, 366 F. Supp. 2d 1134(N.D. Ala. 2005), the Northern District of Alabama granted a motion to suppress the defendant’s SECdeposition from being used in the criminal trial against him on the grounds that the SEC and the U.S.Attorney’s office had improperly coordinated their activities. Without notifying the defendant of the criminalinvestigation against him, the U.S. Attorney’s office directed the SEC investigators regarding the content of thequestions at the deposition and its location, and recruited an SEC investigator to participate in the U.S.Attorney’s interviews of two witnesses. Finding no controlling law on the issue of the limits of parallelinvestigations, the court held that “the prosecution may use evidence acquired in a civil action in a subsequentcriminal proceeding unless the defendant demonstrates that such use would violate his constitutional rights ordepart from the proper administration of criminal justice.” Id. at 1138 (quoting United States v. Teyibo, 877 F.Supp. 846, 855 (S.D.N.Y. 1995), aff’d, 101 F.3d 681 (2d Cir. 1996)).

In S.E.C. v. Reyes, No. C06-04435 CRB (N.D. Cal. Feb. 6, 2007), the Court observed that the government mayhave selectively used its power to grant use immunity to several witnesses in order to reap the benefit of witnesstestimony while effectively preventing defendants from accessing the same information in the SEC action. Although the court could not compel a grant of immunity, it indicated that it would be prepared at anappropriate time to create an exclusionary remedy to deprive the SEC of the benefit of the government’sselective grants of immunity. See also S.E.C. v. Sandifur, No. C05-1631 C, 2006 WL 3692611 (W.D. Wash.Dec. 11, 2006) (denying the government’s request for stay of the depositions of the auditors in an accountingfraud case and ordering a Walsh Act subpoena for the deposition testimony of the former audit manager nowworking for the audit firm’s affiliate in a foreign country); S.E.C. v. Kornman, No. 3:04-CV-1803-L, 2006 WL1506954 (N.D. Tex. May 31, 2006) (calling the SEC’s move to dismiss the civil action “an attempt tocircumvent” the two decisions denying the stay of the civil proceedings and dismissing the SEC’s case whilestill allowing the defendant’s discovery to take place); S.E.C. v. Saad, 229 F.R.D. 90, 92 (S.D.N.Y. 2005)(holding that the government’s argument that it desired to stay the civil discovery process so the defendantcould not gain a special advantage was difficult to credit where “the U.S. Attorney’s Office, having closelycoordinated with the SEC in bringing simultaneous civil and criminal actions against some hapless defendant,should then wish to be relieved of the consequences that will flow if the two actions proceed simultaneously”).

However, in United States v. Stringer, 535 F.3d 929 (9th Cir. 2008) the Ninth Circuit reversed the lower court’sdismissal of securities fraud charges against three defendants. The lower court’s ruling had found that thegovernment had used “trickery and deceit” in conducting parallel SEC and criminal proceedings, and concludedthat the government had used the SEC investigation simply to facilitate a criminal prosecution. U.S. v. Stringer,408 F. Supp. 2d 1083 (D. Or. 2006). The Ninth Circuit, however, found a bona fide parallel investigationbecause the SEC’s civil investigation was opened first, led to SEC sanctions, and was conducted pursuant to theSEC’s civil enforcement jurisdiction. The court also held that SEC Form 1662 provides investigative witnesseswith sufficient notice of their due process rights, namely that the information can be used in a criminalproceeding and the availability of the Fifth Amendment to prevent compelled self incrimination. The Courtalso noted that Congress has expressly authorized the SEC to share information with the Justice Department tofacilitate the investigation and prosecution of crimes. Id. The Ninth Circuit’s ruling is significant as it affirmsthe broad discretion given by courts to the government in conducting parallel proceedings and emphasizes thedifficult cooperation decisions faced by corporate and individual defendants.

4. Self-Regulatory Organizations

While parallel proceedings are most visible in the context of DOJ-SEC coordination, litigants must also beaware of the potential for concurrent actions by self-regulatory organizations (SROs). SROs includeorganizations (such as FINRA or its predecessor NASD) whose members are subject to that organization’sprivate rules and regulations. SROs are treated as private corporations; as a result, their members cannot invokemost constitutional rights and SROs can demand sworn testimony from members. Marvin G. Pickholz,

Securities Crimes § 3:1.30, at 3-2.2 (2001).

5. Communicating With The Government

a. Fifth Amendment

The Fifth Amendment can be a defendant’s greatest shield during a criminal investigation. However, its use isgreatly complicated in parallel proceedings. While the Fifth Amendment protects criminal defendants fromhaving to take the witness stand at trial, testifying before the SEC or in other proceedings may constitute waiverof that privilege. Moreover, civil defendants have no Fifth Amendment protection under the Constitution andcan be compelled to take the stand. If a civil defendant or witness takes the stand or responds to discoveryrequests but refuses to testify, an adverse inference can be drawn by the trier of fact, and that inference can beused against the defendant at the civil trial. Robert S. Khuzami, Parallel Criminal and Civil Proceedings inSecurities Fraud Cases, ABA White Collar Crime 2004, at B-12. Finally, it is important to remember that theFifth Amendment privilege applies only to natural persons; a corporation has no Fifth Amendment right. SeeCurcio v. United States, 354 U.S. 118, 122 (1957).

b. Proffer Agreements

Prosecutors generally prefer not to call a witness before a grand jury if that witness will assert the FifthAmendment. To overcome this, informal “proffer sessions” have emerged, enabling prosecutors to hear thewitness’s version of the events if the witness voluntarily agrees. The session is held pursuant to a writtenagreement stating that the revealed information will not be used directly against that individual, except inlimited circumstances. Marvin G. Pickholz, Securities Crimes § 3:1.50, at 3-3 (2001). These profferagreements fall short of true immunity, but they are viewed by courts as binding contracts and should benegotiated accordingly.

It is important to note that the SEC is often invited to DOJ proffer sessions and may even request that thedefendant sign a separate SEC proffer agreement with different terms. Since proffer sessions are entirelyvoluntary, defense counsel should request that either the SEC not be present or that the SEC subscribe to thesame agreement offered by the prosecutors. Marvin G. Pickholz, Securities Crimes § 3:1.50, at 3-3 (2001); seeS.E.C. v. Johnson, 534 F. Supp. 2d 63 (D.D.C. 2008) (holding that proffer statements allegedly made byexecutives during meetings with prosecutors and FBI agents were inadmissible in a civil enforcement actionbrought by the SEC because the statements were made in the course of plea discussions and the SEC was not asignatory to the proffer agreement).

c. Immunity

Depending on the circumstances, it may be possible for a defendant to obtain immunity for a parallel criminalproceeding. There are two main types of immunity: transactional and derivative use.

1) Transactional Versus Derivative Use Immunity

Transactional immunity covers an entire category of behavior, while derivative use covers just direct or indirectuse (or the “fruits”) of your client’s testimony or statements. See Counselman v. Hitchcock, 142 U.S. 547, 586(1982); Murphy v. Waterfront Comm’n of N.Y. Harbor, 378 U.S. 52 (1964). Though transactional immunity isgenerally preferable, it is almost never granted. Derivative use immunity, on the other hand, is sometimesattainable and can be quite broad in scope. Indeed, it is extremely difficult to successfully prosecute someone

who has been given either form of immunity unless the subject has breached the agreement. Derivative useimmunity can be ordered by the court under 18 U.S.C. § 6002 or can be negotiated through an immunityagreement between a defendant and the Assistant United States Attorney.

2) Informal Immunity

A prosecutor or case agent can also immunize your client through the use of “pocket” or “informal” immunity. This is an oral offer of immunity, typically given to minor witnesses who have committed some lesserwrongdoing and are reluctant to talk. Pocket immunity—if proven to exist—is generally as enforceable asformal immunity, but courts tend to disfavor it since the extent of immunity granted is often unclear. SeeSteven D. Clymer, Compelled Statements from Police Officers and Garrity Immunity, 76 N.Y.U. L. Rev. 1309,1382, n.34 (2001).

d. Privilege And The Holder/Thompson/McCallum/McNulty/Filip Memos

Counsel must be especially wary of privilege waiver in the parallel proceedings context. Though courts are stillsomewhat split, waiver of attorney-client privilege in a federal enforcement proceeding generally waivesassertion of that privilege in all later actions. See In Re Columbia/HCA Healthcare Corp. Billing PracticesLitig., 293 F.3d 289, 298-302 (6th Cir. 2002) (joining the First, Third, Fourth, and D.C. Circuits in rejecting thenotion of “selective waiver” of the attorney-client privilege). But see Diversified Indus. Inc. v. Meredith, 572F.2d 596, 607, 611 (8th Cir. 1977).

This waiver result can greatly complicate dealings with the DOJ, as the DOJ in many instances has practicallyrequired some amount of privilege waiver by the defense, no matter the waiver implications. Specifically,many prosecutors have demanded that corporations waive the attorney-client privilege in any circumstance inwhich the corporation seeks favorable disposition of a government investigation. In a series of memoranda, theDOJ has sought to form a consistent policy with regard to this important privilege/cooperation issue.

1) Holder Memo

This government’s position was outlined in a June 1999 memorandum from then-Deputy Attorney General EricHolder (“Holder Memo”). The Holder Memo provides in part that a party’s “timely and voluntary disclosure ofwrongdoing and its willingness to cooperate in the government’s investigation” are relevant to a prosecutor’sdecision not to criminally charge the corporation. The Memo further states:

“[i]n gauging the extent of the corporation’s cooperation, the prosecutor may consider thecorporation’s willingness to identify the culprits within the corporation, including senior executives,to make witnesses available, to disclose the complete results of its internal investigation, and to waivethe attorney-client and work product privileges.”

2) Thompson Memo

The Holder Memo seems discretionary on its face, but many AUSAs began requiring waiver of applicableprivileges as a prerequisite to any agreement with the government. Then, on January 20, 2003, the governmentelaborated on its position in a memo by Larry Thompson, Deputy Attorney General (“Thompson Memo”). TheThompson Memo identified circumstances it considered obstructionist, including:

(a) overly broad assertions of corporate representation of employees or former employees,

(b) inappropriate directions to employees or their counsel, such as directions not to cooperate openly andfully with the investigation (including declining to be interviewed),

(c) making presentations or submissions that contain misleading assertions or omissions,

(d) incomplete or delayed production of records, and

(e) failure to promptly disclose illegal conduct known to the corporation.

3) McCallum Memo

On October 21, 2005, the government initiated an effort to formalize review of the use of privilege waiver byU.S. Attorneys in a memo by Robert D. McCallum, Jr., Acting Deputy Attorney General (“McCallumMemo”). Noting that some U.S. Attorneys’ Offices had developed review processes requiring federalprosecutors to obtain approval from the United States Attorney or some other supervisor before seeking thewaiver of attorney-client privilege or work product protection, the McCallum Memo directed each U.S.Attorney’s Office to establish a written waiver review process “[c]onsistent with this best practice.” At thesame time, the memo observed that the specific contours of each district’s review process “may vary fromdistrict to district (or component to component), so that each United States Attorney or component head retainsthe prosecutorial discretion necessary, consistent with their circumstances, to seek timely, complete, andaccurate information from business organizations.”

4) McNulty Memo

On December 12, 2006, Deputy Attorney General Paul McNulty issued a memo revising the Thompson Memoby adding new restrictions for prosecutors seeking privileged information from companies. Specifically, itcreates new approval requirements that federal prosecutors must comply with before they can request waiversof attorney-client privilege and work product protections from corporations in criminal investigations. The newguidance requires that prosecutors must first establish a legitimate need for privileged information, and that theymust then seek approval before they can request it.

5) Filip Memo

Most recently, the Department of Justice has modified many of the cooperation credit policies outlined in theMcNulty memorandum, significantly changing its earlier position with respect to attorney-client privilege andattorney fees. First, credit for cooperation no longer depends on whether a corporation has waived attorney-client privilege or work product protection, or produced materials subject to such protection. Instead, itdepends on the disclosure of relevant facts, regardless of whether they stem from protected or unprotectedmaterials. In addition, federal prosecutors are forbidden from requesting privileged communications and workproduct, subject to minimal exceptions. Second, prosecutors are no longer allowed to consider whether acorporation has advanced attorneys’ fees to employees, officers, or directors, entered into a joint defenseagreement, or sanctioned or retained culpable employees in evaluating the corporation’s cooperation. Instead,prosecutors may only consider whether a corporation has disciplined employees that the corporation hasidentified as culpable, and only for the purpose of evaluating the corporation’s remedial measures orcompliance program. Deputy Attorney General Mark Filip, Remarks at the American Bar AssociationSecurities Fraud Conference (Oct. 2, 2008) (transcript available at the U.S. Department of Justice website).

In light of the position set forth in these memos, counsel should take all steps to protect applicable privileges,but advise clients that waiver of available privileges may be difficult to avoid.

6) KPMG Cases

In United States v. Stein, 440 F. Supp. 2d 315 (S.D.N.Y. 2006), the court concluded that the principles set forthin the Thompson Memorandum, coupled with meetings between KPMG and the federal prosecutors, allowedthe conclusion that the government had “conducted itself in a manner that evidenced a desire to minimize theinvolvement of defense attorneys,” resulting in KPMG’s revised policy regarding the payment of legal fees foremployees. This led to the holding that the government, through the Thompson Memorandum and actions ofthe prosecutors, had violated the Fifth and Sixth Amendment rights of individual defendants by causing KPMGto cut off payment of legal fees and defense costs. In United States v. Stein, 435 F. Supp. 2d 330 (S.D.N.Y.2006), the court suppressed defendant statements that were gained through these prosecutorial actions. InUnited States v. Stein, 495 F. Supp. 2d 390, 427 (S.D.N.Y. 2007), the court dismissed the charges against 13 ofthe 16 defendants because the DOJ used the Thompson Memorandum to prevent the defendants from“obtaining funds for their defense that they lawfully would have had absent the government’s interference.” The Second Circuit affirmed these decisions in United States v. Stein, 541 F.3d 130 (2nd Cir. 2008), holdingthat, by strongly influencing defendants’ employer-corporation to condition, cap, and ultimately cease theadvancement of legal fees, the government unjustifiably interfered with defendants’ relationship with counseland their ability to mount the best defense in violation of the Sixth Amendment and upheld the lower court’sdismissal of indictments against plaintiffs.

6. Grand Juries And Subpoenas

a. The Grand Jury

Before a defendant can be tried for most federal crimes, a grand jury must issue an indictment upon a finding ofprobable cause. U.S. Const. amend V. Federal Rule of Criminal Procedure 6(e)(2) requires that all “mattersoccurring before the grand jury” generally be kept secret by the participants. This means that the governmentmay not use grand jury proceedings to augment its efforts in the civil context. United States v. Proctor &Gamble Co., 356 U.S. 677, 683 (1958). But it also means that even the attorney cannot accompany a client intothe grand jury room. As a result, it is rarely advisable for a defense attorney to allow the target of a criminalinvestigation to appear and testify before a grand jury. The Fifth Amendment protection against self-incrimination is available and should almost always be asserted to avoid providing any information whichfurther entangles the client in a criminal investigation.

According to the Seventh Circuit, a defendant’s assertion that he or she had been called as a witness in a grandjury proceeding in order for the prosecution to obtain testimony to serve as the basis for a perjury charge is nota defense when prosecuted for perjury. United States v. Burke, 425 F.3d 400, 408 (7th Cir. 2005).

b. Subpoenas

During a criminal investigation, the grand jury has the power to issue subpoenas for testimony (subpoena adtestificandum) or for documents or other objects (subpoena duces tecum). For parallel proceeding litigants, thismost often comes up where subpoenas ad testificandum are issued for witnesses to appear and testify before agrand jury. Yale Kamisar et al., Modern Criminal Procedure 10(1)(B), at 678 (9th ed. 1999). Unlike a searchwarrant, there is no probable cause requirement for a grand jury to issue a subpoena. Id. at 679.

Administrative agencies also have subpoena power under the False Claims Act (FCA), 31 U.S.C. § 3733. These are sometimes referred to as Civil Investigative Demands (CIDs). Much like grand jury subpoenas, thereis no probable cause requirement and they are enforceable by the appropriate district court.

7. Criminal Discovery And Trial

a. Defendants’ Discovery Rights

Federal Rules of Criminal Procedure 16 and 26.2 govern much of the defendant’s discovery rights in a criminalcase. In addition to the evidence mentioned there, a criminal defendant is also entitled to receive allexculpatory evidence in the government’s possession in time for its effective use at trial, Brady v. Maryland,373 U.S. 83 (1963), as well as any impeachment material. Giglio v. United States, 405 U.S. 150 (1972). Finally, the Jencks Act, 18 U.S.C. § 3500, entitles the defendant to prior statements possessed by thegovernment, of a government witness, if the statement relates to the subject matter of the witness’s testimony. The defendant is entitled to these statements at the conclusion of the witness’s testimony, but as a practicalmatter the statements are typically turned over in time for the defense to examine them without delaying thetrial. Typically, a defendant should request the following materials in a federal criminal case, where available:

grand jury transcripts and other relevant prior witness statements (entitled to under Fed. R. Crim. P. 26.2),

any statements he may have made, whether written or recorded, that are in the possession of thegovernment (entitled to under Fed. R. Crim. P. 16(a)),

the Defendant’s prior record as known or available to the government (entitled to under Fed. R. Crim. P.16(b)),

documents and tangible objects that are material to either the prosecution’s case or the defendant’s defense(entitled to under Fed. R. Crim. P. 16(c)),

the results of any tests or reports of examination that are material to either the prosecution’s case or thedefendant’s defense (entitled to under Fed. R. Crim. P. 16(d)),

a written summary of expert witness testimony to be used at trial by the prosecution (entitled to under Fed.R. Crim. P. 16(e)),

302s (FBI Agent Interview Reports) (not usually entitled to under Jencks Act unless the authoring agent is awitness, or some witness read or relied on them, but may be entitled to under Brady), and

FBI Agent Notes (entitled to under Jencks Act).

In U.S. v. Reyes, 2009 U.S. App. LEXIS 24575 (9th Cir. Nov. 5, 2009), the court reversed the conviction of aCEO for backdating stock options on the ground that a prosecutor’s material misstatements in closing argumentthat he knew from FBI 302s to be false constituted prosecutorial misconduct that prejudiced the defendant. Onremand, Reyes was again tried and again convicted, and the district denied his motions for a new trial and forjudgment of acquittal. U.S. v. Reyes, 2010 U.S. Dist. LEXIS 70369 (N.D. Cal. June 24, 2010).

b. Defendant’s Discovery Obligations

A criminal defendant’s disclosure obligations to the prosecution are much less than those of a civil defendant toa plaintiff. There are a few limited requirements that apply to criminal defendants, however. Federal Rule ofCriminal Procedure 16(b) requires that, when a criminal defendant requests documents or tangible evidencefrom the government or examination results under Rule 16(a)(1)(C) or (D), the defendant must produce thesame kinds of evidence to the government on its request (so long as the defendant intends to introduce thatevidence in its case in chief at trial). Moreover, the defendant must provide the government with written expert

witness reports if (i) the government has complied with defendant’s Rule 16(a)(1)(E) request for an expertreport or (ii) the defendant has given notice of an intent to present expert testimony as to the defendant’s mentalcondition. Fed. R. Crim. P. 16(b)(1)(c).

8. Double Jeopardy

Attorneys involved in parallel proceedings may sometimes encounter double jeopardy issues. The Constitutionprovides that a person may not be prosecuted or punished twice for the same offense. U.S. Const. amend V. Double jeopardy is said to “attach” when the jury is impaneled (jury trial) or when the first witness is sworn(bench trial). Willhauck v. Flanagan, 448 U.S. 1323, 1325-26 (1980). To determine whether a defendant isbeing tried for the “same offense,” the Blockburger test is commonly used. Blockburger v. United States, 284U.S. 299 (1932). The Blockburger test provides that if an offense contains an element not contained in theother, they are different offenses for double jeopardy purposes and both may be charged. United States v.Dixon, 509 U.S. 688 (1993). In rem civil forfeitures have been found not to be punishment for double jeopardypurposes, but in personam civil penalties and fines can be. United States. v. Ursery, 518 U.S 267 (1996). Thus,counsel should be aware of such an argument where civil penalties or fines are at issue.

9. Multiple Defendant Issues

Litigants in parallel proceedings should be aware of two major issues that can arise when there is more than onedefendant in an action. These issues include ethical considerations regarding multiple representation andwhether to enter into a joint defense agreement.

a. Ethical Considerations

ABA Model Rules 1.13(e), 1.7, and 1.8 (and applicable state codes and case law) generally permit multiplerepresentation of, for example, two executives of a company, or the company and one or more executives. Marvin G. Pickholz, Securities Crimes § 3:3, at 3-8-9 (2001). However, such representation is not alwayswise. Counsel should be mindful of the possible dangers of representing more than one defendant wherecommon issues of fact are involved. An attorney retained by a corporate client should first determine whichlevels of the corporate family she will represent. Id. at 3-8. These can include: the corporation, managementdirectors, independent (“outside” or “nonmanagement”) directors, senior corporate officials, or lower levelcorporate employees. The attorney must also consider the compatibility of the clients’ interests, since—as thelitigation or investigation goes forward—clients’ interests may change. If this occurs, the attorney’s ability torepresent a particular client in future parallel proceedings may be limited. See, e.g., In re Grand Jury Subpoena(Under Seal), 415 F.3d 333 (4th Cir. 2005) (holding that employees did not enter into attorney-clientrelationship with company’s attorneys despite statement that “we can represent you as long as no conflictappears” and noting the “legal and ethical mine field” of multiple representation).

b. Joint Defense Agreements

In addition to the ethical issues, parallel proceeding litigants must consider the possibility of a joint defenseagreement. A joint defense agreement (or, perhaps more appropriately, a “common interest” agreement) istypically a written agreement intended to advance a common interest among defendants. Marvin G. Pickholz,Securities Crimes § 3:20-3:23, at 3-43-3-51 (2001). It permits parties to share otherwise privileged materialswithout risking waiver. Prosecutors are generally hostile towards these, but they can be very useful tools fordefendants in preserving confidential information (the “joint defense privilege”). Id. at 3-51. To be effective, ajoint defense agreement should cite case law and specifically outline the common interest, types of protectedcommunications, and the parties involved. It should also regulate or prohibit voluntary communications withthe government, and testifying against other parties. Id. at 3-51-3-58; see, e.g., In re Grand Jury Subpoena

(Under Seal), 415 F.3d 333 (4th Cir. 2005) (finding that because employee’s “common interest agreement”with employer did not exist at the time of employer’s attorneys’ early information-gathering interviews withemployee, these interviews were not protected by attorney-client privilege).

10. Stays And Protective Orders

Defendants in parallel proceedings must familiarize themselves with two important civil proceduralmechanisms: the stay and the protective order. Any party to a civil or administrative proceeding can moveeither for a stay pending the outcome of a parallel criminal proceeding or for a protective order limiting orplacing conditions on civil discovery. Marvin G. Pickholz, Securities Crimes § 3:8, at 3-18 (2001).

a. Stays

Civil or administrative stays are frequently sought by either the defendant or the government pending thecompletion of a parallel criminal case. A stay is especially useful for the defendant, because it allows him toavoid having to choose between invoking the Fifth Amendment—thereby raising the specter of an adverseinference—or testifying—thereby raising the specter of waiver. See Robert S. Khuzami, Parallel Criminal andCivil Proceedings in Securities Fraud Cases, ABA White Collar Crime 2004, at B-14.

In evaluating a motion to stay, the court must exercise discretion and balance the parties’ hardships. See Baxterv. Palmigiano, 425 U.S. 308 (1976). This can include factors such as: (1) the extent to which the issues in thecriminal case overlap with those presented in the civil case; (2) the status of the case, including whether thedefendants have been indicted; (3) the plaintiff’s interests in proceeding expeditiously weighed against theprejudice to plaintiffs caused by delay; (4) the private interests of and burden on the defendants; (5) the interestsof the courts; (6) the interests of non-parties; and (7) the interests of the public. Robert S. Khuzami, ParallelCriminal and Civil Proceedings in Securities Fraud Cases, ABA White Collar Crime 2004, at B-14. Stays mustalso be reasonably limited in length and scope. Landis v. N. Am. Co., 299 U.S. 248 (1936). Courts tend to givedeference to the government when it seeks a stay and usually refuse civil stays sought by the defendant. SeeCampbell v. Eastland, 307 F.2d 478 (5th Cir. 1962). But see S.E.C. v. Cioffi, 2008 WL 4693320 (E.D.N.Y. Oct.23, 2008) (denying the government’s request to stay an SEC enforcement action because defendant had neitheranswered the civil complaint nor propounded discovery requests, and the government was “responsible for thesimultaneous proceedings in the first place”).

Courts are reluctant to stay an agency’s good faith activities if the agency has an independent regulatorypurpose and is not pursuing its action solely to assist the criminal prosecution. See U.S. v. LaSalle Nat’l Bank,437 U.S. 298 (1978); United States v. Kordel, 397 U.S. 1 (1970). However, the SEC has amended its Rules ofPractice to allow criminal authorities to move to intervene for the purpose of staying an administrativeproceeding. See S.E.C. Rule 210(c)(3). By contrast, stays of congressional investigations are unavailable evenwhere the investigation impedes grand jury proceedings in a parallel civil case. See, e.g., Application of U.S.Senate Select Comm. on Presidential Campaign Activities, 361 F. Supp. 1270 (D.D.C. 1973).

b. Protective Orders

Protective orders can be another useful tool for parallel proceeding litigants. Protective orders must complywith Federal Rule of Civil Procedure 26(c)’s “good cause” requirement. Good cause can include a showing ofa concrete threat or clearly defined and serious injury to the party seeking the order. See Cipollone v. LiggettGroup, Inc., 785 F.2d 1108 (3d Cir. 1986); Zenith Radio Corp. v. Matsushita Elec. Indus. Co., Ltd., 529 F.Supp. 866 (E.D. Pa. 1981) (holding that protecting a party from being at a competitive disadvantage wassufficient cause for a protective order). Rule 26(c) further allows the court to make any order which justicerequires to protect a party or person from annoyance, embarrassment, oppression, or undue burden or expense,including one or more of the following:

1) disclosure or discovery not be had;

2) disclosure or discovery may be had only on specified terms and conditions, including a designation of thetime or place;

3) discovery may be had only by a method other than that selected by the party seeking discovery;

4) certain matters not be inquired into, or that the scope of the disclosure or discovery be limited to certainmatters;

5) discovery be conducted with no one present except persons designated by the court;

6) a deposition, after being sealed, be opened only by order of the court;

7) a trade secret or other confidential research, development, or commercial information not be revealed orbe revealed only in a designated way; and

8) the parties simultaneously file specified documents or information enclosed in sealed envelopes to beopened as directed by the court. Fed. R. Civ. P. 26(c).

There is a circuit split over whether a federal grand jury subpoena takes precedence over a civil protectiveorder. For example, in the Fourth Circuit, a federal grand jury subpoena takes precedence, In re Grand JurySubpoena, 836 F.2d 1468 (4th Cir. 1988), while in the Second Circuit, a protective order takes precedence. In reGrand Jury Subpoena Duces Tecum Dated Apr. 19, 1991, 945 F.2d 1221 (2d Cir. 1991). In the Eighth Circuit,a federal grand jury subpoena takes precedence “unless the person seeking to avoid the subpoena candemonstrate the existence of exceptional circumstances that clearly favor subordinating the subpoena to theprotective order.” In re Grand Jury Subpoena, 138 F.3d 442 (1st Cir. 1998).

B. Penal Provisions Of The Federal Securities Laws

Though the elements of a criminal violation of the securities laws generally track the elements of a civilviolation, the burden of proof and mens rea heighten to proof beyond a reasonable doubt and willfulness,respectively. Section 24 of the 1933 Act criminalizes willful violations of the 1933 Act. The most commoncriminal charges under the 1933 Act stem from alleged violations of Sections 5, 17 and 24. Section 32(a)criminalizes willful and knowing violations of the 1934 Exchange Act. The most common criminal chargesunder the 1934 Act are based on alleged violations of Sections 9, 10, 12-14 and 16.

1. Section 24 Of The 1933 Act And Section 32(a) Of The 1934 Act

Section 24 of the 1933 Act, 15 U.S.C. § 77x, provides:

Any person who willfully violates any of the provisions of this title, or the rules andregulations promulgated by the Commission under authority thereof, or any person whowillfully, in a registration statement filed under this title, makes any untrue statement of amaterial fact or omits to state any material fact required to be stated therein or necessary tomake the statements therein not misleading, shall upon conviction be fined not more than$10,000 or imprisoned not more than five years, or both.

Section 32(a) of the 1934 Exchange Act, 15 U.S.C. § 77ff(a), provides:

Any person who willfully violates any provision of this chapter (other than section 78dd-1 ofthis title), or any rule or regulation thereunder the violation of which is made unlawful or theobservance of which is required under the terms of this chapter, or any person who willfullyand knowingly makes, or causes to be made, any statement in any application, report, ordocument required to be filed under this chapter or any rule or regulation thereunder or anyundertaking contained in a registration statement as provided in subsection (d) of section

78-o of this title, or by any self-regulatory organization in connection with an application formembership or participation therein or to become associated with a member thereof, whichstatement was false or misleading with respect to any material fact, shall upon conviction befined not more than $1,000,000, or imprisoned not more than 10 years, or both, except thatwhen such person is a person other than a natural person, a fine not exceeding $2,500,000may be imposed; but no person shall be subject to imprisonment under this section for theviolation of any rule or regulation if he proves that he had no knowledge of such rule orregulation.

a. Sentencing

While Section 24 of the 1933 Act articulates a maximum penalty for criminal violations of securities laws, theimposition of sentences is bounded both by the United States Sentencing Guidelines (USSG) as well as theSupreme Court’s decision in Blakely v. Washington, 542 U.S. 296 (2004). The Court’s decision in Blakelyrendered the USSG discretionary, and mandated jury findings where the statutory maximum is imposed. InUnited States v. Parris, the court concluded that a 300-month downward departure from the SentencingGuidelines in a securities case was warranted given the nature and severity of the crimes. 573 F. Supp. 2d 744(E.D.N.Y. 2008). Looking to nationwide sentencing patterns for comparable crimes, the court decided thatfairness considerations should prevail over other sentencing factors, and ultimately that the “SentencingGuidelines for white-collar crimes” should not be “a black stain on common sense.”

2. Mens Rea: Knowingly And Willfully

Willfully has been defined as “‘a realization on the defendant’s part that he was doing a wrongful act’ under thesecurities laws and ‘that the knowingly wrongful act involved a significant risk of effecting the violation thathas occurred.’” United States v. Cassese, 290 F. Supp. 2d 443, 450 (S.D.N.Y. 2003), aff’d, 428 F. 3d 92 (2dCir. 2005), (quoting United States v. Peltz, 433 F.2d 48, 55 (2d Cir. 1970); see also United States v. Stewart,305 F. Supp. 2d 368, 371 (S.D.N.Y. 2004) (citing United States v. Dixon, 536 F.2d 1388, 1395 (2d Cir. 1976))(“In a criminal prosecution, the Government must prove that the defendant acted ‘willfully,’ that is, with arealization that she was acting wrongfully.”); United States v. Custer Channel Wing Corp., 376 F.2d 675, 680(4th Cir. 1967) (citing United States v. Murdock, 290 U.S. 389, 394-95 (1993)) (“Section 24 of the Act, 15U.S.C. § 77x (1958), makes it a crime to ‘willfully’ violate Section 5. The Supreme Court has said that theword ‘willfully’ does not necessarily mean done with a bad purpose, but may be ‘employed to characterize athing done without ground for believing it is lawful, . . or conduct marked by careless disregard whether or notone has the right to so act.’”); United States v. Wenger, 427 F.3d 840, 852 (10th Cir. 2005) (describing willfulconduct as “at the very least conduct that no ‘ordinary person would engage in innocently’”) (quoting Ratzlaf v.United States, 114 S. Ct. 655, 660-61 (1994)). In Peltz, the Second Circuit distinguished willfully fromknowingly by observing:

The language [of Section 32(a)] makes one point entirely clear. A person can willfully violatean SEC rule even if he does not know of its existence. This conclusion follows from thedifference between the standard for violation of the statute or a rule or regulation, to wit,‘willfully,’ and that for false or misleading statements, namely, ‘willfully and knowingly.’ Itfollows also from the proviso whereby lack of knowledge of a rule or regulation preventsimprisonment but not a fine.

433 F.2d at 54. The Ninth Circuit’s opinion in United States v. Tarallo, 380 F.3d 1174 (9th Cir. 2004) addssome clarity to the landscape of willfulness. There, the court held “that a defendant may commit securitiesfraud ‘willfully’ in violation of 15 U.S.C. § 78ff and 17 C.F.R. § 240.10b-5 even if the defendant did not knowat the time of the acts that the conduct violated the law.” Id. at 1180. Additionally, the Tarallo court held “thata defendant may commit securities fraud ‘willfully’ by intentionally acting with reckless disregard for the truthof material misleading statements.” Id.; see also United States v. Hawkins, 2005 WL 1660984 (N.D. Cal. July

11, 2005) (finding defendant not guilty of criminal securities fraud charges at bench trial); United States v.Ebbers, 458 F.3d 110 (2d Cir. 2006) (holding that the government need not prove violations of GAAP in orderto prove fraud based on improper accounting).

The requirements for proving scienter were an issue in the first criminal trial concerning stock optionsbackdating against the former chief executive officer of Brocade Communications, Inc., United States v. Reyes,No. C 06-00556-1 CRB, 2007 U.S. Dist. LEXIS 66074, at *1 (N.D. Cal. Aug. 29, 2007). Denying defendant’smotions for acquittal and for a new trial, the court ruled that the evidence was sufficient to support the verdictboth with respect to materiality and scienter. Although it was undisputed that he approved backdated optiongrants, Reyes had argued that the evidence was insufficient to support a determination that he had the relevantcriminal intent. The court found, however, that “the chief purpose served by the act of backdating itself is tomake the grants look as though they were granted at fair market value, and thereby to avoid a compensationcharge.” Regarding the materiality of the backdating, the court noted that “‘[i]f Brocade had believed thatinvestors did not care about the compensation charges imposed by stock options, it is difficult to see why thecompany would have developed its backdating scheme, whose principal effect was to hide those very costsfrom shareholders.” Id. at *4-5.

3. Sarbanes-Oxley Act Of 2002

Chief Executive Officers and Chief Financial Officers also face potential criminal liability for violations of thedisclosure requirements of Sarbanes-Oxley.

a. Certification Of Periodic Reports – Section 906

Sections 1350(a)-(b) of Title 18 of the United States Code require “a written statement by the chief executiveofficer and chief financial officer (or equivalent thereof) of the issuer” certifying “that the periodic report fullycomplies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act . . . and thatinformation contained in the periodic report fairly presents, in all material respects, the financial condition andresults of operations of the issuer” to accompany “[e]ach periodic report containing financial statements filed byan issuer with the Securities Exchange Commission pursuant to section 13(a) or 15(d) of the SecuritiesExchange Act of 1934 (15 U.S.C. [§§] 78m(a) or 78o(d)).”

Under 18 U.S.C. § 1350(c), a knowing violation of 18 U.S.C. §§ 1350(a)-(b) may incur both a fine up to$1,000,000 and imprisonment for up to 10 years, while a willful violation of 18 U.S.C. §§ 1350(a)-(b) raises thepotential fine to $5,000,000 and raises the maximum imprisonment to 20 years.

b. Certification Of Quarterly And Annual Reports – Section 302

Section 7241 of Title 15 of the United States Code requires “the principal executive officer or officers and theprincipal financial officer or officers, or persons performing similar functions, certify in each annual orquarterly report filed or submitted under [section 13(a) or 15(d) of the Securities Exchange Act of 1934] thefollowing:

1) the signing officer has reviewed the report;

2) based on the officer’s knowledge, the report does not contain any untrue statement of a material fact oromit to state a material fact necessary in order to make the statements made, in light of the circumstancesunder which such statements were made, not misleading;

3) based on such officer’s knowledge, the financial statements, and other financial information included inthe report, fairly present in all material respects the financial condition and results of operations of theissuer as of, and for, the periods presented in the report;

4) signing officers--

(a) are responsible for establishing and maintaining internal controls;

(b) have designed such internal controls to ensure that material information relating to the issuer and itsconsolidated subsidiaries is made known to such officers by others within those entities, particularlyduring the period in which the periodic reports are being prepared;

(c) have evaluated the effectiveness of the issuer’s internal controls as of a date within 90 days prior to thereport; and

(d) have presented in the report their conclusions about the effectiveness of their internal controls based ontheir evaluation as of that date;

5) the signing officers have disclosed to the issuer’s auditors and the audit committee of the board ofdirectors (or persons fulfilling the equivalent function) –

(a) all significant deficiencies in the design or operation of internal controls which could adversely affect theissuer’s ability to record, process, summarize, and report financial data and have identified for theissuer’s auditors any material weaknesses in internal controls; and

(b) any fraud, whether or not material, that involves management or other employees who have a significantrole in the issuer’s internal controls; and

6) the signing officers have indicated in the report whether or not there were significant changes in internalcontrols or in other factors that could significantly affect internal controls subsequent to the date of theirevaluation, including any corrective actions with regard to significant deficiencies and materialweaknesses.

c. Whistleblower Provisions

Cases brought under the whistleblower provisions of the Sarbanes-Oxley Act are dismissed if the purportedwhistleblowers did not reasonably believe that the company was violating the securities laws. See Allen v.Admin. Review Bd., 514 F.3d 468 (5th Cir. 2008) (holding employees could not have reasonably believedemployer acted with scienter in attempting to fix software problem); Livingston v. Wyeth, Inc., 520 F.3d 344(4th Cir. 2008) (holding employee could not have reasonably believed that the company was violating securitieslaws based on delays in implementing a training program, where the program was completed on time and thecompany never made false statements to government agencies or shareholders).

C. The Non-Securities Criminal Code

The most common additional criminal charges accompanying a violation of the securities laws are: mail andwire fraud; conspiracy; Racketeer Influencing and Corrupt Organization Act (“RICO”) violations; falsestatement; perjury; and obstruction of justice.

1. Mail And Wire Fraud

Unlike Rule 10b-5, which also speaks of “any scheme or artifice to defraud,” the mail and wire fraud statutes donot require the alleged fraud to be in connection with the purchase or sale of securities.

The mail fraud statute is codified in 18 U.S.C. § 1341:

Whoever, having devised or intending to devise any scheme or artifice to defraud, or for obtainingmoney or property by means of false or fraudulent pretenses . . . for the purpose of executing suchscheme or artifice or attempting so to do, places in any post office or authorized depository for mailmatter . . . or deposits or causes to be deposited any matter or thing whatever to be sent or delivered by

any private or commercial interstate carrier . . . shall be fined under this title or imprisoned not more than20 years, or both. If the violation affects a financial institution, such person shall be fined not more than$1,000,000 or imprisoned not more than 30 years, or both.

The wire fraud statute is codified in 18 USC §1343:

Whoever, having devised or intending to devise any scheme or artifice to defraud, or for obtainingmoney or property by means of false or fraudulent pretenses . . . transmits or causes to be transmitted bymeans of wire, radio, or television communication in interstate or foreign commerce, any writings, signs,signals, pictures, or sounds for the purpose of executing such scheme or artifice, shall be fined under thistitle or imprisoned not more than 20 years, or both. If the violation affects a financial institution, suchperson shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.

a. Elements Of Mail And Wire Fraud

In Pereira v. United States, the Court held that the essential elements for mail fraud are “(1) a scheme todefraud, and (2) the mailing of a letter, etc., for the purpose of executing the scheme.” 347 U.S. 1, 8-9 (1954);see also United States v. Serrano, 870 F.2d 1, 6 (1st Cir. 1989) (“To sustain a mail or wire fraud conviction, thegovernment must prove ‘the existence of’ (1) a scheme conceived . . . for the purpose of defrauding . . . bymeans of false pretenses, representations or promises and (2) use of the United States mails [or interstate wirecommunications] in furtherance of that scheme.”); United States v. Pisani, 773 F.2d 397, 409 (2d Cir. 1985)(same); United States v. Bibby, 752 F.2d 1116, 1125 (6th Cir. 1985) (same).

But some Circuits have required an additional specific intent—causality or foreseeability. See, e.g., UnitedStates v. Hedaithy, 392 F.3d 580, 590 (3d Cir. 2004) (holding that the elements of mail or wire fraud are“(1) the defendant’s knowing and willful participation in a scheme or artifice to defraud, (2) with the specificintent to defraud, and (3) the use of the mails or interstate wire communications in furtherance of the scheme.”)(quoting United States v. Antico, 275 F.3d 245, 261 (3d Cir. 2001)); United States v. Aubrey, 878 F.2d 825, 827(5th Cir. 1989) (“To obtain a conviction for mail fraud the prosecution must prove: (1) the existence of ascheme or artifice to defraud that (2) involves the use of the mails for the purpose of executing the scheme and(3) the specific intent to commit fraud.”); United States v. Cosentino, 869 F.2d 301, 307-308 (7th Cir. 1989);United States v. Leyden, 842 F.2d 1026, 1028 (8th Cir. 1988); United States v. Aigbevbolle, 827 F.2d 664, 666(10th Cir. 1987); United States v. Plotke, 725 F.2d 1303, 1306 (11th Cir. 1984).

Aside from the means of communication, the elements of wire fraud under Section 1343 mirror mail fraud;whereas the former applies to use of interstate wire facilities, the latter applies to use of mailing facilities. See,e.g., United States v. Briscoe, 65 F.3d 576, 583 (7th Cir. 1995). Indeed, wire fraud and mail fraud precedenthave interchangeable application. Carpenter v. United States, 484 U.S. 19, 25 n.6 (1987) (“The mail and wirefraud statutes share the same language in relevant part, and accordingly we apply the same analysis to both setsof offenses here.”).

Each use of the mails may be the basis for a separate charge of mail fraud. United States v. Massa, 740 F.2d629, 645-46 (8th Cir. 1984) (explaining that it is well settled that each use of the mails is a separate offenseunder the mail fraud statute, notwithstanding the fact that the defendant may have engaged in one fraudulentscheme).

b. Scheme To Defraud And Fraudulent Representations

The statutes and the courts have eschewed defining the parameters of “a scheme to defraud” in favor of a case-by-case inquiry. See, e.g., United States v. Brewer, 528 F.2d 492, 498 (4th Cir. 1975); Weiss v. United States,122 F.2d 675 (5th Cir. 1941); United States v. Bohonus, 628 F.2d 1167, 1171 (9th Cir. 1980) (“[F]raudulentnature of the ‘scheme or artifice to defraud’ is measured by a non-technical standard.”); United States v.

Hedaithy, 392 F.3d 580, 601 (3d Cir. 2004) (finding that “scheme to defraud” includes schemes to deprivevictim of property rights, as well as schemes designed to obtain the victim’s property). For a misrepresentationor omission to be actionable, it must be material. Neder v. United States, 527 U.S. 1, 25 (1999) (“[M]aterialityof falsehood is an element of the federal mail fraud, wire fraud, and bank fraud statutes.”); United States v.Townley, 665 F.2d 579, 585 (5th Cir. 1982) (“Under the mail fraud statute, it is just as unlawful to speak ‘halftruths,’ or to omit to state facts necessary to make the statements made, in light of the circumstances underwhich they were made, not misleading.”). Additionally, courts will treat a reckless indifference to truth orfalsity as equivalent to an intentional misrepresentation. United States v. Boyer, 694 F.2d 58, 59 (3d Cir. 1982).

A scheme to defraud is said to include a plan or course of action intended to deceive persons of ordinaryprudence and comprehension. United States v. Vaughn, 797 F.2d 1485, 1492-93 (9th Cir. 1986). However,circuits have split over whether to impose a reasonable state of mind requirement to individuals subjected tofraud. In the D.C. Circuit “mail fraud can lie even where only [the] most gullible would be deceived.” 21Marvin G. Pickholz, Securities Crimes § 5:30 (2006) (quoting U.S. v. Brown, 79 F.3d 1550, 1557 (11th Cir.1996)). But “[i]n the Eleventh Circuit, mail fraud requires the government to prove that a reasonable personwould have acted on the representations to prove a crime. The government must show the defendant intendedto create a scheme ‘reasonably calculated to deceive persons of ordinary prudence and comprehension.’” Id.(citing Pelletier v. Zweifel, 921 F.2d 1465, 1498 (11th Cir. 1991); Silverman v. United States, 213 F.2d 405, 407(5th Cir. 1954) (requiring a scheme to be “reasonably calculated to deceive persons of ordinary prudence andcomprehension”); United States v. Brien, 617 F.2d 299, 311 (1st Cir. 1980) (“It is immaterial whether only themost gullible would have been deceived by the techniques involved. Section 1341 protects the naive as well asthe worldly-wise and the former are more in need of protection than the latter.”)).

c. Use Of The Mails Or Wires In Furtherance Of The Scheme

As noted above, the use of mails or wires is a necessary element of mail and wire fraud. “The mailing elementof the statute consists of two requirements: that the defendant ‘caused’ the use of the mails; and that this usewas for the purpose of executing the scheme.” United States v. Freitag, 768 F.2d 240, 242 (8th Cir. 1985). While a certain nexus is required between the use of mails or wires and a scheme to defraud, the use of mails orwires does not have to be an essential aspect of the scheme. Pereira v. United States, 347 U.S. 1, 8-9 (1954). Aforeseeable, though unintended, use of the mails suffices to meet the use-of-mails requirement. Id. at 8. According to the Supreme Court, “[t]he relevant question at all times is whether the mailing is part of theexecution of the scheme as conceived by the perpetrator at the time, regardless of whether the mailing later,through hindsight, may prove to have been counterproductive and return to haunt the perpetrator after thefraud.” Schmuck v. United States, 489 U.S. 705, 712-14 (1989).

While the use of the mails after the completed fraud does not meet Section 1341’s mailing requirement, asubsequent mailing “designed to lull the victims into a false sense of security, postpone their ultimate complaintto the authorities, and therefore make the apprehension of the defendants less likely than if no mailing had takenplace” does. United States v. Maze, 414 U.S. 395, 399-403 (1974); see also United States v. Sampson, 371 U.S.75, 80-81 (1962); United States v. Lane, 474 U.S. 438, 451-52 (1986) (applying the concept of lulling victimsinto a false sense of security to wire fraud); United States v. Pierce, 409 F.3d 228, 232 (4th Cir. 2005).

d. Specific Intent To Defraud

Both Sections 1341 and 1343 require the government to prove specific intent beyond a reasonable doubt. Indetermining specific intent, the government need not prove that defendant intended to violate the mail or wirefraud statutes. United States v. Porcelli, 865 F.2d 1352, 1358 (2d Cir. 1989) (“Specific intent required underthe mail fraud statute is the intent to defraud, and not the intent to violate a statute.”) (citation omitted). Nordoes the specific intent element require the prosecution to show that defendant intended to use the mails orwires. See United States v. Davidson, 760 F.2d 97, 99 (6th Cir. 1985) (“Mail fraud only requires that thedefendant reasonably anticipate, or as a reasonable person foresee, the use of the mails.”); United States v.

Worley, 751 F.2d 348, 350 (10th Cir. 1984) (“The only causation required by the mail fraud statute is whetherthe defendant could reasonably foresee the occurrence of mailings.”).

A showing of recklessness or indifference with respect to the truth or falsity of defendant’s representationssuffices to satisfy the specific intent element. United States v. Themy, 624 F.2d 963, 964-65 (10th Cir. 1980). A corollary to the requisite fraudulent intent element is the complete defense of good faith. United States v.Ammons, 464 F.2d 414, 417 (8th Cir. 1972); United States v. Gering, 716 F.2d 615, 622 (9th Cir. 1983) (same);United States v. Williams, 583 F.2d 1194 (2d Cir. 1978). In this regard, reliance on the bona fide advice ofcounsel is one circumstance that may be considered in determining good faith. United States v. Poludniak, 657F.2d 948, 958-59 (8th Cir. 1981).

e. Honest Services

In 1988, Congress added a sentence to Section 1346 stating that “scheme or artifice to defraud includes ascheme or artifice to deprive another of the intangible right of honest services.” While the concept wastraditionally used in prosecutions for public corruption, it gradually became an increasingly popular tool forprosecuting securities fraud. High-profile convictions under the statute were obtained against, among others,Jeffrey Skilling of Enron and Conrad Black of Hollinger. In June 2010, however, the Supreme Court reversedboth convictions, holding that statutory prohibition of “honest services” fraud is too vague to constitute a crimeabsent a bribe or kickback. Skilling v. U.S., 130 S. Ct. 2896 (2010); Black v. U.S., 130 S. Ct. 2963 (2010).

2. Conspiracy

The conspiracy statute, 18 USC § 371, provides in part:

If two or more persons conspire either to commit any offense against the United States, or to defraud theUnited States, or any agency thereof . . . and one or more of such persons do any act to effect the objectof the conspiracy, each shall be fined under this title or imprisoned not more than five years, or both.

Charging a conspiracy “enable[s] prosecutors to indict multiple defendants each of whom engaged in separateoffense but which, together, were part of a single scheme to defraud, and then to make substantial use of thehearsay of one co-conspirator against the others in order to put before a jury evidence that might not otherwisebe admissible.” Marvin G. Pickholz, Securities Crimes § 5:22, at 5-45 (2001). Nonetheless, the Federal Rulesof Evidence regulate the admission of hearsay statements, specifically under Fed. R. Evid. 801(d)(2)(E). Forexample, the First Circuit requires a judge to find “that a conspiracy existed of which the defendant was amember, and that the statement was made in furtherance of that conspiracy.” United States v. Murphy, 193F.3d 1, 4 (1st Cir. 1999) (citing United States v. Petrozziello, 548 F.2d 20, 23 (1st Cir. 1977)).

a. Elements Of Conspiracy

“The gist of the offense of a conspiracy . . . is agreement among the conspirators to commit an offense attendedby an act of one or more of the conspirators to effect the object of the conspiracy.” United States v. Falcone,311 U.S. 205, 210 (1940). Given that the essence of a conspiracy is an agreement, accomplishing theconspiracy’s end is irrelevant to determining guilt or innocence under Section 371. United States v. Everett,692 F.2d 596, 600 (9th Cir. 1982) (citing United States v. Sanford, 547 F.2d 1085, 1091 (9th Cir. 1976)).

To sustain its burden of proof, the prosecution must show, beyond a reasonable doubt, the following threeelements: “(1) the existence of an agreement to achieve an unlawful objective; (2) the defendant’s knowing andvoluntary participation in the conspiracy; and (3) the commission of an overt act in furtherance of theconspiracy.” United States v. Cure, 804 F.2d 625, 628 (11th Cir. 1986) (citations omitted); see also UnitedStates v. Rankin, 870 F.2d 109, 113 (3d Cir. 1989); United States v. Tedder, 801 F.2d 1437, 1446 (4th Cir.

1986) (same); United States v. Burns, 162 F.3d 840, 849 (5th Cir 1998) (same); United States v. Bostic, 480F.2d 965, 968 (6th Cir. 1973) (same); United States v. Mealy, 851 F.2d 890, 896 (7th Cir. 1988) (same); UnitedStates v. Cerone, 830 F.2d 938, 944 (8th Cir. 1987) (same); United States v. Penagos, 823 F.2d 346, 348 (9thCir. 1987) (same); United States v. Treadwell, 760 F.2d 327, 333 (D.C. Cir. 1985) (same). The Tenth Circuitadds an interdependence element. See United States v. Hanzlicek, 187 F.3d 1228, 1232 (10th Cir. 1999) (“Toobtain a conspiracy conviction, the government must prove that: (1) there was an agreement to violate the law;(2) the defendants knew the essential objectives of the conspiracy; (3) the defendants knowingly and voluntarilyparticipated in the conspiracy; and (4) interdependence existed among the co-conspirators.”).

b. Agreement

An agreement to conspire is an essential element of conspiracy. Iannelli v United States, 420 U.S. 770, 777n.10 (1975) (holding conspiracy requires proof of an agreement to commit an unlawful act). The agreementneed not be formal. United States v. Rubin, 844 F.2d 979, 984 (2d Cir. 1988) (“The government’s proof of anagreement does not require evidence of a formal or express agreement; it is enough that the parties have a tacitunderstanding to carry out the prohibited conduct.”). But such an agreement requires a minimum of two bonafide coconspirators. United States v. Escobar de Bright, 742 F.2d 1196, 1199 (9th Cir. 1984) (“There is neithertrue agreement nor meeting of the minds when an individual ‘conspires’ to violate the law with only one otherperson and that person is a government agent . . . . In short, the formal requirements of the crime of conspiracyhave not been met unless an individual conspires with at least one bona fide coconspirator.”). Furthermore“mere knowledge or approval of or acquiescence in the object and purpose of conspiracy, without an agreementto cooperate in achieving such object or purpose, does not make one a party to conspiracy.” United States v.Hopkins, 716 F.2d 739, 748 (10th Cir. 1982).

In the context of insider trading, the Second Circuit has held that remote tippees may be liable under a singleconspiracy to commit insider trading with a tipper, even if the tipper does not know of their existence. Thecourt held that a conspiracy could potentially be established through the following four avenues: “(1) if thescope of the trading agreement were broader ‘to include trading by or for persons other than the small group ofconspirators’; (2) if the conspirators reasonably foresaw, as a necessary or natural consequence of the unlawfulagreement, information being passed to remote tippees; and (3) [if the tipper has] actual awareness of theremote tippees;” and (4) where there was “mutual dependence among the co-conspirators.” United States v.Geibel, 369 F.3d 682, 690 (2d Cir. 2004) (citations omitted).

c. Specific Intent

To find a defendant guilty of conspiracy, the prosecution must prove mens rea with respect to an “intent toagree” as well as an intent to commit the substantive offense. United States v. Lanza, 790 F.2d 1015, 1022 (2dCir. 1986) (“There are at least two aspects of knowledge involved in a conspiracy: 1) knowing participation ormembership in the scheme charged; and 2) some knowledge of the unlawful aims and objectives of thescheme.”). While the prosecution must prove that a “defendant participate[s] in the charged scheme with someknowledge of its unlawful aims and objectives,” the prosecution need not “prove that accused knew everyobjective of conspiracy, every detail of scheme’s operation, or the identity of every co-conspirator.” UnitedStates v. Wiley, 846 F.2d 150, 153-154 (2d Cir. 1988) (citations omitted). But see United States v. Shelton, No.05-4342, 2006 WL 3406840, at *2-3 (2d Cir. Nov. 22, 2006) (upholding a conviction where the jury was givena conscious avoidance charge, allowing the jury to find the defendant guilty of conspiracy despite the lack ofknowledge regarding the conspiracy’s illegal aims and objectives).

d. Overt Act

The prosecution must prove beyond a reasonable doubt that a member of the conspiracy committed an overt act

during the course and in furtherance of the conspiracy. United States v. Flaherty, 668 F.2d 566, 580 n.4 (1stCir. 1981); United States v. Sacco, 436 F.2d 780, 783 (2d Cir. 1971). Any overt act, even if legal standingalone, will suffice to meet this element where it furthers the conspiracy. Sandroff v. United States, 174 F.2d1014, 1015 (6th Cir. 1949). Furthermore, a defendant need not personally commit the overt act. See UnitedStates v. Flaherty, 668 F.2d 566, 580 n.4 (1st Cir. 1981) (noting that “only one member of a conspiracy needcommit an overt act”); United States v. Sacco, 436 F.2d 780, 783 (2d Cir. 1971) (upholding jury instruction thata conspiracy conviction requires “find[ing] that one of the overt acts alleged was committed by at least one ofthe defendants and that it was committed during the time period ... of the conspiracy”).

e. Pinkerton Liability

As soon as the conspiracy begins, members of the conspiracy are responsible for any crime committed duringthe course of the conspiracy. Pinkerton v. United States, 328 U.S. 640, 645-46 (1946).

3. Racketeer Influenced And Corrupt Organizations Act

Despite its common association with organized crime, any person may be prosecuted under the RacketeerInfluenced and Corrupt Organization Act (“RICO”). United States v. Scotto, 641 F.2d 47 (2d Cir. 1980). Indeed, RICO covers “any person.” 18 U.S.C. § 1962. The RICO statute is codified in Sections 1961 through1968 of Title 18 of the United States Code. RICO “renders criminally and civilly liable ‘any person’ who usesor invests income derived ‘from a pattern of racketeering activity’ to acquire an interest in or to operate anenterprise engaged in interstate commerce, § 1962(a); who acquires or maintains an interest in or control ofsuch an enterprise, conducts or participates in the conduct of its affairs ‘through a pattern of racketeeringactivity’, § 1962(b); who, being employed by or associated with such an enterprise, conducts or participates inthe conduct of its affairs ‘through a pattern of racketeering activity,” § 1962(c); or, finally, who conspires toviolate the first three subsections of § 1962, § 1962(d). H. J. Inc. v. Nw. Bell Tel. Co., 492 U.S. 229, 231(1989). The most common RICO charge is brought under Section 1962(c):

It shall be unlawful for any person employed by or associated with any enterprise engaged in,or the activities of which affect, interstate or foreign commerce, to conduct or participate,directly or indirectly, in the conduct of such enterprise’s affairs through a pattern ofracketeering activity or collection of unlawful debt.

a. Elements

While the essential elements for a RICO charge under 18 U.S.C. § 1962(c) vary slightly by circuit, theformulations are anchored to the statute’s language and typically require the prosecution to show: “(1) theexistence of an enterprise affecting interstate commerce; (2) that the defendant was employed by or associatedwith the enterprise; (3) that the defendant participated, either directly or indirectly, in the conduct of the affairsof the enterprise; and (4) that he or she participated through a pattern of racketeering activity.” United States v.Parise, 159 F.3d 790, 794 (3d Cir. 1998) (quoting United States v. Console, 13 F.3d 641, 652-653 (3d Cir.1993)); see also United States v. Allen, 155 F.3d 35, 40 (2d Cir. 1998) (citing Sedima, S.P.R.L. v. Imrex Co.,473 U.S. 479, 496 (1985)) (same); United States v. Welch, 656 F.2d 1039, 1057 (5th Cir. 1981) (same); UnitedStates v. Sinito, 723 F.2d 1250, 1260 (6th Cir. 1983) (same); United States v. Palumbo Bros., Inc., 145 F.3d850, 867 (7th Cir. 1998) (same); United States v. Weinstein, 762 F.2d 1522, 1536 (11th Cir. 1985) (same);United States v. Perholtz, 842 F.2d 343, 354 (D.C. Cir. 1988) (same); United States v. Smith, 413 F.3d 1253,1266 (10th Cir. 2005) (holding that Section 1962(d) violation required proof of conspiracy in addition to samefour-factor RICO test); United States v. Keltner, 147 F.3d 662, 668 (8th Cir. 1998) (quoting United States v.Darden, 70 F.3d 1507, 1518 (8th Cir. 1995)) (holding that the five following elements are required to prove aRICO violation: “(1) that an enterprise existed; (2) that the enterprise affected interstate or foreign commerce;(3) that the defendant associated with the enterprise; (4) that the defendant participated, directly or indirectly, in

the affairs of the enterprise; and (5) that the defendant participated in the enterprise through a pattern ofracketeering activity by committing at least two racketeering (predicate) acts”).

b. Enterprise

According to 18 U.S.C. § 1961(4), an “‘enterprise’ includes any individual, partnership, corporation,association, or other legal entity, and any union or group of individuals associated in fact although not a legalentity.” The Court has drawn a distinction between the enterprise and pattern of racketeering activity elementin the following terms: “The ‘enterprise’ is not the ‘pattern of racketeering activity;’ it is an entity separate andapart from the pattern of activity in which it engages. The existence of an enterprise at all times remains aseparate element which must be proved by the Government.” United States v. Turkette, 452 U.S. 576, 583(1981); see Williams v. Mohawk Indus., Inc., 411 F.3d 1252, 1258 (11th Cir. 2005) (finding in civil RICO casethat a corporation and its agents, as “a ‘loose or informal’ association of distinct entities” allegedly engaged in aconspiracy, collectively constitute an enterprise). The relationship between an enterprise and the pattern ofracketeering activity has split the Circuits. The Third, Fourth, Fifth, Seventh, Eighth, Ninth and Tenth Circuitsrequire that prosecutors prove an indicia of a continuing organizational ‘structure’ apart from the pattern ofactivity. See United States v. Smith, 413 F.3d 1253, 1266 (10th Cir. 2005) (adopting the Third Circuit’sframework for establishing an enterprise). In contrast, the First, Second and Eleventh Circuits permit the sumof the predicate acts to satisfy the enterprise requirement without proof of a separate external organizationalstructure. See also United States v. Cianci, 378 F.3d 71, 82 (1st Cir. 2004) (“This circuit has cast its lot withcourts that have declined to make [the] ‘ascertainable structure’ criterion a mandatory component of a districtcourt’s jury instructions explaining RICO associated-in-fact enterprises.”).

To satisfy the interstate commerce element, the enterprise must either be a part of interstate commerce or haveat least a de minimis effect on interstate commerce. United States v. Juvenile Male, 118 F.3d 1344, 1347 (9thCir. 1997); United States v. Norton, 867 F.2d 1354, 1359 (11th Cir. 1989); United States v. Robinson, 763 F.2d778, 781 (6th Cir. 1985).

c. Conducting Or Participating In The Activities Of The RICO Enterprise

Participation or management in the operation of a RICO enterprise as well as playing “some part in directingthe enterprise’s affairs” are both necessary to meet RICO’s participation element. Reves v. Ernst & Young, 507U.S. 170, 179 (1993). The Second Circuit has affirmed jury instructions that noted that the participationelement may be met even if the defendant did not have management or control of the enterprise. United Statesv. Miller, 116 F.3d 641, 672 (2d Cir. 1997). The Seventh Circuit has held that outsiders and lower-levelparticipants in an enterprise can be held liable under RICO if it is shown that they “‘facilitate[d] the activities ofthose who are operating [or managing] the enterprise in an illegal manner.’” United States v. Cummings, 395F.3d 392, 399-400 (7th Cir. 2005) (quoting Brouwer v. Raffensperger, Hughes & Co., 199 F.3d 961, 967 (7thCir. 2000)). The court cautioned that “[t]he fundamental question remains whether [any of the participants]operated or managed the [enterprise’s] affairs.” Id. at 400.

d. Pattern Of Racketeering Activity

A laundry list of “racketeering activity” is codified under Section 1961(1)(A)–(G). 18 U.S.C. § 1961(1). Included within the “definition” of “racketeering activity” is “fraud in the sale of securities.” 18 U.S.C. §1961(D). Section 1961(5) “defines” a “pattern of racketeering activity” as “requir[ing] at least two acts ofracketeering activity, one of which occurred after the effective date of this chapter and the last of whichoccurred within ten years (excluding any period of imprisonment) after the commission of a prior act ofracketeering activity.” 18 U.S.C. § 1961(5). The Court requires the prosecution to prove that the racketeeringpredicates are related and continuous in order to meet the pattern of racketeering activity. H.J. Inc. v. Nw. Bell

Tel. Co., 492 U.S. 229, 239 (1989) (“RICO’s legislative history reveals Congress’ intent that to prove a patternof racketeering activity a plaintiff or prosecutor must show that the racketeering predicates are related, and thatthey amount to or pose a threat of continued criminal activity.”); United States v. Diaz, 176 F.3d 52, 93 (2d Cir.1999) (“In order to have been engaged in a ‘pattern of racketeering activity,’ the government must prove (1)that the defendant committed at least two predicate acts of racketeering within ten years of one another, see 18U.S.C. § 1961(5) (1988); (2) that these racketeering predicates are interrelated; and (3) that they revealcontinued, or the threat of continued, racketeering activity.”) (citation omitted). This flexible approach iscapable of “encompass[ing] multiple predicates within a single scheme that were related and that amounted to,or threatened the likelihood of, continued criminal activity.” H.J. Inc., 492 U.S. at 237.

4. False Statements Statute

a. Section 1001

Section 1001(a) of title 18 provides that:

1) Except as otherwise provided in this section, whoever, in any matter within the jurisdiction of theexecutive, legislative, or judicial branch of the Government of the United States, knowingly and willfully–

(a) falsifies, conceals, or covers up by any trick, scheme, or device a material fact;

(b) any materially false, fictitious, or fraudulent statement or representation; or

(c) makes or uses any false writing or document knowing the same to contain any materially false, fictitious,or fraudulent statement or entry;

shall be fined under this title or imprisoned not more than 5 years, or both.

Section 1001(b) clarifies: “Subsection (a) does not apply to a party to a judicial proceeding, or that party’scounsel, for statements, representations, writings or documents submitted by such party or counsel to a judge ormagistrate in that proceeding.”

The Fifth Circuit has described the following elements as required for a Section 1001(a)(1) conviction: “(1)knowingly and willfully; (2) concealing and covering up by trick, scheme, or device; (3) a material fact; (4) inany matter within the jurisdiction of a department or agency of the United States.” United States v. Swaim, 757F.2d 1530, 1533 (5th Cir. 1985).

Section 1001(a)(2) requires the government to prove the following elements: “(1) the defendant made astatement; (2) the statement was false, fictitious, or fraudulent as the defendant knew; (3) the statement wasmade knowingly and willfully; (4) the statement was within the jurisdiction of the federal agency; and (5) thestatement was material. See United States v. Harrod, 981 F.2d 1171, 1175 (10th Cir. 1992) (citations omitted).

If the prosecutor brings a Section 1001(a)(3) charge, rather than proving a false statement, it must prove “thatthe defendant made and used or caused to be made and used a false . . . writing or document as to a material factin relation to a matter within the jurisdiction of the United States . . . .” United States v. Seay, 718 F.2d 1279,1284 (4th Cir. 1983); see also United States v. Blankenship, 382 F.3d 1110 (11th Cir. 2004) (“For a convictionto be sustained under § 1001(a)(3), it is imperative that the ‘writing or document’ be ‘false.’”).

b. “Conceals Or Covers Up By Any Trick, Scheme, Or Device”

For a Section 1001 violation premised on concealment, “it is incumbent upon the government to prove that the

defendant had a legal duty to disclose the material facts at the time he was alleged to have concealed them.” United States v. Anzalone, 766 F.2d 676, 683 (1st Cir. 1985); United States v. Tobon-Builes, 706 F.2d 1092,1096 (11th Cir. 1983) (“Generally, concealment violations under Section 1001 relate to the nondisclosure ofstatements required by statute, government regulation or form.”). Additionally, as the Eighth Circuit has noted,“[t]o establish a concealment violation of Section 1001, the government must prove more than just a passivefailure on the part of the defendant to reveal a material fact. Rather, the government must prove an affirmativeact by which a material fact is actively concealed.” United States v. Shannon, 836 F.2d 1125, 1129-30 (8th Cir.1988); United States v. London, 550 F.2d 206 (5th Cir. 1977) (noting that the plain language of § 1001(a)(1)implies the requirement of an affirmative act by which means a material fact is concealed).

c. “False, Fictitious Or Fraudulent Statements Or Representations”

A “false, fictitious, or fraudulent statement or representation,” for purposes of a Section 1001(a)(2) prosecution,is “one that is ‘more than merely untrue or erroneous,’ rather it implies that the ‘statement is designedly untrue .. . and made with the intention to deceive the person to whom the false statement is made or exhibited.’” United States v. Worthington, 822 F.2d 315, 319 (2d Cir. 1987). Similarly, the Fifth Circuit has held that a“false representation is one that is incorrect and untrue and is made with an intent to deceive or mislead.” United States v. Guzman, 781 F.2d 428, 431 (5th Cir. 1986).

d. “Makes Or Uses Any False Writing Or Document”

If the false statement charge is premised on Section 1001(a)(3), then the following definition may be helpful:“The phrase ‘makes or uses any false writing or document’ means to create, to bring into existence, or to submitor to file some type of form, report, or letter, of any kind, which is not true.” Kevin F. O’Malley, Jay E. Grenig& Hon. William C. Lee, 2A Federal Jury Practice and Instructions § 40.12, at 188 (West Group 2000).

e. Materiality

Courts, in the Section 1001 context, typically define something as material if it has the potential to affectgovernmental function. See, e.g., United States v. Arcadipane, 41 F.3d 1, 7 (1st Cir. 1994) (quoting UnitedStates v. Corsino, 812 F.2d 26, 30 (1st Cir. 1987)) (“[M]ateriality requires only that the fraud in question have anatural tendency to influence, or be capable of affecting or influencing, a governmental function.”); UnitedStates v. Adler, 623 F.2d 1287, 1292 n.7 (8th Cir. 1980). Since materiality is couched in terms of its potentialto affect governmental function, courts do not require governmental function to actually be affected. UnitedStates v. Arcadipane, 41 F.3d at 7 (quoting United States v. Corsino, 812 F.2d 26, 30 (1st Cir. 1986)); UnitedStates v. Lawson, 809 F.2d 1514, 1520 (11th Cir. 1987).

SEC rules prohibit making false statements to auditors. Promulgated under the 1934 Exchange Act, Rule 13b2-2 codified in 17 C.F.R. § 240.1362-2, reads in relevant part:

a. No director or officer of an issuer shall, directly or indirectly:

1. Make or cause to be made a materially false or misleading statement to an accountant inconnection with; or

2. Omit to state, or cause another person to omit to state, any material fact necessary in order to makestatements made, in light of the circumstances under which such statements were made, notmisleading, to an accountant in connection with:

i. Any audit, review or examination of the financial statements of the issuer required to bemade pursuant to this subpart; or

ii. The preparation or filing of any document or report required to be filed with theCommission pursuant to this subpart or otherwise.

b.1. No officer or director of an issuer, or any other person acting under the direction thereof, shall

directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence anyindependent public or certified public accountant engaged in the performance of an audit or reviewof the financial statements of that issuer that are required to be filed with the Commission pursuantto this subpart or otherwise if that person knew or should have known that such action, ifsuccessful, could result in rendering the issuer’s financial statements materially misleading.

2. For purposes of paragraphs (b)(1) and (c)(2) of this section, actions that, “if successful, couldresult in rendering the issuer’s financial statements materially misleading” include, but are notlimited to, actions taken at any time with respect to the professional engagement period to coerce,manipulate, mislead, or fraudulently influence an auditor:

i. To issue or reissue a report on an issuer’s financial statements that is not warranted in thecircumstances (due to material violations of generally accepted accounting principles,generally accepted auditing standards, or other professional or regulatory standards);

ii. Not to perform audit, review or other procedures required by generally accepted auditingstandards or other professional standards;

iii. Not to withdraw an issued report; oriv. Not to communicate matters to an issuer’s audit committee.

17 C.F.R. § 240.13b2-2.

5. Perjury

Sections 1621, 1622 and 1623 of Title 18 of the United States Code cover, respectively, general perjury,subornation of perjury, and false declarations before a court or grand jury. Section 1621, the general perjurystatute, was “enacted in an effort to keep the course of justice free from the pollution of perjury.” United Statesv. Williams, 341 U.S. 58, 68 (1951). Similarly, Section 1623 was enacted “to facilitate perjury prosecutions andthereby enhance the reliability of testimony before federal courts and grand juries.” Dunn v. United States, 442U.S. 100, 107 (1979).

a. General Perjury

The relevant portion of 18 USC § 1621 reads:

Whoever—

1) having taken an oath before a competent tribunal, . . . or person, in any case in which a law of theUnited States authorizes an oath to be administered, that he will testify, declare, depose, or certifytruly, or that any written testimony, declaration, deposition, or certificate by him subscribed, is true,willfully and contrary to such oath states or subscribes any material matter which he does not believeto be true; or

2) in any declaration, certificate, verification, or statement under penalty of perjury as permittedunder section 1746 of title 28, United States Code, willfully subscribes as true any material matterwhich he does not believe to be true;

is guilty of perjury and shall, except as otherwise expressly provided by law, be fined under this title orimprisoned not more than five years, or both. This section is applicable whether the statement or subscription ismade within or without the United States.

A charge of perjury requires the prosecutor to prove that (1) a person (2) testified orally or in writing (3)regarding a material matter (4) under oath (5) before a competent tribunal (6) where United States lawauthorizes an oath to be administered (7) knowing the testimony to be false and (8) giving the testimonywillfully and contrary to the oath. See, e.g., Marvin G. Pickholz, Securities Crimes § 5:43, at 5-75 (2001);Kevin F. O’Malley, Jay E. Grenig & Hon. William C. Lee, 2A Federal Jury Practice and Instructions § 50.03,at 490 (West Group 2000). According to the Supreme Court, the essential elements of Section 1621 are: (1) anoath authorized by law of the United States; (2) taken before a competent tribunal, officer or person, and (3) afalse statement willfully made as to facts material to the hearing. Hammer v. United States, 271 U.S. 620, 626(1926); see also United States v. Stone, 429 F.2d 138, 140 (2d Cir. 1970) (“The essential elements of a violationof 18 U.S.C. § 1621 are the taking of an oath, in a case where a law of the United States authorizes an oath to beadministered, to testify truly, and willfully and contrary to such oath making a false statement, as to a materialfact and which the defendant did not believe to be true.”).

b. Subornation Of Perjury

18 U.S.C. §1622 provides:

Whoever procures another to commit any perjury is guilty of subornation of perjury, and shall be finedunder this title or imprisoned not more than five years, or both.

To prove the charge of subornation of perjury, the government must show that (1) the defendant knowingly andintentionally persuaded or induced the suborned witness to testify falsely; (2) the defendant knew, believed orhad reason to believe that the suborned witness’s testimony would be false; (3) the suborned witness’stestimony was false; and that (4) the suborned witness testified willfully and corruptly knowing the statement tobe false. Marvin G. Pickholz, Securities Crimes § 5:56, at 5-86 (2001); see also United States v. Walker, 148F.3d 518, 526 (5th Cir. 1998) (observing that a Section 1622 charge requires “(1) [t]hat there was falsetestimony material to the indicted crime, and (2) that the accused said or did something to influence the personproviding the false testimony to do so”). Subornation of perjury is premised on an underlying perjury; thus thepredicate offense of perjury is an essential element of subornation of perjury. See United States v. Brumley, 560F.2d 1268, 1275 n.5 (5th Cir. 1977); Catrino v. United States, 176 F.2d 884, 886-87 (9th Cir. 1949). As aresult, the prosecution must prove the elements of either a Section 1621 charge or a Section 1623 charge.

c. Perjury Before A Grand Jury

18 U.S.C. §1623(a) provides in relevant part:

(a) Whoever under oath . . . in any proceeding before or ancillary to any court or grand jury of the UnitedStates knowingly makes any false material declaration or makes or uses any other information . . .knowing the same to contain any false material declaration, shall be fined under this title or imprisonednot more than five years, or both.

. . .

(c) An indictment or information for violation of this section alleging that, in any proceedings before orancillary to any court or grand jury of the United States, the defendant under oath has knowingly madetwo or more declarations, which are inconsistent to the degree that one of them is necessarily false, neednot specify which declaration is false if—

(1) each declaration was material to the point in question, and

(2) each declaration was made within the period of the statute of limitations for the offense chargedunder this section.

In any prosecution under this section, the falsity of a declaration set forth in the indictment orinformation shall be established sufficient for conviction by proof that the defendant while under oathmade irreconcilably contradictory declarations material to the point in question in any proceeding beforeor ancillary to any court or grand jury. It shall be a defense to an indictment or information madepursuant to the first sentence of this subsection that the defendant at the time he made each declarationbelieved the declaration was true.

(d) Where, in the same continuous court or grand jury proceeding in which a declaration is made, theperson making the declaration admits such declaration to be false, such admission shall bar prosecutionunder this section if, at the time the admission is made, the declaration has not substantially affected theproceeding, or it has not become manifest that such falsity has been or will be exposed.

For purposes of §1623, an ancillary proceeding is “an action conducted pursuant to explicit statutory or judicialprocedures.” United States v. Tibbs, 600 F.2d 19, 21 (6th Cir. 1979). This definition of ancillary proceedingencompasses matters within an SEC investigation. See Woolley v. United States, 97 F.2d 258 (9th Cir. 1938).

There are at least five distinctions between Sections 1621 and 1623 aside from the more specific application ofthe latter to proceedings before, or ancillary to, a court or grand jury. First, a greater range of matter is materialunder Section 1623. The questions asked of a witness during a grand jury investigation are broader than thoseasked at trial since the purpose of the investigation is to obtain facts rather than to prove matters directly atissue. United States v. Phillips, 540 F.2d 319, 328-29 (8th Cir. 1976). Second, Section 1623(a) requires a lessstringent “knowingly” mens rea than the “willfully” standard codified in Section 1621. United States v. Gross,511 F.2d 910, 914-15 (3d Cir. 1975). Third, Section 1623(c) allows the prosecution to demonstrate that twomaterial statements are irreconcilably “inconsistent to the degree that one of them is necessarily false.” See alsoUnited States v. McAfee, 8 F.3d 1010, 1014 (5th Cir. 1993) (“[T]he Government need not prove the falsity of[defendant’s] declarations under Section 1623(c); rather, the Government must prove that the defendant underoath has knowingly made two or more declarations, which are inconsistent to the degree that one of them isnecessarily false.”). Fourth, under Section 1623(d), a recantation defense is available. See United States v.Denison, 663 F.2d 611, 616 (5th Cir. 1981) (“Section 1623(d) changed the common law rule that recantation isnot a defense to perjury. The recantation defense, according to the legislative history, ‘serves an inducement tothe witness to give truthful testimony by permitting him voluntarily to correct a false statement withoutincurring the risk of prosecution (by) doing so.’”) (citations omitted). Fifth, Section 1623(e) renders the “twowitness rule,” see infra, inapplicable to perjury prosecutions under Section 1623(a). See 18 U.S.C. § 1623(e)(“Proof beyond a reasonable doubt under this section is sufficient for conviction. It shall not be necessary thatsuch proof be made by any particular number of witnesses.”); United States v. Gross, 511 F.2d 910, 914-15 (3dCir. 1975).

A charge under either Section 1621 or 1623 cannot be based on an “evasive, non-responsive but literally trueanswer even if the answer is intentionally misleading and arguably false by negative implication.” UnitedStates v. Abrams, 568 F.2d 411, 422 (5th Cir. 1978); United States v. Cook, 489 F.2d 286, 287 (9th Cir. 1973).

d. False Testimony

With respect to §1621, “[s]worn oral statements made to SEC investigators, grand juries or congressionalcommittees . . . are within the ambit of the section.” Marvin G. Pickholz, Securities Crimes § 5:47, at 5-77(2001) (footnote omitted).

e. Materiality

The measure of the materiality of a false statement is its ability to influenc[e] the tribunal on the issue before it. United States v. Cosby, 601 F.2d 754, 756 n.2 (5th Cir. 1979); United States v. Flowers, 813 F.2d 1320, 1325(4th Cir. 1987). This materiality test equally applies both to Sections 1621 and 1623. United States v. Lardieri,497 F.2d 317, 319 (3d Cir. 1974). It should be noted that “[t]he statements need only be material . . . to anyproper matter of inquiry—not just to the main issue.” United States v. Gremillion, 464 F.2d 901, 905 (5th Cir.1972).

f. Oath Administered And Oath Authorized

One of the essential elements of a Section 1621 prosecution is that the defendant took an oath. Smith v. UnitedStates, 363 F.2d 143, 144 (5th Cir. 1966).

For liability to attach, the oath needs to be authorized by a United States law, and the oath giver needs to havethe authority to administer the oath. United States v. Debrow, 346 U.S. 374, 377 (1953).

g. Proceeding

For purposes of Section 1623, “every proceeding, including an ancillary proceeding, must incorporate certainnotions of formality and convention .... [A]n action conducted by a judicial representative or an actionconducted pursuant to explicit statutory or judicial procedures may properly be considered an ‘ancillaryproceeding.’... However, an impromptu conversation between an individual and an attorney in the attorney’soffice inherently lacks the formality and convention required. These missing elements cannot be supplied bythe administration of an oath, the signing of an affidavit, or the disclosure of the affiant’s rights and potentialliability.” United States v. Tibbs, 600 F.2d 19, 21 (6th Cir. 1979).

h. Willfully And Contrary To Such Oath

Within the context of giving false testimony to the SEC, the Eighth Circuit offered the following analysis of thespecific intent required for perjury: “To sustain a conviction of perjury it must be shown by clear, convincingand direct evidence to a moral certainty and beyond a reasonable doubt that the defendant committed willfuland corrupt perjury.” Blumenfield v. United States, 306 F.2d 892, 897 (8th Cir. 1962).

i. One Witness Plus Or Corroboration Rule

Often referred to as the two-witness rule, the element of corroboration does not necessarily require twowitnesses to establish the falsity of the testimony underlying the perjury charge. Perhaps a more appropriatetitle for the rule is the one-witness plus rule where the “plus” represents either the testimony of another witnessor corroborating circumstances. See Weiler v. United States, 323 U.S. 606, 607 (1945) (“The Government mustestablish the falsity of the statement alleged to have been made by the defendant under oath, by the testimony oftwo independent witnesses or one witness and corroborating circumstances.”); Hammer v. United States, 271U.S. 620, 626 (1926) (“The general rule in prosecutions for perjury is that the uncorroborated oath of onewitness is not enough to establish the falsity of the testimony of the accused set forth in the indictment asperjury.”). With respect to corroborating evidence, the Weiler court noted: “Two elements must enter into adetermination that corroborative evidence is sufficient: (1) that the evidence, if true, substantiates the testimonyof a single witness who has sworn to the falsity of the alleged perjurious statement; and (2) that thecorroborative evidence is trustworthy.” Weiler, 323 U.S. at 609. As discussed supra, the rule does not apply inall circumstances to prosecutions under Section 1623(e).

6. Obstruction Of Justice

The convictions of Martha Stewart and Frank Quattrone highlight the importance of obstruction of justice insecurities related actions. Aside from the media attention, the statutory context of obstruction of justice hasundergone significant changes over the last several years. Indeed, the passage of the Sarbanes-Oxley legislationbroadened and deepened the statutory landscape of obstruction of justice by adding Sections 1512(c), 1514A,1519 and 1520 to Title 18 of the United States Code.

a. Elements Of Obstruction Of Justice

Sections 1501 through 1520 of Title 18 of the United States Code cover obstruction of justice. Enacted “toprevent miscarriage[s] of justice” as well as “to protect individuals involved in federal judicial proceedings,”these statutes reach all corrupt conduct capable of producing an effect that prevents justice from being dulyadministered, regardless of the means employed. United States v. Williams, 874 F.2d 968, 976-82 (5th Cir.1989).

18 U.S.C. §1503 provides in part:

Whoever corruptly . . . endeavors to influence, intimidate, or impede any grand or petit juror, or officer inor of any court of the United States, or officer who may be serving at any examination or otherproceeding before any United States magistrate judge or other committing magistrate, in the discharge ofhis duty, or injures any such grand or petit juror in his person or property on account of any verdict orindictment assented to by him, or on account of his being or having been such juror, or injures any suchofficer, magistrate judge, or other committing magistrate in his person or property on account of theperformance of his official duties, or corruptly or by threats or force, or by any threatening letter orcommunication, influences, obstructs, or impedes, or endeavors to influence, obstruct, or impede, the dueadministration of justice, shall be punished.

A §1503 violation requires the prosecution to prove beyond a reasonable doubt the following elements: “(1)there was a pending judicial proceeding; (2) the defendant knew of the proceeding; (3) he influenced,obstructed, or impeded, or endeavored to influence, obstruct or impede the due administration of justice; and (4)he did so corruptly.” United States v. Cueto, 151 F.3d 620, 632 (7th Cir. 1998); United States v. Rankin, 870F.2d 109, 112 (3d Cir. 1989) (citing United States v. Tedesco, 635 F.2d 902, 907 (1st Cir. 1980)) (“Theelements of a Section 1503 offense are: ‘(1) endeavoring to (2) corruptly (3) influence . . . the dueadministration of justice.’”); United States v. Thomas, 916 F.2d 647, 651 (11th Cir. 1990) (same); see alsoUnited States v. Biaggi, 853 F.2d 89, 104 (2d Cir. 1988).

18 U.S.C. §1505 provides in relevant part:

Whoever corruptly . . . endeavors to influence, obstruct, or impede the due and proper administration of the lawunder which any pending proceeding is being had before any department or agency of the United States, or the dueand proper exercise of the power of inquiry under which any inquiry or investigation is being had by either House, orany committee of either House or any joint committee of the Congress—

Shall be fined under this title or imprisoned not more than five years, or both.

The Securities and Exchange Commission falls within the rubric of a department or agency of the United States.

18 U.S.C. §1512 provides in relevant part:

(b) Whoever knowingly uses intimidation, threatens, or corruptly persuades another person, or attempts

to do so, or engages in misleading conduct toward another person, with intent to—

(1) influence, delay, or prevent the testimony of any person in an official proceeding;

(2) cause or induce any person to—

(A) withhold testimony, or withhold a record, document, or other object, from an official proceeding;

(B) alter, destroy, mutilate, or conceal an object with intent to impair the object’s integrity or availability for use inan official proceeding;

(C) evade legal process summoning that person to appear as a witness, or to produce a record, document, or otherobject, in an official proceeding; or

(D) be absent from an official proceeding to which such person has been summoned by legal process; or

(3) hinder, delay, or prevent the communication to a law enforcement officer or judge of the UnitedStates of information relating to the commission or possible commission of a Federal offense or aviolation of conditions of probation supervised release, parole, or release pending judicialproceedings;

shall be fined under this title or imprisoned not more than ten years, or both.

(c) Whoever corruptly—

(1) alters, destroys, mutilates, or conceals a record, document, or other object, or attempts to do so,with the intent to impair the object’s integrity or availability for use in an official proceeding; or

(2) otherwise obstructs, influences, or impedes any official proceeding, or attempts to do so,

shall be fined under this title or imprisoned not more than 20 years, or both.

(e) In a prosecution for an offense under this section, it is an affirmative defense, as to which thedefendant has the burden of proof by a preponderance of the evidence, that the conduct consisted solelyof lawful conduct and that the defendant’s sole intention was to encourage, induce, or cause the otherperson to testify truthfully.

Under 18 U.S.C. § 1519, the prosecution need not prove that the defendant intended to obstruct an actual orpending investigation. Rather, the prosecution must merely prove that the obstructive conduct was done in“contemplation” of a possible investigation.

Sarbanes-Oxley added 18 U.S.C. §1519, which reads:

Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry inany record, document, or tangible object with the intent to impede, obstruct, or influence theinvestigation or proper administration of any matter within the jurisdiction of any department or agencyof the United States or any case filed under title 11, or in relation to or contemplation of any such matteror case, shall be fined under this title, imprisoned not more than 20 years, or both.

Sarbanes-Oxley also added 18 U.S.C. §1520, which states in relevant part:

(b) Whoever knowingly and willfully violates subsection (a)(1), or any rule or regulation promulgated bythe Securities and Exchange Commission under subsection (a)(2), shall be fined under this title,imprisoned not more than 10 years, or both.

(c) Nothing in this section shall be deemed to diminish or relieve any person of any other duty orobligation imposed by Federal or State law or regulation to maintain, or refrain from destroying, anydocument.

b. Specific Intent

A showing of specific intent is necessary to find a defendant guilty of obstructing justice. In Pettibone v.United States, 148 U.S. 197, 206 (1893), the Court held that the defendant must know or be on notice that aproceeding is pending. More recently, the Court observed that “[I]f the defendant lacks knowledge that hisactions are likely to affect the judicial proceeding, he lacks the requisite intent to obstruct.” United States v.Aguilar, 515 U.S. 593, 599 (1995). The Supreme Court recently reiterated that, in the context of Section1512(b)(2), some judicial proceeding must be foreseen.

It is, however, one thing to say that [under Section 1512(f)(1)] a proceeding ‘need not be pending orabout to be instituted at the time of the offense,’ and quite another to say a proceeding need not evenbe foreseen. A ‘knowingly…corrupt persuade[r]’ cannot be someone who persuades others…when hedoes not have in contemplation any particular official proceeding in which [that conduct] might bematerial.

Arthur Andersen LLP v. United States, 544 U.S. 696, 697 (2005). It is unclear whether Arthur Andersen’srequirement that the defendant must have acted in contemplation of a particular judicial proceeding applies toprosecutions under Section 1512(b)(3), as it does to Section 1512(b)(2). In United States v. Byrne, 435 F.3d 16(1st Cir. 2006), the First Circuit held that it did not. Distinguishing Arthur Andersen, the court explained that:

“the communication to a law enforcement officer” [in subsection (b)(3)] easily encompasses an earlierand less formal investigation than that contemplated by subsection (b)(2). Unlike subsection (b)(2)...,which protect[s] particular “official proceedings,”... subsection (b)(3) protects the general ability oflaw enforcement agents to gather information relating to federal crimes (and the witnesses who desireto speak truthfully to law enforcement agents about those crimes).

Id. at 24 (citations omitted). According to the Third Circuit, in a decision prior to Arthur Andersen, “proving aviolation of 18 U.S.C. § 1512(b)(3) does not depend on the existence or imminency of a federal investigationbut rather on the possible existence of a federal crime and a defendant’s intention to thwart an inquiry into thatcrime by officials who happen to be federal.” United States v. Guadalupe, 402 F.3d 409, 411 (3d Cir. 2005). The specific intent to hinder a federal investigation “may be inferred from the fact that the offense was federalin nature, plus ‘additional appropriate evidence.’” Id. at 412 (finding defendant’s position and experience assufficient to impute knowledge of federal nature of crime and potential for federal investigation).

Some courts have held that the defendant must harbor an intent to obstruct. United States v. Jeter, 775 F.2d670, 679 (6th Cir. 1985) (“[O]ne must impede the due administration of justice with the general intent ofknowledge as well as the specific intent of purpose to obstruct.”). In contrast, other courts have analyzed theintent to obstruct within the rubric of “corruptly.” United States v. Thomas, 916 F.2d 647, 651 (11th Cir. 1990)(“Although the government is not required to prove that the defendant had the specific purpose of obstructingjustice, ... it must establish that the conduct was prompted, at least in part, by a ‘corrupt motive.’”) (citationsomitted); United States v. Silverman, 745 F.2d 1386, 1393 (11th Cir. 1984) (“The government is not required toprove, however, that the defendant harbored the specific purpose of obstructing the due administration ofjustice; all the government has to establish is that the defendant should have reasonably foreseen that the naturaland probable consequences of the success of his scheme would achieve precisely that result.”).

c. Corruptly

Courts routinely forgo the opportunity to define corruptly in favor of a case-by-case contextual analysis. United

States v. Brady, 168 F.3d 574, 578-79 (1st Cir. 1999) (“There is no hope in one of providing a definitive glosson the word ‘corruptly’; neither would it be wise to try. However, we think it is ordinarily sufficient to satisfythe ‘corruptly’ requirement of the statute-without regard to other circumstances that might also establishcorruption (e.g., offering a bribe)-if the contemnor’s purpose for refusing to testify is to prevent the grand juryfrom locating the criminals. This is broadly consistent with a standard instruction for the obstruction statute,captures most of the malign cases, and will need qualification only in the rare cases where such a purpose maybe privileged by law or otherwise.”); United States v. Brand, 775 F.2d 1460, 1465 (11th Cir. 1985) (noting thatcorruptly “takes on different meanings in various contexts”).

Nevertheless, certain characteristics have attached to “corruptly.” On one hand, circuits courts have definedcorruptly in terms of an improper motive or evil purpose. See, e.g., United States v. Partin, 552 F.2d 621, 641(5th Cir. 1977) (“The word corruptly means a defendant acted with improper motive or with bad or evil orwicked purpose. Any endeavor to influence or intimidate or impede a witness falls within the meaning of theword corruptly.”); United States v. Jackson, 607 F.2d 1219, 1221-22 (8th Cir. 1979); United States v.Haldeman, 559 F.2d 31, 114-15 n.229 (D.C. Cir. 1976) (same). On the other hand, circuit courts have tied theconcept of corruptly to knowledge or foreseeability of obstruction. United States v. Jeter, 775 F.2d 670, 679(6th Cir. 1985); United States v. Machi, 811 F.2d 991, 997 (7th Cir. 1987); United States v. Rasheed, 663 F.2d843, 852 (9th Cir. 1981); United States v. Brenson, 104 F.3d 1267, 1278 (11th Cir. 1997) (approving a juryinstruction that read, in part: “[c]orruptly describes the specific intent of the crime. Generally, the governmentmust show that the defendant ... knowingly and intentionally understood an action from which an obstruction ofjustice was a reasonably foreseeable result. Although the government is not required to prove that thedefendant ... had the specific purpose of obstruction of justice”). A slight variant on this interpretation ofcorruptly is to associate the term with an “intent to do an act which results in obstruction.” United States v.Neiswender, 590 F.2d 1269, 1274 (4th Cir. 1979); United States v. Laurins, 857 F.2d 529, 536-37 (9th Cir.1988) (defining corruptly as an “act ... done with the purpose of obstructing justice”).

The Supreme Court held that the mens rea of “knowingly” in Section 1512(b) modifies the language “corruptlypersuades,” such that criminal liability is limited to “persuaders conscious of their wrongdoing.” ArthurAndersen v. United States, 544 U.S. 696, 705-706 (2005). “‘[K]nowledge’ and ‘knowingly’ are normallyassociated with awareness, understanding, or consciousness, and ‘corrupt’ and ‘corruptly’ with wrongful,immoral, depraved, or evil. Joining these meanings together makes sense both linguistically and in the statutoryscheme.” Id. (rejecting jury instructions that would create liability for “innocent [persuasion] to withholdinformation from the Government”).

d. Endeavors

The Court has described endeavor as “any effort or essay to do or accomplish the evil purpose that the sectionwas enacted to prevent.” United States v. Russell, 255 U.S. 138, 143 (1921); accord United States v. Cioffi, 493F.2d 1111, 1119 (2d Cir. 1974); United States v. Silverman, 745 F.2d 1386, 1393 (11th Cir. 1984). Indescribing endeavor for purposes of obstruction of justice, the Russell court noted that “[g]uilt is incurred by thetrial-success may aggravate; it is not a condition of it.” 255 U.S. at 143. Courts uniformly hold that an“endeavor” need not be successful. See, e.g., United States v. Nicosia, 638 F.2d 970, 975 (7th Cir. 1980);United States v. Wash. Water Power Co., 793 F.2d 1079, 1085 (9th Cir. 1986); United States v. Collis, 128 F.3d313, 318 (6th Cir. 1997) (same).

VIII. INTERPLAY OF SECURITIES CLASS ACTIONS, DERIVATIVE ACTIONS, SECINVESTIGATIONS AND CRIMINAL PROSECUTIONS

Securities class actions, derivative actions, SEC investigations and criminal prosecutions each require differentresponses and competing priorities. However, companies facing securities claims often find themselves caughtin the middle -- forced to simultaneously defend on multiple fronts against claims with competing interests. Forexample, the Reform Act calls for a discovery stay to halt abusive litigation tactics, yet derivative plaintiffs’frequent attempts to circumvent the stay and the SEC requirement of full and comprehensive cooperation oftenundermine this protection. In addition, the Fifth Amendment protects criminal defendants, yet refusal to testifyin civil and SEC proceedings can lead to serious disadvantages. Also, the attorney-client privilege is one of thecornerstones of the American legal system, yet the SEC often threatens and treats harshly a company thatrefuses to waive it – despite the fact that waiver has now been ruled to extend to other arenas. These and amultitude of other interwoven concerns must be taken into account and balanced from the outset whendefending securities claims.

In addition, multiple claims can cover numerous parties and require independent counsel not only for eachclaim, but sometimes for each defendant. Criminal and SEC litigation quite commonly generate conflictsamong individual defendants that can only be addressed through separate representation. As a result, aneffective defense often must coordinate the concerns of multiple defendants along with those stemming frommultiple claims.

A. Case Initiation

While a company’s securities-related litigation concerns traditionally began with the filing of a class actionlawsuit, followed by an inquiry or investigation from the SEC or other regulatory agency, this is no longertypical. It is increasingly common for concerns to originate from a company’s own internal controls or theinitiative of regulatory bodies such as the SEC and SROs. Private securities class actions are more often filedin tandem with or subsequent to such regulatory investigations. Criminal investigations and derivative actionsusually still follow SEC enforcement and private securities class actions. Whichever form of claim comes first,a company must now anticipate that others will follow and act accordingly.

B. Preliminary Discovery

At the outset of a securities claim, defense counsel should conduct a preliminary investigation into allegedissues in order to properly evaluate the case to prevent potential misrepresentations. Internal control issues andinquiries from regulatory agencies usually result in a similar, but more formal, internal investigation. Thisinternal investigation often entails interviewing involved personnel and reviewing relevant documents. However, independence concerns with internal investigations frequently mean that such investigations arestructured to maximize objectivity. This commonly leads to an independent subset of management (often theaudit committee or a committee of outside directors) hiring outside counsel (often a law firm that has not doneany prior work for the company) to conduct the investigation. Coordinating these efforts is important toeffectively manage the expense of litigation and to insure future cooperative efforts.

One issue of special import to defense counsel is the reporting obligations of attorneys under Sarbanes-Oxley.


See Section I.F.3.e., supra. Counsel conducting such investigations are obligated to report any materialviolations. Doing so may often instigate a parallel regulatory proceeding, and failing to do so may lead to civilor criminal liability for counsel.

C. Privilege Concerns

The written findings of any internal investigation constitute work product, and any conclusions based thereon orderived therefrom are protected by the attorney-client privilege. The management personnel overseeing theinvestigation typically control the privilege on behalf of the company. However, the SEC may ask that thisprivilege be waived. The SEC has stated that while it no longer considers the waiver of attorney-client andwork-product privileges in its assessment of defendants’ cooperation, it continues to consider the extent towhich a corporation discloses relevant facts and evidence, regardless of whether such disclosure involveswaiver. Because several courts have ruled that selective disclosure to the SEC and other regulatory agencieswaives privileges for all actions, defendants have found themselves faced with a direct conflict. SeeSection I.F.3.c., supra. It is almost certain that parties in any parallel securities class actions and derivativeactions will ask for those findings and conclusions (along with anything reviewed in connection therewith) atthe outset of discovery – and use that information as a roadmap for their claims. Counsel and defendants mustcarefully weigh the risks and benefits of regulatory disclosure and the resultant waiver of privilege.

The Reform Act stay on discovery pending the motion to dismiss provides some breathing room in classactions, but courts overseeing derivative actions have ruled both ways on allowing discovery. See SectionI.E.2.d., supra. Hence defendants need to carefully weigh the pros and cons of waiving privilege, as that waivermay significantly bolster the viability of other actions. At the very least, investigating counsel should be verymindful of potential disclosure when preparing any materials.

D. Representation Issues

Similarly, the need to retain separate independent counsel to conduct internal investigations raises joint andparallel representation issues. During many internal investigations, separate counsel handle concurrentsecurities class actions and derivative actions. Should criminal proceedings loom, individual defendants oftenfind themselves needing additional independent representation. Under these circumstances, well-formulatedjoint defense agreements are needed to coordinate between concurrent actions and preserve applicableprivileges throughout.

With criminal or SEC proceedings, individual defendants may have interests that do not fully align with thoseof other defendants. In the wake of stringent penalties handed out in fairly recent criminal prosecutions,including the conviction of former Worldcom chief Bernard Ebbers, individual officers and directors areincreasingly more concerned with potential criminal exposure. This potential conflict should be recognizedfrom the outset and addressed in the joint representation agreement.

E. Discovery

As noted above, the Reform Act’s discovery stay can create a disparity in discovery obligations betweenvarious parallel proceedings. Discovery in securities class actions is commonly stayed pending the outcome ofthe motion to dismiss. But courts have not uniformly imposed and/or enforced the Reform Act discovery stayin derivative actions. They have rendered mixed rulings on discovery in derivative actions during the ReformAct stay, so counsel must be mindful of the potential for such discovery. If possible, stipulations stayingdiscovery should be sought from derivative plaintiff’s counsel. The SEC and other regulatory authoritiesgenerally conduct discovery through informal requests and rarely suspend discovery for any reason. The U.S.Attorney’s Office and other criminal investigatory agencies likewise conduct discovery without regard to theReform Act stay. It is also possible that producing discovery in one action will lead to the filing of otheractions.

The Reform Act’s discovery stay may also be jeopardized in the context of parallel proceedings. When adefendant produces discovery in an SEC or regulatory action, it negates the basis for the discovery stay(preventing undue and burdensome expense). Some courts have ruled that maintaining the discovery stay insuch situations “unduly prejudices” the securities class action plaintiffs and have lifted the stay. See In reWorldcom, Inc. Sec. Litig., 234 F. Supp. 2d 301 (S.D.N.Y. 2002).

F. Written Discovery

Responses to interrogatories, requests for admission, and requests for the production of documents (includingthe production of requested documents) are often the most time-consuming and expensive phase of litigation. In the context of parallel proceedings, it is vital to coordinate document collection, information gathering fromwitnesses, and responses to written discovery – both to minimize expense and avoid responses that mayjeopardize other proceedings.

G. Depositions

Deposition testimony, because it is taken under oath, may be admissible in other proceedings. Multipledepositions can also lead to conflicting testimony and much more probing questions in later depositions. Assuch, defense counsel should be very careful to monitor and limit deposition occasions.

Additionally, defendants planning on invoking the Fifth Amendment in either pending or potential criminalproceedings should be very careful to avoid civil testimony because of the negative inference that can be drawnon that basis in the civil context. See Section I.F.6., infra. In addition, prior civil testimony can result in waiverof Fifth Amendment protections in later criminal proceedings. With parallel proceedings, counsel mustcarefully weigh the pros and cons of allowing their client to be deposed.

H. Settlement

As noted above, it is much more difficult to reach global settlements of multiple securities claims. Plaintiffs aredifferent entities and have different agendas and interests – often conflicting. As such, counsel shouldcoordinate all settlement discussions and proposals among the different pending proceedings.

Counsel should be especially careful when settling one action while still proceeding with others. This isextremely important when one attempts to settle a regulatory action while proceeding with a securities classaction. Often, settlement with criminal or regulatory agencies entails a press release by that agency, which cansubstantiate or otherwise directly influence a parallel class or derivative action. Equally important, manysettlement agreements by individuals contain clauses prohibiting the individual from taking a position oncertain key issues that may be material to other pending actions. Counsel should pay close attention to theramifications of such agreements.

I. Insurance Concerns

Very few insurance policies provide coverage for preliminary internal investigations that may be prompted byan informal SEC or SRO inquiry. Most policies require either a formal written order, subpoena, or a Wellsnotice to trigger coverage. Almost no policy covers an internal investigation prompted by internal controlconcerns. Instead, only the filing or service of a complaint triggers coverage under most policies. This meansthat companies often find themselves enmeshed in expensive, pre-litigation discovery situations that are notcovered by insurance policies. In circumstances involving parallel securities class actions, defense counsel forthe securities class actions should take the lead in discovery to insure coverage for such discovery.

Once securities claims proceed downstream to the point where coverage is available for all actions, conflictsoften arise with respect to the best use of those proceeds because many insurance policies have priority clauses.

Questions and differences will often arise over the use of insurance monies, especially when the sameindividual defendants are named in all actions. These issues are underscored when settlement becomes possiblein one, but not all actions. At that point, defense counsel must weigh the benefits of settlement against the needto retain funds to cover the cost of defending further actions.

[1] After the Ninth Circuit reversed the directed verdict, the Everex case was tried a second time, and the jury returned a defenseverdict at the conclusion of the second trial. Howard v. Hui, No. C 92-3742-CRB (N.D. Cal. Feb 8, 2002).

[2] While a large body of case law has developed on what elements are required to prevail on a private Rule 10b-5 claim, some courtssuch as the Tenth Circuit have articulated different requirements for the SEC in an enforcement action under Rule 10b-5: 1) a materialmisrepresentation; 2) in connection with the purchase or sale of a security; 3) use of jurisdictional means; and 4) scienter. S.E.C. v.Autocorp Equities, Inc., 292 F. Supp. 2d 1310, 1318 (D. Utah 2003) (citing Geman v. S.E.C., 334 F.3d 1183, 1192 (10th Cir. 2003)).