“strong inference” of scienter securities litigation

REPO

RTSe

curit

ies L

itiga

tion

Complete Table of Contents listed on page 2.

Content HIGHLIGHTS

July/August 2007 n Volume 4 n Issue 7

Tellabs Endorses “Holistic” Approach to Assessing Whether a Plaintiff Pleads a “Strong Inference” of Scienter B y J o r d a n E t h & M a r k F o s t E r

Jordan Eth is a partner with Morrison & Foerster LLP and Co-Chair of the Firm’s Securities Litigation,

Enforcement, and White-Collar Defense group. He is also a member of the Editorial Board of Securities

Litigation Report. Mark Foster is an associate at Morrison & Foerster LLP and practices in the Firm’s Securi-

ties Litigation, Enforcement, and White-Collar Defense group. Contact: [email protected].

40492646

The Supreme Court has now weighed-in on the “strong inference” state of mind pleading standard imposed by the Private Securities Litigation Reform Act of 1995 (the “Reform Act”).1 Tellabs v. Makor Issues & Rights.2 Tellabs holds that “to qualify as ‘strong,’. . . an inference of scienter must be more than merely plausible or reasonable—it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.”3 To determine whether a plaintiff pleads facts that support inferences that are cogent and compelling, judges must consid-er competing inferences and “assess all the allegations” in a complaint “holistically.”4 Holistic evaluation requires judges to de-termine—case-by-case—“whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in iso-lation, meets that standard,” according to Justice Ruth Bader Ginsburg, who wrote for the 8-1 majority.5

Tellabs confers a significant benefit on defendants: judges must consider all pos-

sible inferences—culpable and innocent—drawn from the alleged facts and those judicially noticeable. This was not true in all Circuits before Tellabs. The Seventh Circuit, for example, which the Supreme Court reversed in Tellabs, applied the tra-ditional test that requires construing all allegations in a plaintiff’s favor, and held that a complaint could survive so long as a ContInUEd on PaGE 4

From the EditorsJoseph M. McLaughlin & Gregg Wirth ....................... 3

In Billing, Supreme Court Rules that IPO Litigation is Immune from Antitrust Scrutiny By Kevin Arquit ......................................................... 11

Securities Litigation Report

�

MANAGING EDITOR:GREGG WIRTH

CHAIRMAN: JOSEPH M. MCLAuGHLINSimpson Thacher & Bartlett LLP,New York, NY

BOARD OF EDITORS: Corporate Governance, Risk Management & Professional Responsibility:JONATHAN C. DICkEyGibson, Dunn & Crutcher LLP,Palo Alto, CA

Regulation, the SEC, and the Department of Justice:MARk RADkELeBoeuf, Lamb, Greene & MacRae, LLP Washington, DC

The Courts, Electronic Discovery, & Plaintiffs’ Issues:ANDREW B.WEISSMANWilmer Cutler Pickering Hale & Dorr LLP Washington, DC

ALAN SCHuLMANBernstein Litowitz Berger & Grossmann LLPSan Diego, CA

LAWRENCE ByRNEWhite & Case LLP, New York, NY

JAMES BENEDICTMilbank, Tweed, Hadley & McCloyNew York, NY

WAyNE M. CARLINWachtell, Lipton, Rosen & Katz New York, NY

PAuL H. DAWESLatham & Watkins LLP, Menlo Park, CA

JORDAN ETHMorrison & Foerster LLP San Francisco, CA

JOy A. kRuSELieff Cabraser Heimann & Bernstein, LLPSan Francisco, CA

HEATHER FOxSVP & Chief Underwriting Officer National Union Fire Insurance Company of Pittsburgh, PA New York, NY

JONATHAN M. HOFFCadwalader, Wickersham & Taft LLPNew York, NY

kARIN kRAMERHowrey LLP, San Francisco, CA

GRACE LAMONTPricewaterhouseCoopersNew York, NY

ALFRED J. LECHNER, JR.Lerner, David, Littenberg, Krumholz & Mentlik, LLP Westfield, NJ

PAuL LOMASFreshfields Bruckhaus Deringer London

LINDA MuLLENIxProfessor of Law University of Texas School of LawAustin, TX

JOHN F. SAvARESEWachtell, Lipton, Rosen & Katz New York, NY

SHERRIE R. SAvETTBerger & Montague , P.C.Philadelphia, PA

ROBERT A.WALLNERMilberg Weiss LLP New York, NY

MICHAEL R. yOuNGWillkie Farr & Gallagher LLPNew York, NY

Please address all editorial, subscription, and other correspondence to the publishers at [email protected] authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) 750-8400; fax (978) 646-8600 or West’s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651) 687-7551. Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. West Legalworks offers a broad range of marketing vehicles. For advertising and sponsorship related inquiries or for additional information, please contact Mike Kramer, Director of Sales. Tel: 212-337-8466. Email: [email protected] publication was created to provide you with accurate and authoritative information concerning the subject matter covered. However, this publication was not necessarily prepared by persons licensed to practice law in a particular jurisdication. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional.Copyright is not claimed as to any part of the original work prepared by a United States Government officer or employee as part of the person’s official duties.

Securities Litigation ReportWest Legalworks395 Hudson Street, 6th FloorNew York, NY 10014

One Year Subscription n 10 Issues n $498.00 (ISSN#: PENDING)

Editorial Board

Table of CONTENTS

Sarbanes-Oxley at Five

SOx’s Whistleblower Provision–Promise unfulfilledBy Jason M. Zuckerman .................................................................14

The Fifth Circuit Holds that Loss Causation is a Class Certification IssueBy Warren R. Stern & Garrett B. Moritz .......................................19

Online Editions Now AvailableWest Legalworks is pleased to announce that this

newsletter is now available on the Internet to Subscribers of the print edition.

The online version offers additional interactive capabilities that enhance the usefulness of your subscription including

Search features for current and archived articles and Links to other information and Westlaw® cases.

To take advantage of this service, please visit www.glwnewsletters.com/register.asp

to register or call 800.308.1700.

Free Service for Subscribers


�

Decisions… What Does Tellabs Mean for Securities Litigation?

Before turning to the landscape-changing Tellabs decision, Securities Litigation Report is proud to an-nounce that Joseph M. McLaughlin in now the Chair-man of SLR‘s Editorial Advisory Board. McLaughlin has served as a member of the SLR Editorial Board since its inception, is a partner in the Litigation De-partment of Simpson Thacher & Bartlett LLP, where he specializes in complex class actions, securities litigation and product liability litigation. He has rep-resented clients in everything from tobacco-related cases to tender offer class action litigation, and is the author of McLaughlin on Class Actions: Law and Practice (Thomson West 3d ed. 2007).

We at SLR are grateful to Mr. McLaughlin’s contribu-tions to this publication in the past and are thrilled at his taking a bigger role. We hope all our readers and editori-al board members join us in welcoming Mr. McLaugh-lin to the helm of Securities Litigation Report.

— GREGG WIRTH

In this issue…In our top story, authors Jordan Eth and Mark

Foster of Morrison & Foerster LLP examine the potential impact of the Supreme Court’s Tellabs decision on securities litigation. Under Tellabs, to survive a motion to dismiss, a plaintiff must allege particularized facts that give rise to an inference of defendant’s fraudulent intent that is “more than merely plausible or reasonable—it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.” Was the decision a body blow to securities law plaintiffs; are plaintiffs hang-ing their head in despair? Is it a landmark, new ral-lying point for defendants? Or is the right view held by those who say that the majority was a coalition unlikely to reach a radical conclusion?

The standard enunciated by the Supreme Court for pleading a “strong inference” of fraudulent in-tent provides clear and forceful authority for district courts to dismiss securities fraud cases that are based on speculative, or even merely reasonable, scienter theories. Tellabs requires a showing that the infer-ence of fraudulent intent be “cogent,” “compelling,” “powerful” and more than a mere possibility, and re-quires courts to assess competing inferences and judge each case “holistically,” the authors explain, adding “[…] In this regard, Tellabs raises the bar for plead-ing scienter higher than it had been in some courts.”

And while securities litigators, shareholder advo-cates, plaintiff attorneys and the lower federal courts all digest this, the Supreme Court in Stoneridge still has scheme liability to consider.

Also in this issue… Author Kevin Arquit of Simp-son Thacher & Bartlett LLP reviews the impact of the Supreme Court’s decision in Credit Suisse First Bos-ton v. Glen Billing, the IPO antitrust litigation case. In that ruling, the author explains, the Supreme Court held that certain practices used during the IPO pro-cess are “impliedly immune from antitrust challenges” because such conduct is the sole purview of the SEC. The Court ruled no antitrust liability could come from such underwriting strategies as “laddering” or “tying arrangements” which plaintiffs claimed artificially in-flated the prices of new stocks during their IPOs.

SOX Anniversary. July 30 is the fifth anniversary of the enactment of the Sarbanes-Oxley Act. To mark the event, Securities Litigation Report will present -- beginning in this issue and continuing over the next few months – articles about the real world impact of SOX. In this issue, author Jason M. Zuckerman ana-lyzes how SOX’s whistleblower protection rules have been interpreted – and undone – by the courts.

— JOSEPH M. MCLAUGHL IN & GREGG WIRTH

We are pleased to present you with a newly redesigned newsletter starting with this issue. Our goal, when we set out to redesign the newsletter, was to provide our readers with a fresh and modern look and an easy to read layout. Our new design continues to bring you informative content written by experts and now includes information about events, publications and services relevant to your business.

From the EDITORS


�

“reasonable person” could infer that a defendant acted with scienter, regardless of any competing inferences.6 In this regard, Tellabs raises the bar for pleading scienter higher than it had been in some courts.

Tellabs, however, does not raise the pleading bar as high as some had hoped. Although plaintiffs’ scienter allegations must be “cogent” and “com-pelling” to be considered “strong,” the allegations “need not be irrefutable, i.e., of the ‘smoking gun’ genre, or even the most plausible of competing in-ferences.”7 Rather, plaintiffs’ allegations must be “at least as compelling as any opposing inference of nonfraudulent intent.”8 At the pleading stage, at least as a theoretical matter, in those rare cases where inferences of scienter and innocence are in equipoise, ties will go to plaintiffs.9

The tie-breaking default that now favors plain-tiffs at the pleading stage was not the universal rule before Tellabs. Courts in at least four Circuits had required plaintiffs to plead inferences of scienter that were “more plausible” than any inferences of innocence, a standard that Justices Antonin Scalia and Samuel A. Alito would have preferred.10 The Tellabs standard is also different from an alterna-tive formulation urged by the United States De-partment of Justice and Securities and Exchange Commission, which would have required a plain-tiff to plead facts showing a “high likelihood” that a defendant acted with scienter.11

The Tellabs standard advances what the Court described as the Reform Act’s “twin goals: to curb frivolous, lawyer-driven litigation, while preserv-ing investors’ ability to recover on meritorious claims.”12 It will take years to assess whether more or less certainty comes in the wake of Tel-labs, especially since the Supreme Court rejected any bright-line rules. Going forward, however, it is probable that inferences of scienter and inno-cence will be litigated more frequently, more vig-orously, and perhaps more creatively than ever in all courts.

BackgroundSection 10(b) of the Securities Exchange Act of

1934 (the “Exchange Act”) prohibits the “use or employ, in connection with the purchase or sale of

any security… , [of] any manipulative or deceptive device or contrivance.”13 Rule 10b-5, promulgated thereunder, implements Section 10(b) and provides that it is unlawful to “employ any device, scheme or artifice to defraud… , make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made… not misleading, or… engage in any act, practice, or course of business… that would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”14

Over thirty years ago, the Supreme Court held that Section 10(b) and Rule 10b-5 give rise to a private right of action by purchasers and sellers of securities against those who defraud them. Ernst & Ernst v. Hochfelder.15 To plead a viable private claim, a plaintiff must plead facts show-ing, among other things, that a defendant acted with scienter.16 For purposes of securities fraud, scienter is defined as a defendant’s intention “to deceive, manipulate, or defraud.”17 Section 10(b) and Rule 10b-5 under Section 10(b) are the anti-fraud provisions that plaintiffs most frequently assert in private securities litigation.18

For almost two decades, the various Circuit Courts devised “distinctly different standards” for pleading scienter.19 That divergence and the perceived exploitation of that divergence, among other things, encouraged Congress to pass the Re-form Act in 1995. One goal of the Reform Act was “to establish uniform and more stringent plead-ing requirements.”20 Among other procedural and substantive provisions, the Reform Act (as codi-fied in Section 21D(b)(2) of the Exchange Act), mandated that plaintiffs “state with particularity facts giving rise to a strong inference that the de-fendant acted with the required state of mind.”21

Congress, however, left the term “strong infer-ence” undefined. In the ten years after passage of the Reform Act, the Courts of Appeals diverged in interpreting “strong inference” and the method for assessing inferences.22 The Supreme Court granted certiorari in Tellabs “to resolve the disagreement among the Circuits on whether, and to what ex-tent, a court must consider competing inferences in determining whether a securities fraud complaint gives rise to a ‘strong inference’ of scienter.”23

ContInUEd FroM PaGE 1


�

The Holistic StandardTellabs resolves the split among the Circuit

Courts in two ways. The decision defines “strong inference,” and it prescribes a three-part “holis-tic” approach that courts must use when deter-mining whether allegations and inferences in a given case add up to the defined standard when ruling on motions to dismiss.24

Tellabs holds that a “strong inference” of scien-ter is “more than merely ‘reasonable’ or ‘permis-sible.’”25 Rather, a strong inference must be “pow-erful,” “cogent,” “effective,” and “compelling.”26 Strength, however, remains a relative term as the “strength of an inference cannot be decided in a vacuum.”27 Deciding whether an inference is co-gent, compelling, or effective means that a “court’s job is not to scrutinize each allegation in isolation but to assess all the allegations holistically.”28

Under the holistic standard announced in Tel-labs, a securities fraud “complaint will survive . . . only if a reasonable person would deem the inference of scienter cogent and at least as com-pelling as any opposing inference one could draw from the facts alleged.”29 This standard thus re-quires courts to consider inferences of culpability as well as inferences of innocence. In other words, a court’s “inquiry is inherently comparative.”30

Before Tellabs, a comparative analysis of al-legations and inferences was not mandatory. At least three different approaches existed, as out-lined below.

• No Competing Inferences: In the Seventh Circuit, competing inferences of innocence could not be considered, and a complaint could “survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required in-tent.”31 The Seventh Circuit opted not to permit consideration of competing inferences out of concern that doing so would usurp the jury’s role in weighing facts,32 a concern that the Supreme Court rejected.33

• CompetingInferencesWithTiesToPlaintiffs: In the Eighth and Tenth Circuits, courts were permitted (but not required) to consider com-peting inferences, but were required to side

with the plaintiff when “[f]aced with two seem-ingly equally strong inferences, one favoring the plaintiff and one favoring the defendant.”34

• CompetingInferencesWithTiesToDefen-dants: In the First, Fourth, Sixth, and Ninth Circuits, courts were permitted to consider all possible inferences, culpable and inno-cent, and held that the inferences of scienter had to be more plausible than the inferences of innocence.35

Tellabs rejected the Seventh Circuit’s stan-dard, which did not “capture the stricter demand Congress sought to convey” when it passed the Reform Act.36 Tellabs, however, also declined to adopt the standard used by the First, Fourth, Sixth, and Ninth Circuits, which required a plain-tiff’s allegations of scienter to be more plausible than any inferences of innocence.37 Instead, the Tellabs standard most closely resembles the stan-dard that the Eighth and Tenth Circuits had been using—considering all inferences but giving the edge to plaintiffs where the inferences of scienter and innocence are equal—but with an enhance-ment: Tellabs makes review of competing infer-ences mandatory, not optional.38

The Supreme Court established three “prescrip-tions” to guide courts in holistically evaluating whether allegations give rise to a “strong infer-ence” of scienter.39 First, a court must “accept all factual allegations in the complaint as true” when “faced with a Rule 12(b)(6) motion to dismiss a §10(b) action.”40

Second, a court must “consider the complaint in its entirety,” and also consider “other sources courts examine when ruling on 12(b)(6) motions.”41 Oth-er sources include “documents incorporated into the complaint by reference, and matters of which a court may take judicial notice.”42

For years, the issue of whether a court could look at such information had been a fertile area of litigation, as defendants often submitted evidence such as stock price trading data, press releases, SEC filings, analyst reports, and similar information to place a plaintiff’s allegations of fraud in context. Plaintiffs, in turn, often moved to strike the materi-als, and argued that a court could not look beyond the four corners of a complaint when ruling on a


�

motion to dismiss. Tellabs should support defen-dants in the future as they demonstrate inferences of innocence from publicly available information.

Third, a court “must take into account plau-sible opposing inferences.”43 This is where the sig-nificance of the competing inferences comes into play. Courts must engage in comparative analysis and ask: “[h]ow likely is it that one conclusion, as compared to others, follows from the underlying facts,”44 and “[w]hen the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?”45

The third step is key. An inference of scienter “must be cogent and compelling, thus strong in light of other explanations.”46 Any allegations that “are too vague or ambiguous” must “count against inferring scienter.”47 Nevertheless, the Supreme Court made it clear that an “inference that defendant acted with scienter need not be ir-refutable, i.e., of the ‘smoking-gun’ genre . . .”48 According to the Court, this standard will “screen out frivolous suits, while allowing meritorious ac-tions to go forward.”49

The Supreme Court also clarified a related thorny issue by holding that those cases that do go forward must meet an even higher burden in later phases of litigation. Some courts had suggest-ed that the pleading standard was higher than the proof standard.50 Tellabs clearly rejected that idea and holds that at trial (or summary judgment), plaintiffs will have to prove their case by showing that “it is more likely than not that the defendant acted with scienter.” 51 In close cases in later phases of litigation, ties go to the defendants.52

No Concrete GuidanceWhile the Supreme Court articulates clear ap-

proach for comparing inferences. Tellabs, pro-vides little concrete guidance. Instead, the Court vacated the Seventh Circuit decision, and remand-ed for consideration in light of the new standard that requires consideration of all inferences, cul-pable and innocent.53

The Supreme Court, however, did shed some light on how courts should consider “pecuniary motive” when weighing competing inferences.54 Tellabs had argued that its CEO’s lack of a “pe-

cuniary motive”—an inference of innocence—would be dispositive.55 The Supreme Court re-jected a bright-line rule.56 The Court explained that “motive can be a relevant consideration, and personal financial gain may weigh heavily in fa-vor of a scienter inference,” but “the absence of a motive allegation is not fatal.”57

Before Tellabs, the varying Circuit Courts attrib-uted various degrees of significance to the presence or absence of allegations showing that a defendant had a personal financial motive to commit fraud. For example, a plaintiff’s particularized motive alle-gations showing that a defendant’s stock sales were relatively suspicious in timing or amount, could, standing alone, give rise to a strong inference of scienter in some jurisdictions, including the Second and Third Circuits.58 In the Ninth and Eleventh Circuits, by contrast, suspicious stock sales stand-ing alone, could never give rise to a strong infer-ence of scienter.59 The Sixth and Ninth Circuits suggested that the absence of suspicious stock sales could “dull” or even “negate” a strong inference of scienter,60 and other Circuits agreed that the ab-sence of motive allegations would make it more difficult for plaintiffs to establish strong inferences of scienter.61 Tellabs confirms that the absence of a pecuniary motive cuts against scienter, and em-phasizes the importance of courts considering “the complaint in its entirety.”62

The closest that Tellabs comes to providing concrete guidance about what a reasonable per-son could deem a strong inference of scienter takes the form of a hypothetical involving a jade falcon.63 The Court observed that “if a jade fal-con were stolen from a room to which only A and B had access,” “law enforcement officials as well as the owner of the precious falcon would find the inference of guilt as to B quite strong—cer-tainly strong enough to warrant further investi-gation.”64 In other words, a plaintiff’s allegations about B would give rise to an inference of scienter that is sufficiently strong so that the case could go forward into discovery.65

Justice Scalia, who concurred in the judgment, countered that it “would be impossible to form a strong belief that it was B and not A, or A and not B, who stole the falcon.” His minority view, however, shows that the Tellabs standard, which


�

filters scienter allegations and inferences through the fiction of a “reasonable person,” will not guarantee uniform application of the law given that reasonable judges (i.e. reasonable persons) can disagree about whether an inference from a simplistic hypothetical is compelling or not.

unresolved IssuesThe Tellabs decision does not resolve all issues

regarding interpretation of the scienter element in securities fraud cases, and the Supreme Court rec-ognized that other “uncertainties” remain.66 For example, the Supreme Court expressly reserved (as it has before) consideration of whether reckless behavior satisfies the substantive requirement for pleading scienter.67 The Court noted, however, that every Circuit that has answered the question “has held that a plaintiff may meet the scienter require-ment by showing that the defendant acted inten-tionally or recklessly, though the Circuits Courts differ on the degree of recklessness required.”68

Most Circuit Courts define recklessness as “an act so highly unreasonable and such an extreme departure from the standard of ordinary care as to present a danger of misleading the plaintiff to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.”69 The Ninth Circuit goes further and requires plaintiffs to show “con-sciousness or deliberateness,” facts that “come closer to demonstrating intent.”70 After Tellabs, the Ninth Circuit’s substantive standard will re-main the most stringent scienter standard, and the various Circuits will likely continue to diverge in their interpretations regarding the degree of reck-lessness that plaintiffs must establish.

The Supreme Court also did not squarely reach whether the “group-pleading doctrine” survived the Reform Act.71 Before passage of the Reform Act, the group-pleading doctrine was a pleading presumption that permitted plaintiffs to plead that information in a company’s allegedly false press releases and SEC filings (“group-published information”) was the collective effort of the com-pany’s officers and directors.72 Recognizing that the courts were divided on whether the group-pleading doctrine survived the Reform Act, the Supreme Court decided not to “disturb” the Sev-

enth Circuit’s conclusion that it did not,73 which was consistent with the decision of the only other Circuit Court that has squarely considered the is-sue.74 The Supreme Court’s decision not to “dis-turb” that conclusion should provide defendants the stronger argument in future cases if plaintiffs continue to invoke the doctrine after Tellabs.

Other OpinionsThree justices filed separate opinions in Tel-

labs. Justices Scalia and Alito concurred in the judgment. Both justices stated that the Court’s holding that inferences of scienter be “at least as compelling as any opposing inference” could not be equated with a “strong inference.”75 They would have held that an inference of scienter is strong only if it is “more plausible than the in-ference of innocence.”76 Justice Scalia explained that there was nothing to indicate that Congress intended “to relax the ordinary rule under which a tie goes to the defendant.”77 Justice Alito added that the “more plausible” standard would have aligned the pleading standard with the test used at the “summary-judgment” and “judgment-as-a-matter of law stages.”78 He stated that align-ment of standards would be more consistent with Congressional intent than the standard adopted by the majority, which he described as a “test pre-viously unknown in civil litigation.”79

Justice John Paul Stevens was the lone dissenter. He opined that the Court should have adopted a “probable cause” standard.80 He explained that the basic purpose of the Reform Act was to pro-tect defendants from the costs and intrusiveness of discovery and trial in unmeritorious cases.81 He reasoned that the “probable cause” standard, au-thorizing a search in criminal matters, would be a more familiar to judges and “would be both easi-er to apply and more consistent with the [Reform Act].”82 Justice Stevens concluded that it was un-likely that Congress intended to adopt a standard that “makes it more difficult to commence a civil case than a criminal case.”83

ConclusionTellabs alters private securities litigation in

subtle but significant ways. Although a majority


�

of Circuit Courts previously permitted judges to consider competing inferences to varying degrees at the motion to dismiss stage, Tellabs now man-dates that judges consider competing inferences, and imposes a uniform method for comparing those inferences. Tellabs also importantly estab-lishes a uniform standard for determining when those inferences add up to a strong inference of scienter—that is, when they are at least as strong as the opposing inferences of innocence.

The holistic standard assures that defendants will get a fair shot early in litigation to demonstrate that there are plausible explanations for alleged misconduct that overcome a plaintiff’s claims of securities fraud. This early opportunity to argue inferences of innocence reinforces the importance for defendants of motions to dismiss in securities fraud cases. Tellabs holds that competing infer-ences must be considered, but this does not re-lieve plaintiffs of their heavy burden under the Reform Act to plead particularized facts that give rise to, a “strong inference” of scienter.84 Where a complaint fails to plead compelling inferences of culpability, a securities fraud case cannot go for-ward, regardless of whether defendants elect to present inferences that support their innocence.

The holistic standard announced in Tellabs evokes an image of the scales of justice, with in-ferences of scienter on one side, and inferences of innocence on another. Where the scales tip in favor of plaintiffs or balance exactly, securities fraud cases will go forward to discovery; where they do not, the cases will end.

The image of scales oversimplifies how holistic analysis may work in reality. Holistic analysis, by definition, involves consideration of allegations collectively, rather than separately or in isolation.85 Judges, however, will not be able to quantify com-peting inferences to determine what set of infer-ences is more compelling (even if that were pos-sible). For example, a judge might compare the absence of suspicious stock sales—an inference of innocence—to reports from a confidential witness claiming that the defendants knew their statements were false when made—an inference of scienter. How will the court compare the relative strength of those different types of inferences and determine which is more cogent and compelling? Once ad-

ditional inferences are thrown into the total mix, the analysis may become even more unpredictable. Without any means of valuing the strength of vari-ous types of inferences, the “holistic” approach prescribed by Tellabs may ultimately entail a sig-nificant element of judicial subjectivity—a “know it when they see it” type of test.86

Ultimately, the Supreme Court’s decision not to apply its new standard to the allegations before it may lead to uncertainty or inconsistency in how federal judges throughout the country assess alle-gations holistically. Future divergence may even-tually prompt Congress to enact new legislation that provides a truly uniform and comprehensive standard for establishing scienter in securities fraud cases.

The Supreme Court Is Set To Address “Scheme” Claims Next

The Supreme Court will have another oppor-tunity to articulate a definitive standard affecting private securities litigation during its next Term, which begins in October. In the fall, the Court will hear arguments in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.87 In Stoneridge, the Court will consider whether shareholders can pur-sue “scheme” claims under Section 10(b), and Rule 10b-5(a) and (c), which prohibit manipulative and deceptive conduct undertaken in connection with the purchase or sale of securities.

Often shareholders assert such “scheme claims” against secondary actors who do not directly par-ticipate in the making of public statements to investors but may provide behind-the-scenes as-sistance of some form to a party that makes mis-leading statements. These secondary actors often include vendors, business partners, accountants, banks, lawyers, and even low-level employees of an issuer. The Fifth Circuit and the Eighth Cir-cuit (in the case under review in Stoneridge) have held that such claims are barred by the Supreme Court’s decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,88 which prohibited aiding and abetting claims in private securities litigation.89

The Ninth Circuit, on the other hand, has ruled that “scheme claims” are viable if plaintiffs plead


�

facts showing that a secondary actor “engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in further-ance of a scheme.”90 The Ninth Circuit, in permit-ting “scheme claims,” adopted a test proffered by the SEC in an amicus brief submitted in the case.91 The SEC, however, will not present its views to the Supreme Court in Stoneridge. Although the SEC recommended that it and the Solicitor Gen-eral file a joint amicus brief to back the share-holders’ arguments in favor of scheme liability,92 the Bush Administration opted not to, reportedly based on advice from Treasury Secretary Henry Paulson, who explained that abusive litigation is “an Achilles’ heel of our economy.”93

The Supreme Court’s resolution of Stoneridge could significantly affect securities litigation. If Stoneridge permits “scheme claims,” more types of defendants face exposure. Some of those par-ties will be targeted as “deep pockets.” Other potential defendants may agree to cooperate with plaintiffs early on in litigation—to escape liabil-ity— and cooperate with plaintiffs’ efforts against others—possibly leading to more frequent diver-gence and finger-pointing among various groups of individuals and groups whose interests are typically aligned with those of a public compa-ny accused of fraud. Depending on the Supreme Court’s ultimate ruling, the decision in Stoneridge has the potential to increase the number of pri-vate securities cases that are filed, and to affect the way that cases are litigated.

NOTES1 Pub.L.No.10�-��,10�Stat.��.� Tellabs, Inc. v. Makor Issues & Rights, Ltd.,1��S.

Ct.��,�00�WL1��0�,(U.S.�00�).� Id.at*�.� Id.at*11.� Id.at*�.� Id.at*�.� Id.at*10.� Id.at*�,*10.� See id. at *1� (Scalia, J. concurring) (observing

thatthemajority’stestgives“plaintiffstheedgeinclosecases”).

10 See id. at *1�–*1� (Scalia, J., concurring); id. at*1�–1�(Alito,J.,concurring).

11 Brief for the United States As Amicus CuriaeSupporting Petitioners, at �0, Tellabs v. Makor

Issues & Rights, Ltd., (U.S.Feb.�,�00�)(No.0�-��); see also Brief for Amici Curiae Joseph A.Grundfest,etal. InSupportofPetitionersat1�(a “strong inference” means “significantly orsubstantiallymorelikelythannottobetrue”).

1� Tellabs,�00�WL1��0�,at*�.1� 1�U.S.C.§��j(b).1� 1�CFR§��0.10b-�.1� Ernst & Ernst v. Hochfelder, �� U.S. 1��, 1��,

��S.Ct.1��,��L.Ed.�d��,Fed.Sec.L.Rep.(CCH)P��(1��).

1� Ernst,��U.S.at1��.Plaintiffsmustalsopleadfacts showing a material misrepresentation oromissionoffact,reliance,economicloss,andlosscausation.Dura Pharmaceuticals, Inc. v. Broudo,��U.S.��,��1-��,1��S.Ct.1��,1�1L.Ed.�d��,BlueSkyL.Rep.(CCH)P��,Fed.Sec.L.Rep.(CCH)P��1�(�00�).

1� Ernst,��U.S.at1��.1� Cornerstone Research, Securities Class Action

Case Filings 2006: A Year In Review 20,availableat, http://securities.stanford.edu/clearinghouse_research/�00�_YIR/�00�010�-01.pdf (last visitedJuly10,�00�).EventhoughTellabsaddressesthescienterelementofaSection10(b)claim, thereisnoreasonwhytheSupremeCourt’sreasoningwould not extend to other types of actionsgovernedbytheReformActthathavedifferentstateofmindrequirements.

1� H.R. Conf. Rep. No. 10�-��, at �1 (1��), as reprinted in 1�� U.S.C.C.A.N. ��0, ��0; see also�ACharlesWright&ArthurMiller, FederalPracticeandProcedure§1�01.1,pp.�00–0�(�ded.�00�).

�0 H.R. Conf. Rep. No. 10�-��, at �1 (1��), as reprintedin1��U.S.C.C.A.N.��0,��0.

�1 1�U.S.C.§��u-�(b)(�).�� Tellabs,�00�WL1��0�,at*�.�� Id.at*�.�� Id.�� Id.at*�.�� Id.at*10.�� Id.�� Id.at*11.�� Id.at*10.�0 Id.�1 Makor Issues & Rights, Ltd. v. Tellabs, Inc., ��

F.�d ��, �0�, Fed. Sec. L. Rep. (CCH) P ��,Fed.Sec.L.Rep.(CCH)P��,��(�thCir.�00�),asmodifiedondenialofreh’g,(July10,�00�)andcert. granted, 1�� S. Ct. ��, 1�� L. Ed. �d ��1(U.S.�00�)andvacatedandremanded,1��S.Ct.��(U.S.�00�).

�� Id.


10

�� Tellabs,�00�WL1��0�,at*11–1�.�� Pirraglia v. Novell, Inc., 339 F.3d 1182,1188, Fed.

Sec. L. Rep. (CCH) P 92,478 (10th Cir. 2003);accordIn re K-tel Intern., Inc. Securities Litigation, �00F.�d��1,��n.�,Fed.Sec.L.Rep.(CCH)P�1��(�thCir.�00�).

�� Helwig v. Vencor, Inc.,��1F.�d��0,��,Fed.Sec.L.Rep.(CCH)P�1��,�001FEDApp.01��P(�thCir.�001);accordCredit Suisse First Boston Corp.,In re, ��1 F.�d ��, ��, Fed. Sec. L. Rep. (CCH) P�� (1st Cir. �00�) (“Scienter allegations donotpassthe‘stronginference’testwhen,viewedin light of the complaint as a whole, there arelegitimate explanations for the behavior thatare equally convincing.”); Ottmann v. Hanger Orthopedic Group, Inc., �� F.�d ��, ��0,Fed. Sec. L. Rep. (CCH) P �� (�th Cir. �00�);Gompper v. VISX, Inc.,��F.�d��,��,Fed.Sec.L.Rep.(CCH)P�1��(�thCir.�00�)(holdingthatacomplaintshouldbedismissedif“itisequallyifnotmoreplausible”thatdefendantsdidnotactwithscienter).

�� Id.at*�.�� Id.at*�(quotationsomitted).�� Id.�� Id.at*�.�0 Id.(citing�BWright&Miller§1��).�1 Id.at*�.�� Id.�� Id.at*10.�� Id.�� Id.at*11.�� Id.at*10.�� Id.�� Id.�� Id.at*1�.�0 InHoward v. Everex Systems, Inc.,��F.�d10��,

10��-��,Fed.Sec.L.Rep.(CCH)P�1�1�(�thCir.�000), for example, the Ninth Circuit held thatthe Reform Act “did not alter the substantiverequirements for scienter under § 10(b).”CitingHoward severalcourtshadheldthat it is“generallymoredifficulttoovercomeamotiontodismissthanamotionforsummaryjudgment.”In re Homestore.com, Inc. Securities Litigation,��F.Supp.�d��,��(C.D.Cal.�00�);Reiger v. Price Waterhouse Coopers LLP,11�F.Supp.�d100�,1011,Fed.Sec.L.Rep.(CCH)P�1��(S.D.Cal. �000), aff’d, �� F.�d��, Fed. Sec. L. Rep.(CCH)P�1��(�thCir.�00�).

�1 Tellabs,�00�WL1��0�,at*1�(citingHerman & MacLean v. Huddleston,��U.S.��,��0,10�S.Ct.��,��L.Ed.�d��,Fed.Sec.L.Rep.(CCH)P��0��(1��)).

�� The Supreme Court added that “under ourconstruction of the ‘strong inference’ standard,aplaintiff isnotforcedtopleadmorethanshewouldberequiredtoproveattrial.”Id.at*1�.

�� Id.at*1�.�� Tellabs,�00�WL1��0�,at*11.�� Id.�� Id.�� Id.�� See, e.g., Kalnit v. Eichler,��F.�d1�1,1��(�dCir.

�001); In re Advanta Corp. Securities Litigation,1�0 F.�d ��, ��-��, Fed. Sec. L. Rep. (CCH) P�0��,��Fed.R.Serv.�d1��(�dCir.1��).

�� In re Silicon Graphics Inc. Securities Litigation,1��F.�d��0,��,��,Fed.Sec.L.Rep.(CCH)P�0�10,��Fed.R.Serv.�d1�11(�thCir.1��),asamended,(Aug.�,1��);Bryant v. Avado Brands, Inc.,1��F.�d1��1,1��,Fed.Sec.L.Rep.(CCH)P�0��,��Fed.R.Evid.Serv.1��,��Fed.R.Serv.�d��0(11thCir.1��).

�0 PR Diamonds, Inc. v. Chandler,��F.�d��1,��1,Fed. Sec. L. Rep. (CCH) P ��, �00� FED App.011�P (�th Cir. �00�) (“the absence of insidesalesdullsallegationsoffraudulentmotive”and“worksagainstan inferenceof scienter”); In re Vantive Corp. Securities Litigation,��F.�d10��,10��, Fed. Sec. L. Rep. (CCH) P �1��0 (�th Cir.�00�) (finding that minimal stock sales could“negate”aninferenceofscienter).

�1 See, e.g., Kalnit,��F.�dat1��;K-tel Int’l,�00F.�dat��.

�� Tellabs,�00�WL1��0�,at*�,11.�� Id.at*10n.�.�� Id.�� Id.at*1�&n.”*”�� Id.at*�.�� Id.at*�n.�.�� Id.�� Nathenson v. Zonagen Inc.,��F.�d�00,�0�,Fed.

Sec.L.Rep.(CCH)P�1��(�thCir.�001);City of Philadelphia v. Fleming Companies, Inc.,��F.�d1��,1��,Fed.Sec.L.Rep.(CCH)P�1��(10thCir.�001);Advanta,1�0F.�dat��;Phillips v. LCI Intern., Inc.,1�0F.�d�0�,��1,Fed.Sec.L.Rep.(CCH)P�0��(�thCir.1��).

�0 Silicon Graphics, Inc.,1��F.�dat��,��.�1 Tellabs,�00�WL1��0�,at*11n.�.�� Southland Sec. Corp. v. INSpire Ins. Solutions, Inc.,

��F.�d��,��(�thCir.�00�).�� Tellabs,�00�WL1��0�,at*11n.�.�� Southland,��F.�dat��.�� Tellabs, �00� WL 1��0�, at *1� (Scalia, J.,

concurring);id.at*1�(Alito,J.,concurring).�� Id.at*1�&n.”*”(Scalia,J.,concurring).


11

�� Id.at*1�.�� Id.at*1�(Alito,J.,concurring).�� Id.at*1�(Alito,J.,concurring).�0 Id.at*1�(Stevens,J.dissenting).�1 Id.�� Id.�� Id.�� 1�U.S.C.§��u-�(b)(�).�� Id.at*11;seealsoMerriam-Webster’sCollegiate

Dictionary��(10thed.1��)(“holistic”means“relating to or concerned with wholes or withcomplete systems rather than with the analysisof,treatmentof,ordissectionintoparts”).

�� See Jacobellis v. State of Ohio,��U.S.1��,1��,��S.Ct.1��,1�L.Ed.�d��(1��) (Stewart,J.,concurring)(“Ishallnottodayattemptfurthertodefine thekindsofmaterial Iunderstand tobe embraced within that shorthand description[ofhard-corepornography];andperhapsIcouldneversucceedinintelligiblydoingso.ButIknowitwhenIseeit.”).

�� Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 1�� S. Ct. 1��, 1�� L. Ed. �d �� (U.S.�00�).

�� Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,�11U.S.1��,1�1,11�S.Ct.1��,1��L.Ed.�d11�,Fed.Sec.L.Rep.(CCH)P��1��(1��).

�� Regents of University of California v. Credit Suisse First Boston (USA), Inc.,��F.�d��,Fed.Sec.L.Rep. (CCH) P ��1�� (�th Cir. �00�), petition forcert. filed, �� U.S.L.W. �� (U.S. Mar. �, �00�)(No. 0�-1��1); In re Charter Communications, Inc., Securities Litigation,��F.�d��,Fed.Sec.L.Rep.(CCH)P��(�thCir.�00�),cert.granted,1��S.Ct.1��,1��L.Ed.�d��(U.S.�00�)(No.0�-��).

�0 Simpson v. AOL Time Warner Inc.,��F.�d10�0,10��-��, 10��, Fed. Sec. L. Rep. (CCH) P ��00(�thCir.�00�),petitionforcert.filed,��U.S.L.W.��(U.S.Oct.1�,�00�)(No.0�-��0).

�1 Id.at10��.�� SiobhanHughes,U.S. Lets Pass Deadline to Back

Shareholders in High Court Case, Wall StreetJournalOnline,June1�,�00�,availableathttp://online.wsj.com/article/SB11�1��1��0�.html(lastvisitedJuly�,�00�).

�� Joe Engler, Washington’s Biggest Decision,Washingtonpost.com,July�,�00�,atD0�,availableat http://www.washingtonpost.com/wp-dyn/content/article/�00�/0�/01/AR�00�0�0100��_pf.html(lastvisitedJuly�,�00�).

In Billing, Supreme Court Rules that IPO Litigation is Immune from Antitrust Scrutiny B y k E v I n a r q U I t

Kevin Arquit is a partner at Simpson Thacher & Bartlett LLP. Contact: [email protected].

On June 18, the Supreme Court ruled in Credit Suisse First Boston v. Glen Billing (“IPO Antitrust Litigation”) that certain long-standing securities industry practices in the issuance of initial pub-lic offerings (“IPOs”) are impliedly immune from antitrust challenges on the ground that the regula-tion of such conduct is within the sole purview of the securities laws and the Securities & Exchange Commission. The Court ruled that no antitrust liability could arise from: (1) “laddering” agree-ments whereby investors were required to prom-ise to place bids in the aftermarket at prices above the IPO price; (2) “tying” arrangements whereby investors commit to purchase other, less attrac-tive securities; and (3) other allegedly excessive commissions, including for the purchase of an issuer’s shares in follow-up or secondary public offerings (for which the underwriters would earn underwriting discounts). The Court held that the securities laws impliedly preclude the application of the antitrust laws to such conduct.

BackgroundDuring the dot-com boom of the 1990s, the

stock of many technology and telecommunica-tions companies was publicly launched in high-stakes IPOs. Typically, these IPOs were underwrit-ten by groups of investment banks that undertook the risk that the stocks would fail or plummet in price after the initial wave of interest. Underwrit-ers have been permitted under the securities laws to enter into syndicates and reach agreements on


1�

many aspects of an IPO, including agreements on initial prices and allocation of shares. They are also permitted by the SEC to make inquiry of those interested in purchasing allocations of an IPO as to their general future plans for holding, selling, or purchasing in the aftermarket as part of the IPO “bookbuilding” process.

The Billing complaint was filed in the U.S. District Court for the Southern District of New York by a putative class of individuals who pur-chased shares of stock in certain technology re-lated companies through IPOs or in the aftermar-ket immediately following IPOs during the late 1990s. More specifically, the complaint charged ten investment banks, including Morgan Stan-ley, Goldman Sachs, Lehman Brothers, Credit Suisse First Boston, and JPMorgan Chase (“the Underwriter Defendants”), along with a number of institutional investors, with conspiring to arti-ficially inflate the aftermarket prices of some 900 Internet and technology stocks sold in those IPOs. The complaint alleged that the Defendants jointly agreed to require purchasers in IPOs to engage in laddering and tying agreements, as well as other allegedly excessive commission arrangements, all of which artificially inflated the share prices of the securities in question. At the same time, putative class action complaints were filed in the Southern District of New York alleging violations of the securities laws under Section 10(b) of the Securi-ties Exchange Act of 1934 and Section 11 of the Securities Act of 1933, covering the very same al-leged conduct.

Defendants moved to dismiss the IPO Antitrust Litigation and argued that the conduct alleged was impliedly immune from attack under federal and state antitrust laws because the underwriting activities were actively and pervasively within the regulatory authority of the SEC and there was a potential for conflict between the application of the antitrust and securities laws. The district court granted the motion to dismiss, with Judge William H. Pauley noting that certain of the chal-lenged conduct was expressly permitted under the securities laws and other challenged conduct fell directly within the ambit of the SEC’s regulatory

authority. However, on appeal, the Second Cir-cuit reversed the district court’s decision, finding no convincing evidence that Congress intended expressly to immunize the alleged conduct from the antitrust laws. The Second Circuit held that, because the SEC had never used its authority to authorize tie-ins, such as alleged here, there is no potential conflict between the securities laws and the antitrust laws that would compel use of the implied immunity doctrine. The court concluded that application of implied immunity requires a determination that Congress both contemplated the specific potential conflict and intended for the antitrust laws to be repealed. Highlighting the conflict between the two areas of law, at both the district court and Second Circuit levels, the SEC submitted an amicus brief supporting the Defendants’ arguments in favor of application of a broad implied immunity. The SEC argued that it regulated (and could permit) the alleged activity and that application of the antitrust laws would interfere with its jurisdiction. The SEC pointed out that it was the most capable to make the fac-tually specific line drawing that was necessary to determine if the particular activity should be per-mitted. The Antitrust Division of the Department of Justice submitted an amicus brief in opposi-tion to use of the doctrine arguing that the SEC could never permit the Defendants to engage in all the specifically alleged activity and that there-fore there was no conflict or potential for conflict between the SEC and DOJ that would require im-munity from the antitrust laws.

The Supreme Court granted the Underwriter Defendants’ petition for certiorari to resolve whether, in a private treble damages action under the antitrust laws challenging underwriter con-duct related to IPOs, the standard for implying immunity is the “potential for conflict with the securities laws,” or whether “a specific expression of congressional intent to immunize such conduct and a showing that the SEC has power to permit the specific practices at issue” is required.

In a joint brief to the Supreme Court, the SEC and Department of Justice compromised and ar-gued in support of a reversal and remand based on


1�

implied immunity, but with a narrower scope for immunity than proposed by the SEC in the lower courts and the Defendants at each stage of the pro-ceeding. The United States urged that the case be remanded with direction to limit immunity to joint conduct specifically authorized under the securities laws and to activities that are “inextricably inter-twined” with such permitted collaboration.

Summary of the Decision The Billing case was decided by an eight-

member Court, as Associate Justice Anthony Kennedy recused himself. In a decision written by Justice Stephen Breyer, the Court reversed the Second Circuit in a 7-1 decision. Justice Clarence Thomas dissented.

In a sweeping but carefully articulated decision, the Supreme Court held that the securities laws im-pliedly preclude the antitrust claims at issue. The Court, accepting the Defendants’ arguments, held that the implied immunity doctrine requires the courts to determine whether antitrust suits such as this are likely to prove practically incompatible with the SEC’s administration of the securities laws in matters for which the SEC has regulatory authority and has been exercising that authority. Under that standard, the Court concluded that the two areas of the law are incompatible because allowing the antitrust claims to stand creates the risk that underwriters’ “bookbuilding” conduct that is allowed or encouraged by the SEC could be found by a court or jury to violate the anti-trust laws. That risk, the Court reasoned, could have a “chilling effect” on IPO “bookbuilding” conduct that is important to the capital raising function of the financial markets. Specifically, the Court observed that the “line drawing “ between conduct that is found to be legal and that which is illegal likely would be different for the courts deciding antitrust claims, which are focused on competition only, than it would be for the SEC, which is charged with regulating and ensuring efficient operation of capital markets. Unless im-plied immunity from application of the antitrust laws is granted, the courts dealing with such an-titrust actions could be called upon to interpret evidence of conduct affirmatively encouraged by the SEC—such as underwriting syndicates seek-

ing information on customer IPO aftermarket intentions—as supporting an antitrust violation. Therefore, the Court concluded that allowing antitrust lawsuits, in the IPO underwriting con-text presented, would threaten serious harm to the efficient functioning of the securities markets and, as such, is “clearly incompatible” with the securities laws. Moreover, the Court noted that, because the SEC itself is required to take account of competitive considerations, sufficient protec-tion of competition should be provided for in the SEC regulatory process. Accordingly, the Court rejected the compromise position of narrow im-munity urged by the United States and accepted the broader immunity as urged by the Defendants (and the SEC in the lower courts).

Implications This ruling clarifies the scope of antitrust im-

munity with concrete standards. The decision acknowledges that collaboration among competi-tors regarding pricing and bookbuilding is an im-portant part of the underwriting process and that permission of treble damage antitrust claims to such activity could interfere with the regulatory authority that Congress delegated to the SEC, thereby chilling capital-raising activities critical to the economy. In addition, the decision confirms that the SEC is well-equipped to make nuanced determinations as to whether alleged conduct exceeds the boundaries of lawful activities and serves the regulatory goal of efficient financial markets, without the additional overlay of the antitrust laws. Consequently, the ruling will make it difficult for plaintiffs to convert alleged securi-ties violations into treble damages antitrust suits. Also, even outside of the securities areas, this rul-ing will have applicability to antitrust lawsuits challenging conduct regulated by other regula-tory regimes with no explicit immunity. Finally, this ruling is one of a number of antitrust cases this past term where the Supreme Court held for the defense. These cases will make it more dif-ficult for the Government and private parties to bring and prosecute antitrust claims.


1�

Sarbanes-Oxley at Five

SOX’s Whistleblower Provision– Promise UnfulfilledB y J a s o n M . Z U C k E r M a n

Jason M. Zuckerman, Principal of The Law Office of Jason M. Zuckerman, PLLC and Of Counsel at The Employment Law Group, P.C., litigates whistleblower retaliation claims under the Sarbanes-Oxley Act, the False Claims Act, and various federal and state whistleblower protection laws. Contact: [email protected].

[The following article is one of several Securities Litigation Report will be presenting beginning in this issue and continuing over the next several months about the fifth anniversary of the passage of the Sarbanes-Oxley Act.]

In enacting the most comprehensive securities law and investor protection reform in more than half a century, Congress made whistleblower protection a central tool to improve the accuracy and reliability of corporate disclosures. To ensure that employees with first-hand knowledge of ac-counting fraud feel that they can raise concerns without jeopardizing their livelihood, Congress enacted Section 806 of the Sarbanes-Oxley Act (“SOX”), which was intended to provide robust protection for whistleblowers.1 As stated in the legislative history, “U.S. laws need to encourage and protect those who report fraudulent activity that can damage innocent investors in publicly traded companies.”2

Five years after its enactment, Section 806 has failed to live up to its promise. Indeed, a recent empirical study found that the Department of Labor (“DOL”) has strictly construed, and in some cases misapplied, Section 806, and that less than 5% of whistleblowers prevailed in Section 806 claims before DOL.3 In addition, the Depart-

ment of Labor’s Administrative Review Board (“ARB”) recently judicially amended Section 806 by imposing a standard for protected conduct that is contrary to the plain meaning and intent of the statute. Despite these developments, how-ever, Section 806 can potentially provide strong protection to whistleblowers, and it has sensitized employers to the importance of encouraging em-ployees to report financial misconduct and tak-ing prompt remedial action to correct accounting fraud or securities law violations. This article dis-cusses how the elements of a Section 806 claim have been interpreted, focusing primarily on the scope of protected conduct.

Protected ConductSection 806 of SOX protects employees who

provide information to management, a Federal agency, or Congress relating to alleged violations of the federal mail, wire, radio, TV, bank, securi-ties fraud statutes,4 or any rule or regulation of the Securities and Exchange Commission, or any provision of Federal law relating to fraud against shareholders.5 An employee need not prove an ac-tual violation of a law, but only that he reasonably believed that his employer was violating securities laws or regulations. As summarized by the ALJ in Jayaraj v. Pro-Pharmaceuticals, Inc.:6

The statute is clear that the Complainant is not required to show that the reported conduct actually constituted a violation of the law, but only that she reasonably be-lieved that the employer violated one of the enumerated statutes or regulations; a belief that an activity was illegal may be reasonable even when subsequent investi-gation reveals a complainant was wrong.7

Protected Conduct Not Limited to Concerns about Shareholder Fraud

Although the plain language of Section 806 un-ambiguously protects employees who “provide information, cause information to be provided, or otherwise assist in an investigation regarding any conduct which the employee reasonably believes constitutes a violation of . . . any rule or regula-


1�

tion of the Securities and Exchange Commission,”8 there was conflicting authority as to whether pro-tected conduct under SOX is limited to the report-ing of concerns about shareholder fraud. In Grant v. Dominion East Ohio Gas,9 the Administrative Law Judge (“ALJ”) found that the complainant did not engage in protected activity where none of his expressed concerns “contained any reference to fraud or implication that the company had acted in-tentionally to mislead shareholders or misstate the company’s bottom line.” In Walton v. Nova Info. Systems,10 however, the ALJ held that complain-ant’s disclosures to management about deficient internal controls is within the zone of protection afforded by SOX. The ARB resolved this conflict-ing interpretation by applying the plain meaning of SOX to conclude that protected conduct is not limited to providing information to management about “just fraud, but also [the] ‘violation of . . . any rule or regulation of the Securities and Ex-change Commission.’”11 Similarly, a federal judge recently held:

If the drafters meant for section 806 to only protect employees who report fraud against shareholders, then they could have easily done so by inserting a comma before “re-lating to fraud against shareholders.” The drafters, however, did not do so. Therefore, the Court finds that reporting alleged viola-tions of mail fraud or wire fraud does not have to relate to shareholder fraud in order to be protected activity under the statute.12

As SOX protects disclosures about what an employee reasonably believes constitutes a vio-lation of any rule or regulation of the Securities and Exchange Commission,” providing informa-tion to management about a wide range of SEC rules designed to prevent fraud constitutes pro-tected conduct. This includes SEC rules requiring publicly-traded companies to maintain adequate internal controls, such as SEC Rule 13a-15(a).13 Indeed, protecting disclosures about internal con-trols is critical to effectuating the overall purpose of SOX. As stated in the SEC’s rules implement-ing the Section 404 internal control requirements, “the required evaluation [of internal controls] should help to identify potential weaknesses and

deficiencies in advance of a system breakdown, thereby facilitating the continuous, orderly and timely flow of information . . . [i]mproved disclo-sure may help companies detect fraudulent, finan-cial reporting earlier and perhaps thereby deter financial fraud or minimize its adverse effects.”14 Limiting protected conduct under SOX to actual shareholder fraud would limit the opportunity for companies and shareholders to learn about financial fraud before it is too late.

Degree of Specificity RequiredThe DOL’s ARB has taken a highly formalis-

tic approach to analyzing whether an employee’s disclosure is protected under SOX. In Platone v. FLYi, Inc.,15 the ARB held that in order to consti-tute protected conduct, a complainant’s protected communications “must relate ‘definitively and specifically’ to the subject matter of the particular statute under which protection is afforded.”16 The terms “definitively and specifically,” however, do not appear in Section 806, and this heightened burden to establish protected conduct finds no support in the legislative history. To the contrary, Congress intended “to close the loopholes that have allowed for continued offenses in America’s corporate community,” not to create additional loopholes.17 Moreover, as a remedial statute, Sec-tion 806 of SOX should be construed broadly.18

Fortunately, federal courts have generally steered clear of the Platone formalistic approach, and do not require SOX complainants to dem-onstrate that they provided management with a legal memorandum citing the specific SEC rule about which they raised a concern to manage-ment. For example, in Collins v. Beazer Homes, USA, Inc.,19 the court held:

[T]he mere fact that the severity or speci-ficity of her complaints does not rise to the level of action that would spur Congress to draft legislation does not mean that the legislation it did draft was not meant to protect her. In short, if Congress had in-tended to limit the protection of Sarbanes Oxley ... or to have required complainants to specifically identify the code section that they believe was being violated, it could have done so. It did not. Congress in-


1�

stead protected ‘employees’ and adopted the ‘reasonable belief’ standard for those who ‘blow the whistle on fraud and pro-tect investors.’20

In sum, employers should not assume that feder-al courts will apply the ARB’s heightened standard for protected conduct, and instead should assume that employees can engage in protected conduct without citing securities law chapter and verse.

Reasonable BeliefIn the most closely-watched SOX case—Welch

v. Cardinal Bankshares Corp.—the ARB recently issued a surprising interpretation of the “reason-able belief” standard.21 Prior to the ARB’s deci-sion, it was well-established that “a complainant is not required to show an actual violation of the law,” but instead “only that she ‘reasonably be-lieved’ there to be a violation of one of the enu-merated laws or regulations.”22

In Welch, the ALJ concluded that the com-plainant engaged in protected activity when he repeatedly provided information to management about deficient internal controls.23 More than three years after the ALJ issued this decision, the ARB reversed on the basis that Welch lacked an objectively reasonable basis to believe that Car-dinal was violating SEC rules. In their decision, the ARB set forth a new standard for assessing reasonable belief: “Because the analysis for deter-mining whether an employee reasonably believes a practice is unlawful is an objective one, the issue may be resolved as a matter of law.”24 The deci-sion was surprising for at least three reasons.

First, limiting protected disclosures to unequiv-ocal, actual violations of securities laws patently undermines the basic purpose of Section 806, which is to provide an early warning of fraud or internal control deficiencies that could result in shareholder fraud, before shareholders have been harmed. As an ALJ noted in Getman v. Southwest Securities, Inc.,25 requiring a SOX complainant to prove an actual violation of law “would require that a whistleblower allow the violation to occur before reporting it. This would defeat the intent of the Act and the whistleblower law in general, which is to prevent the carrying out of the un-

derlying crime.” Similarly, the ALJ in Morefield v. Exelon Services, Inc.,26 noted:

The value of the whistleblower resides in his or her insider status. These employees often find themselves uniquely positioned to head off the type of ‘manipulations’ that have a tendency or capacity to de-ceive or defraud the public. By blowing the whistle, they may anticipate the deception buried in a draft report or internal docu-ment, which if not corrected, could even-tually taint the public disclosure. Beyond that, their reasonable concerns may, for example, address the inadequacy of inter-nal controls promulgated in compliance with Sarbanes-Oxley mandates or SEC rules that impact on procedures through out the organization, or the application of accounting principles, or the exposure of incipient problems which, if left unattend-ed, could mature into violations of rules or regulations of the type an audit committee would hope to forestall.27

Second, the ARB’s construction of “reasonable belief” is contrary to Congressional intent in that the legislative history of Section 806 specifically states that the reasonableness test “is intended to include all good faith and reasonable report-ing of fraud, and there should be no presump-tion that reporting is otherwise, absent specific evidence.”28 Moreover, when Congress chose to include the terms “reasonable belief” in Section 806, it presumably had in mind well-established DOL precedent under analogous whistleblower protection statutes holding that “reasonable be-lief” is a mixed question of law and fact, and broadly construing “reasonable belief.” By rede-fining “reasonable belief,” the ARB has substan-tially narrowed the scope of protected conduct under SOX.

Third, the ARB concluded that Welch’s dis-closures about Cardinal’s internal controls were not objectively reasonable without engaging in any analysis of the actual SEC internal account-ing rules that implement Section 404 of SOX and Section 13 of the Securities Exchange Act of 1934. If reasonable belief is solely an issue of law, then


1�

presumably the relevant SEC rules governing in-ternal accounting controls should factor into that analysis. The ARB’s Welch decision will likely re-sult in ALJs dismissing SOX claims on summary judgment based on an “I know it when I see it” analysis of whether the complainant’s alleged protected disclosure sufficiently states an actual violation of an SEC rule.

Fortunately, SOX whistleblowers have fared better in federal court. For example, Judge Charles J. Siragusa of the Western District of New York held in Smith v. Corning Inc.29 that disclos-ing a violation of generally accepted accounting principles or deficient internal controls can con-stitute protected conduct under SOX.30 Similarly, Judge Sterling Johnson, Jr. of the Eastern District of New York held that helping a coworker raise concerns to a company’s CEO about incomplete executive compensation disclosures constitutes protected conduct, and that summary judgment should be denied where “a fair and reasonable juror could find that Plaintiff reasonably believed that the company was engaging in accounting practices that needed to be corrected before its financial statements misled shareholders.”31

Disclosures about Mail and Wire FraudIn Platone, the ARB further narrowed the scope

of protected conduct under SOX by holding that where a Section 806 whistleblower complaint is grounded in federal mail and wire fraud statutes, “the alleged fraudulent conduct must at least be of the type that would be adverse to investor’s interests.”32 The ARB’s only explanation for re-writing this category of protected disclosure is a vague statement in the preamble of SOX that ar-guably supports a contrary conclusion.33 Federal courts have not followed this judicial amendment to Section 806. For example, in Reyna v. Conagra Foods, Inc.,34 the court held that “[t]he statute clearly protects an employee against retaliation based upon that employee’s reporting of mail fraud or wire fraud regardless of whether that fraud involves a shareholder of the company.”

In sum, the ARB’s decisions construing the standard for protected conduct under Section 806 have imposed a high bar for complainants, and will likely discourage the types of disclosures that

Congress sought to encourage. Federal courts, however, have generally construed protected con-duct broadly, and SOX litigation will likely shift to federal courts, thereby diminishing the impact and significance of the ARB’s decisions.35

Adverse ActionThe range of prohibited retaliatory acts under

SOX is very broad. The statute specifically prohibits covered companies from “discharg[ing], demot[ing], suspend[ing], threaten[ing], harass[ing] or in any other manner discriminat[ing] against an employee” with respect to the employee’s compensation, terms, conditions, or privileges of employment.36 Under the plain meaning of SOX, a supervisor’s threat to terminate an employee in retaliation for the employ-ee engaging in protected conduct constitutes an ac-tionable adverse employment action. The ARB has applied the Supreme Court’s Burlington standard to SOX claims,37 under which conduct that “could well dissuade a reasonable worker from making or supporting a charge of discrimination” constitutes actionable retaliation.38

SOx Burden-Shifting FrameworkTo prevail under Section 806, a complainant must

prove by a preponderance of the evidence that: (1) he engaged in a protected activity or conduct; (2) the respondent knew that he engaged in the protected activity; (3) he suffered an unfavorable personnel action; and (4) the protected activity was a contrib-uting factor in the unfavorable action.39

This burden-shifting framework is very favor-able to employees. A contributing factor need not be motivating or substantial, and instead can be “any factor which, alone or in connection with other factors, tends to affect in any way the out-come of the decision.”40 Temporal proximity alone is sufficient to establish an inference of cau-sation.41 Moreover, if the complainant proves the elements of a Section 806 claim by a preponder-ance of the evidence, the respondent must dem-onstrate by clear and convincing evidence that it would have taken the same unfavorable person-nel action in the absence of the complainant’s protected activity.42


1�

Due to the broad range of adverse actions pro-hibited by Section 806 and the employee-friendly burden of proof, a complainant who can meet the ARB’s onerous standard for protected conduct has a good chance of prevailing on the merits. Ac-cordingly, the primary focus of Section 806 litiga-tion will be the employee’s protected conduct. If federal circuit courts of appeal continue to reject the ARB’s narrow construction of protected con-duct under Section 806 and instead apply a stan-dard that is consistent with the plain meaning and intent of the statute, Section 806 might realize its purpose of encouraging employees to improve the accuracy and reliability of corporate disclosures.

ConclusionA recent article in Business Week43 reports that

a survey performed by LRN, an ethics and gover-nance consulting firm, found that although com-panies have adopted comprehensive codes of eth-ics and anti-retaliation policies, most employees are reluctant to report misconduct. In particular, the survey found that “73% of full-time American employees reported encountering ethical lapses on the job,” but only “one in three . . . reported an incident they believed to be unethical or ques-tionable.” Until employees believe that they are protected from retaliation, Section 806 of SOX will not effectuate Congress’ intent “to encourage and protect those who report fraudulent activity that can damage innocent investors in publicly traded companies.”44

NOTES1 See 1� U.S.C. § 1�1�A. In addition, Congress

criminalized retaliation by any person ororganization against an individual who hasprovidedtruthfulinformationtolawenforcementofficersconcerningthecommissionofanyfederaloffense.1�U.S.C.§1�1�(e).

� S. Rep. No. 10�-1��, as reprinted in �00� WL��at*1�.

� Richard Moberly, Unfulfilled Expectations:An Empirical Analysis of Why Sarbanes-OxleyWhistleblowers Rarely Win, William & Mary LawReview,Vol.��,Fall�00�.However,manySOXclaims

aresettledearlyonbecausecompaniesoftenwishtoavoidbroaddiscoveryaboutflawedaccountingpracticesorinaccuratefinancialreporting.

� See1�U.S.C.A.§§1��1,1��,1��,and1��.� Taylor v. Wells Fargo Bank, NA, ARBNo.0�-0��

at �, ALJ No. �00�-SOX-�� (ARB June ��, �00�)(citing1�U.S.C.A.§1�1�A(a)).

� Jayaraj v. Pro-Pharmaceuticals, Inc., �00�-SOX-��at1�-1�(ALJFeb.11,�00�).

� Jayaraj,�00�-SOX-��at1�-1�.� 1�U.S.C.§1�1�A(a)(emphasisadded).� Grant v. Dominion East Ohio Gas, �00�-SOX-��

(ALJMar.10,�00�).10 Walton v. Nova Info. Systems,�00�-SOX-10�(ALJ

March��,�00�).11 Klopfenstein v. PCC Flow Techs. Holdings Inc.,

ARBNo.0�-1��,at�,1�;seealsoAllen v. Stewart Enterprises, Inc.,ARBNo.0�-0�1,ALJNos.�00�-SOX-�0to��(ARBJuly��,�00�)(“ReportingthatacompanyviolateditsinternalaccountingcontrolsmayconstituteSOX-protectedactivity.”).

1� Reyna v. Conagra Foods, Inc.,�00�WL1�0��,at*1�(M.D.Ga.�00�).

1� See, e.g., Collins v. Beazer Homes USA, Inc.,��F.Supp.�d1��,�1I.E.R.Cas.(BNA)1��1,��Empl.Prac. Dec. (CCH) P �1��, 1� A.L.R. Fed. �d ��(N.D.Ga.�00�).

1� Management’sReportsonInternalControlOverFinancialReportingandCertificationofDisclosurein Exchange Act Periodic Reports, Release Nos.��-��;��-��;andIC-��0��(June�,�00�).

1� Platone v. FLYi, Inc., ARB No. 0�-1��, ALJ No.�00�-SOX-��,at1�(ARBSept.��,�00�).

1� Id.No.0�-1��at1�.1� CorporateFraudAccountabilityActof�00�(July

1�,�00�),atH��(statementofCongresswomanRoukema). See also 1�� Cong. Rec. S1��-01,S1��, �00� WL 1�� (Jan. ��, �00�) (“Thelawwasintentionallywrittentosweepbroadly,protecting any employee of a publicly tradedcompanywhotooksuchreasonableactiontotrytoprotectinvestorsandthemarket”).

1� See, Mackowiak v. University Nuclear Systems, Inc., ��F.�d11��(�thCir.1��).

1� Collins v. Beazer Homes USA, Inc., �� F. Supp.�d1��,�1I.E.R.Cas.(BNA)1��1,��Empl.Prac.Dec. (CCH)P�1��,1�A.L.R. Fed.�d�� (N.D.Ga.�00�).

�0 Id.at1��(citationsomitted).�1 See Welch v. Cardinal Bankshares Corp., ARB

No. 0�-0��, ALJ No. �00�-SOX-1� (ARB May �1,�00�).

�� Kalkunte v. DVI Financial Services, Inc.,�00�-SOX-��(ALJJuly1�,�00�).


1�

�� Welch,�00�-SOX-1�(ALJJan.��,�00�).�� Welch, ARB No. 0�-0�� at 10 (citing Jordan v.

Alternative Resources Corp.,��F.�d��,��,��FairEmpl.Prac.Cas. (BNA)1�00,��Empl.Prac.Dec. (CCH)P��(�thCir.�00�),cert.denied,1��S.Ct.�0��,1��L.Ed.�d�0�(U.S.�00�)).

�� Getman v. Southwest Securities, Inc.,�00�-SOX-�,at1�n.� (DOLFeb.�,�00�), reversed on other grounds,ARBNo.0�-0��(ARBJuly��,�00�).

�� Morefield v. Exelon Services, Inc.,�00�-SOX-�at�(ALJJan.��,�00�).

�� Id.at�.�� Legislative History of Title VIII of HR ��: The

Sarbanes-Oxley Act of �00�, Cong. Rec. S��1�,S��0(dailyed.July��,�00�),availableat�00�WL ��0��, citing Passaic Valley Sewerage Com’rs v. U.S. Dept. of Labor,��F.�d��,�I.E.R.Cas. (BNA)��,1��Lab.Cas. (CCH)P10��,��Envtl.L.Rep.�11��(�dCir.1��) (settingfortha broad definition of “good faith” protecteddisclosures under analogous whistleblowerprotectionstatutes).

�� Smith v. Corning Inc.,No.0�-CV-��1�CJS(W.D.N.Y.July�,�00�).

�0 Although Congress specifically intended toprotect whistleblowers who warn managementaboutthetypeofaccountingchicanerythatledtothecollapseofEnron,theARBheldinWelchthat disclosures about violations of generallyacceptedaccountingpracticesarenotprotectedunderSOX.Welch,ARBNo.0�-0��at11.

�1 Mahony v. KeySpan Corp.,�00�WL�0��1�at*�(E.D.N.Y.�00�).

�� Platone,ARBNo.0�-1��at1�.�� AccordingtotheARB,areferenceinthepreamble

of SOX to “protect[ing] investors” must meanthat Congress did not intend to protect fromretaliation employee who blow the whistle onmail fraudorwire fraud.SeePlatone,ARBNo.0�-1�� at 1�. As Congress chose to specificallyincludemailfraudandwireinthecategoriesofprotecteddisclosuresinSection�0�,itmusthaveassumedthatdisclosuresaboutmailfraudorwirefraudprotect investors.NarrowingthescopeofprotectedconductbasedonavaguestatementinapreambledoesnoteffectuateCongress’intent.Id.atn.10�.

�� Reyna v. Conagra Foods, Inc.,�00�WL1�0��at*1�(M.D.Ga.�00�).

�� ASection�0�complaintmustbefiledwiththeDOL, but if DOL has not issued a final decisionwithin 1�0 days of the filing of the complaint,thecomplainantcanremovetheclaimtofederalcourt.1�U.S.C.§1�1�A(b)(1)(B).

�� 1�U.S.C.§1�1�A(a).�� Hirst v. Southeast Airlines, Inc.,ARBNos.0�-11�,

0�-1�0,ALJNo.�00�-AIR-��(ARBJan.�1,�00�).�� Hirst, ARB Nos. 0�-11�, at 10-11, quoting

Burlington Northern and Santa Fe Ry. Co. v. White,1��S.Ct.��0�,��0�,1��L.Ed.�d��,��FairEmpl.Prac.Cas.(BNA)��,��Empl.Prac.Dec.(CCH)P��(U.S.�00�).

�� U.S.C.A.§��1�1(a)-(b)(�)(B)(iii)-(iv);Taylor v. Wells Fargo Bank, NA,ARBNo.0�-0��,ALJNo.�00�-SOX-��,at�(ARBJune��,�00�).

�0 Halloum v. Intel Corp., �00�-SOX-� (ALJ Mar. �,�00�)(quoting Marano v. Department of Justice,�F.�d11��,11�0,� I.E.R.Cas. (BNA)1�� (Fed.Cir.1��)).

�1 BechtelConstr.Co.v.Sec’yofLabor,�0F.�d��,�� (11th Cir. 1��); Collins, �� F. Supp �d at1��.

�� C.F.R.§1��0.10�(c).�� PallaviGogoi,TheTroubleWithBusinessEthics,

Business Week,June��,�00�.�� 1�� Cong. Rec. S��1�, ��0 (daily ed. July ��,

�00�).

The Fifth Circuit Holds that Loss Causation is a Class Certification IssueB y W a r r E n r . s t E r n & G a r r E t t B . M o r I t Z

Warren R. Stern is a partner in the litigation department of the firm of Wachtell, Lipton, Rosen & Katz. Garrett B. Moritz is an attorney associated with that firm. Contact: [email protected].

In the Fifth Circuit, a district court must now refuse to certify a class in a securities fraud class action unless the plaintiff can prove by a prepon-derance of the evidence that the alleged misrepre-sentation caused the class to suffer a loss. If this decision stands and is followed in other Circuits, the law will have moved a long way to reducing the burdens of securities fraud class actions.

In Oscar Private Equity Investments v. Al-legiance Telecom, Inc.,1 the plaintiffs brought a securities fraud class action in the U.S. District


�0

Court for the Northern District of Texas on be-half of purchasers of Allegiance Telecom common stock between April 24, 2001 and February 19, 2002. The plaintiffs alleged that the defendants, who had been Allegiance officers,2 violated Sec-tion 10(b) of the Securities Exchange Act of 1934 by misrepresenting over this ten-month period the number of telecommunications lines installed by Allegiance. The plaintiffs moved for class certi-fication, relying on the presumption of class-wide reliance adopted in Basic, Inc. v. Levinson.3 De-fendants opposed on the ground that, under Fifth Circuit precedent, the presumption of reliance was rebutted because plaintiffs had not shown that the corrective announcement—as opposed to other adverse developments announced concur-rently—caused plaintiffs’ loss. The district court granted class certification, holding that rebuttal of the Basic presumption was not appropriate on a motion for class certification.4 The Fifth Circuit granted an interlocutory appeal pursuant to Rule 23(f) of the Federal Rules of Civil Procedure,5 and vacated the order certifying the class.

The Fifth Circuit, in an opinion by Judge Pat-rick E. Higginbotham, held that “loss causation must be established at the class certification stage by a preponderance of all admissible evidence.”6 The Court primarily relied on Greenberg v. Cross-roads Systems, Inc.,7 and Unger v. Amedisys, Inc.8 Greenberg, an appeal from a grant of summary judgment, held that “to trigger the presumption [of reliance] plaintiffs must demonstrate that . . . the cause of the decline in price is due to the reve-lation of the truth and not the release of unrelated negative information.”9 Unger, an interlocutory appeal from a grant of class certification, held that, on a Rule 23 motion in a fraud-on-the-mar-ket case, a district court “must address and weigh factors both for and against market efficiency” and must “find” the facts favoring class certifica-tion.10 Allegiance Telecom, the Court said, “lies at the intersection of Greenberg and Unger,” and therefore the district court “erred in ruling that the class certification stage is not the proper time for defendants to rebut lead Plaintiffs’ fraud-on-the-market presumption.”11

The Court dismissed as “outdated” the idea that class certification was merely a provisional

procedural step “divorced from the merits of the claim.”12 The Court found the idea particularly repugnant in a fraud-on-the-market case where class certification greatly magnified the risks to the defendants:

The power of the fraud-on-the-market doc-trine is on display here. With proof that these securities were being traded in an ef-ficient market, the district court effectively concluded that if plaintiffs can establish at trial that defendants acted with the requi-site intent in counting its installations then defendants would be liable for millions of dollars in paper losses on the day follow-ing the fourth-quarter filing date, less the amount the defendant may be able to per-suade a jury was caused by other circum-stances–whether the purchaser held on and later sold at a higher price or rode the stock down to bankruptcy. In short, the efficient market doctrine facilitates an extraordinary aggregation of claims. We cannot ignore the in terrorem power of certification, con-tinuing to abide the practice of withholding until “trial” a merit inquiry central to the certification decision, and failing to insist upon a greater showing of loss causation to sustain certification, at least in the instance of simultaneous disclosure of multiple piec-es of negative news.13

The Court found support for its holding in the 1999 amendment to Rule 23(c)(1)(A) requiring a certification ruling only “at an early practicable time” rather than “as soon as practicable,” as the Rule formerly required; another amendment to Rule 23 that the Court read to eliminate “con-ditional” class certification; the Private Securities Litigation Reform Act (“PSLRA”); and decisions in other Circuits holding that issues that overlap with the merits should be decided at the class cer-tification stage if they relate to the requirements of Rule 23.14

The Court relied on economic theory to explain why the question of loss causation—typically thought of as a “merits” issue divorced from Rule 23—overlapped with the question of class-wide reliance. The Court explained that, while a mar-


�1

ket may be efficient (as the market for Allegiance stock clearly was), it may not have efficiently priced the particular alleged misinformation or may have priced the true information due to trad-ing by insiders. “Both explanations,” the Fifth Circuit explained, “resist application of the semi-strong efficient-market hypothesis, the theory on which the presumption of class-wide reliance depends.”15 Thus, absent proof of loss causation, the Court could not determine whether the mar-ket “relied” on the misrepresentation.

Although the Court had found legal error, it could not vacate the class certification order on that ground alone. The district court, in fact, had weighed the ev-idence on loss causation and found that “it is more likely than not that a significant part of the stock de-cline causing the putative Class’s loss is attributable to the line count corrective disclosure.”16 The Fifth Circuit, however, held that this finding was “unten-able.”17 To show that the price decline was caused in significant part by the corrective disclosure, the plaintiffs had relied on analyst comments lament-ing the line count revision and on an expert event study showing that Allegiance’s stock price reacted negatively to the “entire bundle” of adverse news.18 The Court held that this evidence proved market efficiency but not loss causation: “When multiple negative items are announced contemporaneously, mere proximity between the announcement and the stock loss is insufficient to establish loss causa-tion.”19 The Court disavowed requiring either quan-tification of damages at the class certification stage or event studies, but emphasized that the plaintiffs must “offer some empirically-based showing that the corrective disclosure was more than just present at the scene.”20

Judge James L. Dennis dissented. He took strong issue with the majority’s holding that loss causation must be considered at the class certification stage: “The majority’s decision is, in effect, a breathtak-ing revision of securities class action procedure that eviscerates Basic’s fraud-on-the-market presump-tion, creates a split from other circuits by requiring mini-trials on the merits of cases at the class certi-fication state, and effectively overrules legitimately binding circuit precedents.”21 He also labeled the majority’s assessment of the evidence as improper “de novo” review.22 Judge Dennis attacked Green-

berg’s holding that a fraud-on-the-market plaintiff must show that the market price of the stock actu-ally moved in response to the misrepresentation or the corrective disclosure, and argued that, in any event, Greenberg would not require the plaintiffs to prove loss causation as a condition to the pre-sumption of reliance. He accused the majority of substituting its policy views for stare decisis23 and of ignoring Dura Pharmaceuticals, Inc. v. Brou-do,24 in which the Supreme Court reaffirmed Ba-sic. Finally, he accused the majority of disregarding settled procedural limitations by insisting that the district court consider a merits issue in ruling on class certification.

The fate of Allegiance Telecom may not yet be determined. Although plaintiffs’ petition for re-hearing en banc has been denied, the time for seek-ing certiorari has not passed. But anyone who has ever defended a securities class action case will recognize that putting the plaintiff to its proof on loss causation at the outset of the case may make good sense. Why burden a defendant and the Court with an expensive and complex case when a plaintiff will not be able to carry its burden of proving that the alleged corrective disclosure did not cause its losses? This question will turn entirely on matters of public record and expert testimony; discovery would be superfluous. The Allegiance Telecom majority understood this, and their deci-sion reflects the same dry-eyed assessment of the class action device that animated the Class Action Fairness Act of 200525 and the recent decision of the Supreme Court in Bell Atlantic Corp. v. Twom-bly.26 One recent commentator has even suggested that Allegiance Telecom may “portend[] the wave of the future: early merits-based consideration of plaintiffs’ class action complaints.”27

Of course, Allegiance Telecom may be a two-edged sword. If a defendant contests class cer-tification on loss causation grounds and loses, the defendant could be in a worse position than it would have been had the class been certified without consideration of loss causation. In the latter case, the loss causation issue would remain, creating a risk for the plaintiff that the defendant could exploit in settlement negotiations. A defen-dant with a relatively strong case on liability and a relatively weak case on loss causation may be


��

well-advised to refrain from raising the loss cau-sation argument at the class certification stage. In order to be in a position to make such a judg-ment, defendants and their counsel should, at the inception of the case, concentrate carefully on the liability issues and work with financial econo-mists to exhaust all possible theories to rebut loss causation and market efficiency.

NOTES1 Oscar Private Equity Investments v. Allegiance

Telecom, Inc.,��F.�d��1(�thCir.�00�).� Plaintiffs originally named as defendants

Allegiance Telecom, its former chairman andCEO, and a former executive vice president ofsales. Allegiance Telecom filed for bankruptcyandwasnotapartybythetimethecasereachedtheFifthCircuit.Id.at��.

� Basic Inc. v. Levinson,��U.S.��,10�S.Ct.��,��L.Ed.�d1��,Fed.Sec.L.Rep.(CCH)P��,��Fed.R.Evid.Serv.��1,10Fed.R.Serv.�d�0�(1��).

� See Oscar Private Equity Investments v. Holland,�00� WL ��, at *1� n.1� (N.D. Tex. �00�),ordervacated,��F.�d��1(�thCir.�00�)(“Basicheld that the presumption of reliance wasrebuttable, but only as related to a summaryjudgmentmotion....TheCourtisoftheopinionthattheclasscertificationstageisnotthepropertime for Defendants to rebut Lead Plaintiffs’fraudonthemarketpresumption.”(citingBasic,��U.S.at��)); id.at*1�n.1�(“‘At[theclasscertification]stageintheproceedings,theCourtneed only inquire whether the stock traded inanefficientmarketandnotexaminethemeritsof thecase . . .Thus theCourtwillnotaddresswhetherDefendantscanrebutthepresumptionof reliance.’” (alterations in original) (quotingLehocky v. Tidel Technologies, Inc.,��0F.R.D.��1,�0�n.�(S.D.Tex.�00�))).

� Federal Rule of Civil Procedure ��(f) provides:“A court of appeals may permit an appealfrom an order granting or denying class-actioncertification under this rule if a petition forpermissiontoappealisfiledwiththecircuitclerkwithin 10 days after the order is entered. Anappealdoesnotstayproceedings inthedistrictcourt unless the district judge or the court ofappealssoorders.”

� Allegiance Telecom,��F.�dat��.� Greenberg v. Crossroads Systems, Inc.,��F.�d��,

Fed.Sec.L.Rep.(CCH)P��(�thCir.�00�).

� Unger v. Amedisys Inc.,�01F.�d�1�,Fed.Sec.L.Rep.(CCH)P��11�(�thCir.�00�).

� Greenberg, �� F.�d at ��. Greenberg reliedon the Fifth Circuit’s decision in Nathenson v. Zonagen Inc.,��F.�d�00,Fed.Sec.L.Rep.(CCH)P�1��(�thCir.�001). InNathenson, thecourtheld that “a fraud-on-the-market theory maynot be the basis for recovery in respect to anallegedmisrepresentationwhichdoesnotaffectthe market price of the security in question.”Id. at �1� (emphasis in original). Thus, in theNathenson court’s view, the requirement “thatthecomplainedofmisrepresentationoromissionhave actually affected the market price of thestock…relatestoreliance.”Id.at�1�.

10 Unger, �01 F.�d at ��. Unger is consistent witha recent trend toward more rigorous scrutiny ofplaintiff’sevidenceofmarketefficiencyattheclasscertification stage.See In re Initial Public Offering Securities Litigation,��1F.�d��,��,Fed.Sec.L.Rep.(CCH) P ��1�� (�d Cir. �00�), decision clarified ondenialofreh’g,��F.�d�0(�dCir.�00�)(reversingdistrict court’s class certificationdecisionbasedonmore rigorous scrutiny of plaintiff’s evidence ofmarket efficiency); Warren R. Stern & Garrett B.Moritz,Market Efficiency and Class Certification in Securities Fraud ClassActions,SEC.LITIG.REP.vol.�,no.10(�00�).

11 Allegiance Telecom,��F.�dat��-�0.1� Id.at��.1� Id.at��-��.1� Id.at��.1� Id.at��.1� Id.at��0.1� Id.1� Id.at��0-�1.1� Id.at��1.�0 Id.�1 Id.at��.�� Id.�� See id. at �� (“Under the majority’s approach,

Basic‘s…primaryholdingissupplantedbyextensionsof the policy considerations that the majoritysees reflected in the enactment of the PSLRA andin recentamendments toRule��. . . . Suchpolicyconsiderations, however, no matter how sincerelyinterpreted or applied, do not give this court theauthoritytooverruletheSupremeCourt’sdecisionsortochangetherecognizedelementsofaSection10(b)claim,bothofwhichthemajorityeffectivelydoestoday.”).

�� Dura Pharmaceuticals, Inc. v. Broudo,��U.S.��,1��S.Ct.1��,1�1L.Ed.�d��,BlueSkyL.Rep.(CCH)P��,Fed.Sec.L.Rep.(CCH)P��1�(�00�).


��

�� U.S.C.§1�11et seq., Pub. L. 10�-�,11�Stat.�

(Feb.1�,�00�);see, e.g.,S.Rep.10�-1�,at� (Feb.

��, �00�) (“By now, there should be little debate

aboutthenumerousproblemswithourcurrentclass

actionsystem.”).

�� Bell Atlantic Corp. v. Twombly,1��S.Ct.1��,�00�-

1 Trade Cas. (CCH) P ��0� (U.S. �00�) (abrogating

thepleadingstandardofConleyv.Gibson,��U.S.

�1(1��),because,amongotherreasons,“[i]tisno

answer to say that a claim just shy of a plausible

entitlement to relief can, ifgroundless,beweededout early in the discovery process through ‘carefulcasemanagement,’given thecommon lament thatthe successof judicial supervision in checking [classaction] discovery abuse has been on the modestside”); see also id. (“[I]t is self-evident that theproblemof[classaction]discoveryabusecannotbesolvedby‘carefulscrutinyofevidenceatthesummaryjudgment stage’… the threat of discovery expensewill push cost-conscious defendants to settle evenanemiccasesbeforereachingthoseproceedings.”).

�� SarahS.Gold&RichardL.Spinogatti,Loss Causation: A New Hurdle for Class Certification,N.Y.L.J., June1�,�00�,at�.

West Legalworks™ Presents

Fall 2007 Events

PRIVATE EQUITY AND M&A

CONFERENCES

Essential for the professional in you.

3rd AnnuAl SouthEAStErnM&A ForuM

SEPTEMBER 26, 2007Atlanta, Georgia

PrivAtE Equity 2008: WhAt you nEEd to KnoW noW

OCTOBER 18, 2007 New York City

AnnuAl M&A inStitutEOCTOBER 30, 2007

New York City

For more information or to registervisit: www.westlegalworks.com

Email: [email protected]: 800-308-1700

COPYRIGHT 2007 WEST LEGALWORKS, A THOMSON WEST BUSINESS. ALL RIGHTS RESERVED.

FIRST CLASSU.S.POSTAGE

PAIDWEST

West Legalworks 395 Hudson Street, 6th FloorNew York, NY 10014

Securities Litigation REPORT

West Legalworks395 Hudson Street, 6th Floor, New York, NY 10014Phone:212-337-8444 or 800-308-1700Fax:212-337-8445 E-mail:[email protected]:www.westlegalworks.com

Securities Litigation REPORT

YES! Rush me Securities Litigation Report and enter my one-year trial subscription (10 issues) at the price of $498.00. After 30 days, I will honor your invoice or cancel without obligation.

Postage charged separately. All prices are subject to sales tax where applicable.

Name METHOD OF PAYMENT

Company ®Check enclosed (to West Legalworks)

Street Address ®BILL ME ®VISA ®MASTERCARD ®AMEX

City/State/Zip Account #

Phone Exp. Date

Fax Signature

E-mail

“strong inference” of scienter securities litigation

Documents