Section III: Caselaw Developments 2021

Scienter and scienter pleading. The SEC adopted Rule 10b-5 to implement Securities Exchange Act of 1934 (“Exchange Act”) section 10(b), which prohibits, in the purchase or sale of any security, “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe.” A violation of Rule 10b-5 requires that the defendant have scienter, defined as either an intent to defraud or severe recklessness, sometimes characterized as “an extreme departure from the standards of ordinary care, … which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.” Exchange Act section 21D(b)(2)(A) requires that, in a private Rule 10b-5 lawsuit seeking money damages, the plaintiff must plead “with particularity facts giving rise to a strong inference that the defendant acted with [this] required state of mind.” To comply with this statute, the private plaintiff must allege facts raising “an inference of scienter” that is “more than merely plausible or reasonable—it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.”

Last year, the Ninth Circuit affirmed dismissal of a Rule 10b-5 claim on the ground that the defendant investment bank more likely published a research report—with a per share valuation in excess of a client’s announcement twenty-four hours later of an offering at a price below that valuation—due to a snafu rather than as part of a fraud. The Fourth Circuit held that a Rule 10b-5 claim founded on after-the-fact admissions that a financing company had followed a poor strategy during the period of an alleged fraud asserted merely fraud by hindsight and did not raise a strong inference of scienter, particularly in light of the defendant entity’s many warnings that it financed companies with limited financial resources and that those financings were highly speculative. The First Circuit held scienter pleading sufficient on a theory of alternatives—either the top executives who touted a new product had apprised themselves of a new product’s capabilities and discovered that it did not work, in which case the executives intentionally misled by their comments; or the officers had boasted about the product without apprising themselves of its inoperability, in which case they misled by recklessness.

Analyst target price. The entity defendant in Prodanova v. H.C. Wainwright & Co., LLC (“Wainwright”) provided investment banking services to clients in the life sciences industry and also employed stock analysts who published reports on such companies. On October 10, 2017 at 4:03 AM, a Wainwright stock analyst published a report on MannKind Corporation (“MannKind”), a small publicly traded pharmaceutical company that had five days before announced a favorable FDA labeling decision that had boosted the company’s stock price. On the basis of “MannKind’s publicly available cash flow and debt data, [the] expected ‘near-term recapitalization and dilution,’” the analyst “set a $7 buy target” for the company’s stock, which had closed at $5.3300 on October 9. The stock popped, closing at $6.71 on the 10th (an increase of 26 percent). At 9:02 PM on October 10, however, Wainwright announced that it would provide exclusive placement services for a MannKind direct offering of 10,166,600 shares of common stock at $6 per share. On the 11th, MannKind’s stock dropped 18 percent, closing at $5.47/share.

An investor sued, purporting to represent all who bought the stock in the less than twenty-four-hour period between Wainwright’s publication of the analyst report and its announcement of the offering. She alleged that Wainwright, its CEO, its COO, and the analyst, committed Rule 10b-5 fraud by issuing the $7 buy target.

Agreeing with the district court judge who dismissed the case, the Ninth Circuit affirmed on the ground that the plaintiff failed to allege facts supporting a strong inference that any of the defendants acted with scienter. The FINRA regulation requiring investment banks to erect information walls between research analysts and investment bankers at firms like Wainwright figured into the case. So did the plaintiff ’s allegation that a confidential witness had identified an “industry custom—that investment banks generally maintain compliance departments that have visibility into both the research and investment banking groups”—a custom that the witness said Wainwright followed, with compliance departments putting bank clients who are about to make an offering on a “watch list” in order, among other things, to prevent publication of analyst reports about the clients making those offerings.

The appellate court found nothing in the complaint from which to infer a plausible motive for fraud. The plaintiff argued that Wainwright was motivated to publish the $7 target price because that target would increase Wainwright’s compensation from the $6 offering. But Wainwright’s compensation for the offering was fixed at 5 percent of the gross proceeds, the price of the offering was set, and Wainwright’s percentage would not change whether the trading price for MannKind’s stock was $6 or $7. Although the plaintiff contended that Wainwright still had a motive for fraud because the $7 price target would ensure that all 10,166,600 shares were purchased, the complaint “allege[d] no facts to show that the Offering would not have sold out but for the Report’s publication and the later increase in MannKind’s share price and trading volume.” The Ninth Circuit commented, as well, that the awkward sequence—“issuing a $7 target price in a Report just before a dilutive offering of $6 per share—likely strained [the bank’s] longstanding relationship with MannKind” and that “[t]he risk of losing a longtime client and publicly sullying its own reputation in the industry far outweighs the benefit of a slightly higher return on one transaction.”

The court found the scienter allegations against the individual defendants similarly deficient. The complaint pled “no facts alleging that [the analyst authoring the report] knew about the Offering.” Indeed, the information wall between analysts and investment bankers at Wainwright—which the plaintiff acknowledged—supported the conclusion that the analyst had no such knowledge. As to the CEO, the complaint offered only that he was the “primary contact” for both the analyst and investment banking portions of the firm, without defining what that meant, and provided “no particularized facts” to show that the CEO had the necessary knowledge about the MannKind offering “when the [analyst] Report was published and [that he] had control over the Report’s publication.” Nor did the complaint “present facts establishing his involvement with the compliance department’s review of the Report.” While the COO supervised the compliance personnel, the plaintiff “offered no information on whether compliance personnel reported to [the COO] about the details of the Report or whether he was directly involved with the Report at all.” And while that officer “may have had a role in negotiating the Offering and known about it before the Report’s publication[,] … without particularized allegations showing that he was directly involved with the Report and ignored its falsity, there is not enough factual support for a plausible inference of scienter.”

The court then considered the possibility that somehow the compliance department, as a whole, acted with scienter. Beginning with the principle that this theory could only succeed if the plaintiff could “provide specific facts showing a connection between the false statement and the mindset of the person who made it,” the Ninth Circuit found that “[t]he complaint contains no factual allegations that the watch list included the Offering, that a compliance officer checked the list and realized the conflict, and then that same officer approved the Report knowing that a conflict existed.”

Taking it all in all, and specifically considering “the lack of a plausible motive as well as the lack of particularized facts showing any individual’s knowledge or deliberate recklessness about the Report’s falsity at the time of its publication,” the court found that “the most plausible inferences are that someone failed to put MannKind on the watch list, failed to properly check the watch list, or failed to realize that a conflict existed when approving the Report.” The circumstances looked like a “snafu” rather than a fraud.

Unsuccessful business strategy. Triangle Capital Corporation (“Triangle”) raised money from the public and loaned it out, during 2014 and 2015, in mezzanine financing, which was “‘a hybrid of debt and equity financing that provide[d] the lender with the ability to convert to an ownership or equity interest in the borrowing company in the event of default, after senior lenders [were] paid.’” Triangle stated in its 2014 10-K that the companies to which it loaned “‘would be rated below investment grade if they were rated,’ which are commonly referred to as ‘“high yield” or “junk.”’”

In May 2017, one of Triangle’s controlling shareholders, who was also an executive and director at the company, characterized 2014 and 2015 as “‘a period where Triangle was [chasing] yield more than it should have.’” In August 2017, Triangle disclosed that 5.4 percent of its total portfolio of loans (valued at cost) was now in “non-accrual” status. In November 2017, Triangle disclosed that seven more investments had gone to non-accrual, and another controlling shareholder, who was also at this time the CEO, said that in 2014 and 2015 “‘investment professionals … recommended to our former CEO [Tucker] to begin moving away from mezzanine structures and into lower yielding but more secure second lien unitranche and senior structures… . Unfortunately the strategic decision was made not to move off balance sheet in a meaningful way and [Triangle] continued to lead with a yield focused mezzanine strategy. In the process of doing so we added incremental exposure to a number of riskier credits, many of which are now underperforming.’” He characterized this as “‘the wrong strategic call.’”

After Triangle’s stock price dropped by 21 percent shortly after the last of these comments, an investor (on behalf of a proposed class who bought Triangle stock during the period from May 7, 2014 to November 1, 2017) brought a Rule 10b-5 action against the company and executives.

In affirming dismissal, the Fourth Circuit held that the plaintiff had “not satisfied the … heightened burden for pleading scienter.” Triangle’s organization included “a team of outside experts” who “conducted the underwriting and due diligence, … then prepared a report for Triangle’s ‘investment committee,’” which then made final loan decisions. The plaintiff sought to allege scienter, in part by pleading that those outside experts “at some unspecified time between 2013 and 2015” told members of Triangle’s investment committee that Triangle should shift from emphasizing mezzanine financing to emphasizing unitranche financing that “‘combin[ed] senior and subordinated debt into one package with a blended [interest] rate,’ which both lowered a borrower’s costs and presented other ancillary strategic benefits that mezzanine lending did not.” But the complaint “never specifie[d] when this advice was given, how firm in their conviction these investment advisors were in recommending that Triangle should avoid mezzanine deals moving forward, or what a mix of mezzanine and unitranche investments should look like.”

While the plaintiff contended that the May 2017 look-back assessment that the company had been “chasing” “yield more than it should have” showed the defendants’ scienter, the Fourth Circuit responded that “this statement does not allow us to reasonably infer, much less strongly infer, that at the time Defendants made those investments they knew or recklessly disregarded the risk that pursuing yield necessarily required a sacrifice in the quality of their investments.” In the same way, the November look-back characterization of the decision to stand by mezzanine financing instead of switching to unitranche loans as the “‘wrong strategic call’” showed only “buyer’s remorse” rather than knowledge or reckless disregard of risks that exceeded those inherent in “the typical ‘high yield’ or ‘junk’ securities that constituted Triangle’s investment portfolio.”

The plaintiff pointed to a December 2015 industry report by Brown Gibson Lang & Company (“BGL”), arguing that it showed “that the mezzanine market was rapidly shrinking.” The court of appeals, however, found that “the Report contain[ed] just as many optimistic statements about the state of the mezzanine lending market as it [did] those expressing concern with the potential changes in that market.” And the BGL report included (i) comments from two mezzanine-lending firms that 2015 was exceptionally successful, (ii) most lending firms’ “portfolio credit quality was ‘strong … across most sectors’”; and (iii) “‘[d]efault risk remains low.’”

The plaintiff also sought to infer scienter from Triangle’s change of CEO in early February 2016. However, “without allegations demonstrating Defendants’ contemporaneous knowledge that their 2014 and 2015 investments lacked quality, we find it difficult to give this regime change any weight toward a scienter inference.” Nor did Triangle’s capital raises in 2016 and 2017 support such an inference on the theory that the defendants wanted “to keep share prices and dividends high in order to attract more investors.” The Fourth Circuit found such “generalized motives—which are shared by all companies— … insufficient to plead scienter.”

Turning from these specifics to “holistically” examining the case, the Fourth Circuit found, instead of fraud, “the much stronger inference is that Defendants had an honest debate about the merits of a subjective business judgment, and in hindsight, simply made the wrong choice with some investments.” This fit with the BGL report, which recounted that different participants in the financing industry held “varying perspectives on the relative merits of mezzanine lending” and with Triangle’s change of CEOs, which the court found more reasonably to reflect “an extension of that debate, rather than as an effort to cover up his (and others’) fraud.”

Moreover, the court found that “[t]he breadth of Defendants’ risk disclosures to investors further strengthens the competing inference of innocence,” with Triangle’s 2014 10-K advising that (i) the debtors to which Triangle loaned money “often ‘ha[d] limited financial resources to meet future capital needs,’ creating the risk that they ‘may be unable to meet their obligations’ to Triangle”; (ii) the information publicly available about those debtors was often sparse, which could prevent Triangle from making “‘a fully informed investment decision’”; (iii) “Triangle’s investments were by design ‘highly speculative’ and presented ‘a higher amount of risk than alternative investment options and a higher risk of volatility or loss of principal’”; and (iv) accordingly, investing in Triangle “‘may not be suitable for someone with [a] lower risk tolerance.’” Triangle also stated that it “invested in ‘junk’ rated companies” and that, because it operated in a competitive market, it “could be forced ‘to accept less attractive investment terms.’”

Significance and analysis. Altogether, the defense narrative sold well—that the plaintiff complained of “statements and omissions of facts arising from the execution of legitimate, subjective business judgments that, only when viewed in hindsight, allegedly become misleading.” This suggests that, as lawyers counsel clients that have suffered a business setback and wish to forthrightly admit to strategic mistakes, the attorneys should remind the clients to add, if this be the truth, that the unsuccessful strategy was adopted and pursued based on the information that the company had at the time and the honest judgment of management at the time. In most cases this should be true as it will have made no sense for the company and its executives to have deliberately adopted a losing strategy.

Statements touting inoperable new product. Carbonite, Inc. (“Carbonite”) provided cloud-based backup and data protection services. On October 18, 2018, Carbonite announced Server VM Edition (“VME”) to provide backup for virtual computer environments. On July 25, 2019, however, Carbonite stated that (i) it was withdrawing VME from the market and lowering revenue forecasts, attributing approximately one-third of that reduction to VME’s demise, and (ii) the CEO had resigned. The complaint in the ensuing Rule 10b-5 investor lawsuit alleged that VME had not successfully backed up even one customer’s data before Carbonite launched the product and never did so after the launch, despite the efforts of a “tiger team” Carbonite created and multiple fixes and a large patch that the company distributed. The complaint alleged that, before the October 2018 product introduction, “Carbonite employees … ‘reported internally that the product was not ready and should not be running.’”

Reversing dismissal, the First Circuit focused on two statements by Carbonite executives. In the first, the CEO said that VME “‘significantly improves our performance for backing up virtual environments and makes us extremely competitive going after that market,’” which was one in which Carbonite had not been performing well. In the second, the CFO said that, with VME, “‘we have put something out that we think is just completely competitive and just a super strong product.’”

Rejecting the defense argument that these were “merely optimistic opinions,” the appellate court held that the CEO’s representation “could be reasonably construed in context as a statement of fact, at least to the extent that it plainly implied some better ‘performance for backing up virtual environments,’” which was “false as compared to the complaint’s contention that as of [the date of the statement] VME could not back up virtual environments.” While the CFO’s statement was presented in the form of a “belief ” (i.e., “‘we think’”), the First Circuit concluded that plaintiffs “plausibly” alleged that it was false in “at least one and possibly all three” of the ways in which an opinion can be false or misleading under the Supreme Court’s Omnicare decision. For this purpose, the First Circuit interpreted Omnicare to mean that the CFO’s statement “plausibly conveyed at least three facts: first, that [the CFO] actually believed VME to be ‘completely competitive’ and ‘super strong’; second, that his opinion ‘fairly align[ed] with the information’ that [the CFO] possessed at the time; and third, that his opinion was based on the type of reasonable inquiry that an investor in context would expect to have been made.”

The appellate court also held the complaint pled the CEO and CFO statements material because Carbonite’s executives said that VME was important. The CFO, for example, had stated that “‘we’ve got a new offering out, [VME], which I think is a really important product for us, and I think it will help us address a pretty big segment of the market.’”

Most important, however, the First Circuit found the complaint to plead facts raising a strong inference of scienter. The plaintiffs pled “facts that, if true, make it clear that the Carbonite employees familiar with the product knew that it did not work yet,” with “nothing in the alleged facts render[ing] less than sufficiently compelling the conclusion that [the CEO] and [the CFO] would have known of the product’s status had they inquired.” The complaint also alleged “the company thought [VME] important enough to warrant two specific plugs from top management, thereby creating a very strong inference that the senior executives who gave those apparently prepared remarks touting the product would have paid at least some attention to the product’s status.” The First Circuit therefore accepted the plaintiffs’ reasoning that the pled facts led to either one of two conclusions, each sufficient for scienter—(i) the CEO and CFO had inquired about VME’s operational status before making their statements, in which case they knew that the statements were false when they made them, or (ii) the CEO and CFO had not inquired about VME’s capabilities, in which case they were reckless in a Rule 10b-5 sense when they spoke.

Significance and analysis. The Carbonite opinion finds scienter pleading sufficient without pointing to any particular facts pled to show that either the CEO or CFO, at the time of their respective statements, knew that VME did not work. The decision points to no allegation that a particularly described document informed either executive of that fact before either made his statement. The First Circuit does not say that the complaint referred to any confidential witness who claimed to have so informed either officer.

The reasoning displays some similarity to the “core operations” theory, which assumes for purposes of scienter analysis that top executives know important facts about products and services essential to their companies’ survival. But the First Circuit does not name that theory nor discuss the limitations that courts have placed on it in light of the statutory requirement that a complaint must “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” The Carbonite reasoning also recalls the Seventh Circuit’s comment that “it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud. Suppose General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero. There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false.” But the First Circuit does not reference this prior authority either or suggest that such a conclusion would be possible—given the statutory pleading requirement—only in a rare case.

Instead, Carbonite holds scienter pleading sufficient if (i) a company announces a new product in top officers’ statements, (ii) said product does not work, and (iii) the top officers make complimentary comments about that product. Its reasoning is that either the top officers inquired about the product, learned about the product’s deficiencies, and therefore intended their statements to deceive; or the top officers did not inquire and therefore made their statements with the severe recklessness that suffices for Rule 10b-5 scienter. Effectively, this takes the judge-made core operations exception and the judge-created Seventh Circuit hypothetical and expands them to the point that they threaten to swallow the statutory rule that scienter must connect specific facts linking the mental state of particular defendants to challenged representations.

Application of the Affiliated Ute presumption. In Affiliated Ute Citizens of Utah v. United States, the Supreme Court held that, in Rule 10b-5 actions “involving primarily a failure to disclose,” “positive proof of reliance is not a prerequisite to recovery.” Instead, the “obligation to disclose and [the] withholding of a material fact establish the requisite element of causation in fact.” Underlying this principle is the notion that “[r]equiring a plaintiff to show a speculative state of facts, i.e., how he would have acted if omitted material information had been disclosed, … would [impose] an unnecessarily unrealistic evidentiary burden.” Hence, the Court established “a rebuttable presumption of reliance” where “there is an omission of a material fact by one with a duty to disclose.”

Since it is possible for a plaintiff ’s case to rest on misrepresentations as well as omissions, courts have created protocols to determine whether and to what extent the Affiliated Ute presumption applies in such actions, with the Ninth Circuit ruling that the presumption “should not be applied to cases that allege both misstatements and omissions unless the case can be characterized as one that primarily alleges omissions.” In 2021, that court applied that protocol in a Rule 10b-5 action brought by purchasers of Volkswagen bonds while that automobile company concealed its installation of defeat mechanisms in its diesel-powered vehicles to hide their unlawfully high emissions. The court of appeals reversed denial of summary judgment sought by the defendants, finding that the lower court erred in ruling that the Affiliated Ute presumption applied because “although Plaintiff bases its claims on certain affirmative statements, ‘Volkswagen’s failure to disclose [the defeat device issue] is ultimately what drives Plaintiff ’s claims’ and ‘[t]he case is best characterized as a nondisclosure case.’”

Disagreeing with that characterization, the court of appeals “acknowledg[ed] … that Plaintiff alleges an omission, and that omission looms large over Plaintiff ’s claims,” but pointed out that the complaint included “more than nine pages of affirmative misrepresentations that were made by Volkswagen [in the bond offering materials] and relied upon by Plaintiff and its investment advisor.” For example, Volkswagen had represented that:

Currently, Volkswagen offers in Europe [438/532] models or model variants with CO2 emissions below 130g CO2/km; [324/416] models emit less than 120g CO2/km and [54/85] models are currently already below 100g CO2/km.

…

A focal point of Volkswagen’s current and future development activities is and will be innovative mobility concepts and the reduction of fuel consumption and emissions of the fleet.

The plaintiff pled that such “statements were ‘materially false’ because Volkswagen ‘did not intend to … reduce emissions’ and ‘misleading because they implied that Volkswagen had already reduced vehicle emissions when in truth Volkswagen’s diesel engines emitted more pollutants than [it] represented.’” Plaintiff also charged that such representations were “‘misleading because they implied that Volkswagen’s vehicles were compliant with emissions regulations’ when they were not.” Similarly, Volkswagen boasted that it was a “leader” in “environmentally friendly mobility” and that it “closely coordinates technology and product planning with its brands so as to avoid breaches of emission limits, which would entail severe sanctions.” The complaint said that statements like these “were ‘materially false and misleading because rather than actually being “environmentally friendly,” [Volkswagen] diesel vehicles were equipped with secret defeat devices that allowed them to be sold under the pretense that their NOx emissions were within the legal limits when they actually exceeded such limits by as much as 40 times.’” And such statements were, the plaintiff asserted, “‘misleading because they failed to disclose that its basis for avoiding breaches of emissions limits … and offering environmentally friendly emissions standards was an unlawful scheme to meet regulatory emissions standards; and, that but for the illegal scheme, Volkswagen would not have been able to sell a substantial portion of its vehicles.’”

The plaintiff, which was a public employee retirement fund, affirmatively alleged that both it and its investment adviser “reviewed and relied upon the information contained in the Offering Memorandum that corresponds to Plaintiff ’s Bond purchases, including the alleged omissions and misrepresentations.” Moreover, while plaintiff unquestionably pled “an omission regarding Volkswagen’s use of defeat devices, … that omission is simply the inverse of the affirmative misrepresentations described.”

The Ninth Circuit concluded that this was not a case in which the plaintiffs had to shoulder “the difficult or impossible evidentiary burden of proving a ‘speculative possibility in an area where motivations are complex and difficult to determine.’” Accordingly, “the Affiliated Ute presumption of reliance d[id] not apply because Plaintiff can prove reliance through ordinary means by demonstrating a connection between the alleged misstatements and its injury.” Otherwise, since every misrepresentation is also an omission to say that it is untrue, the presumption—meant to cover exceptions—“would swallow the rule.”

Life sciences. The First Circuit affirmed a judgment in an SEC enforcement action against a CEO on a Rule 10b-5 claim where he responded to an analyst question about “further trials” by saying that there had been no “formal discussions” with the FDA about such trials even though, at a pre-NDA meeting documented by minutes, FDA representatives had recommended that the company conduct a second Phase 3 study for the relevant drug. That same court, however, affirmed a defense judgment on the pleadings, where the issuer had encountered difficulties in outsourced manufacturing for finished drug tablets but had disclosed that it depended on a single source for this work and the outsource manufacturer had—before the interruption leading to the lawsuit—overcome problems before any tablet shortage occurred.

FDA recommendation to conduct additional trial. AVEO Pharmaceuticals (“AVEO”) created a drug to treat kidney cancer. The company stated in its 10-K for 2011 that it expected to file an NDA in the third quarter of 2012. In May 2012, AVEO published the results of a Phase 3 clinical trial (the “TIVO-1” study), showing that its drug outperformed an approved treatment on a progression-free survival metric but underperformed that competitor on overall survival (“OS”).

Later that month, AVEO representatives met with FDA officials to discuss the company’s plan to submit the NDA (the “pre-NDA meeting”) and, during that meeting, the FDA representatives “recommended [(i)] that AVEO conduct a second Phase 3 study for [the drug] (‘a second adequately powered randomized trial in a population comparable to that in the US’)” and (ii) that the company “‘conduct the final analysis of overall survival in the [TIVO-1] trial.’” Minutes “jointly prepared with input from both FDA personnel and AVEO representatives” documented these recommendations, and AVEO’s Chief Medical Officer (“CMO”) reported the recommendations to AVEO’s executive committee. He also reported the FDA’s “feedback” to AVEO’s board of directors and to a steering committee for AVEO and another company, which had joint ventured with AVEO in developing the drug. AVEO’s CEO “was privy to all of these presentations” that the CMO made.

In June 2012, AVEO’s board approved an additional trial, while hoping that the FDA might approve the drug before that trial would end, and in July the company proposed to the FDA that the additional trial could be done after the drug was approved, requesting a meeting to discuss that possibility (the “Type A meeting”). On August 2, AVEO filed an 8-K with an attached earnings release that included a section titled “Regulatory Update” and said: “The FDA has expressed concern regarding the OS trend in [TIVO-1] and has said that it will review these findings at the time of the NDA filing as well as during the review of the NDA.” The release also stated that the company was undertaking “additional analyses to be included in the NDA submission that demonstrate that the OS data from TIVO-1 are consistent with improved clinical outcomes in [renal cell carcinoma] patients receiving more than one line of therapy.” But the release cautioned that, while AVEO was “continuing to work toward submitting the NDA by end of the third quarter[,] … there is a chance that the additional OS analyses may cause the submission to move into the fourth quarter.”

AVEO conducted an analyst call on that same day, for which the CEO “and his communications staff ” created a script for addressing questions “about whether the FDA had recommended further trials.” The script called for responding that the agency had not “required an additional study” prior to approval of the company’s kidney cancer treatment and to respond, “IF PUSHED,” that AVEO “wouldn’t want to speculate” on the FDA’s future actions. During the ensuing call, the CMO responded to an analyst question by stating that “we believe that the current data package should be sufficient” and added that “I can’t speculate on what the agency might be thinking or what additional actions might be necessary.” The analyst “reasonably understood [this] response to mean that ‘[the CMO] ha[d] no idea what the FDA might outline as a way to fix the [OS] issue.’” In response to a follow-up question by another analyst, the CMO said: “regarding any future study, I think—again, I just can’t speculate on what the agency might want us to do in the future.” That analyst then authored a “report stating that ‘new trials will not be required’ for [AVEO’s drug], and that report was sent to [AVEO’s CEO] on August 3.” Yet a third analyst on the call interpreted the CMO’s responses “to mean ‘[t]hat a discussion of another study has not come up.’”

In late August 2012, the FDA told AVEO—in response to its request for a Type A meeting—that it had “significant concerns regarding” the “design” for the second study the company was proposing and “offered no encouragement that the recommended second study could be done post-marketing.” AVEO then declined to proceed with the meeting.

After AVEO submitted its NDA in September and the FDA advised in November that the NDA provided enough information for agency review but cautioned that “the TIVO-1 overall survival data would be a ‘review issue[ ]’ considered by the Oncologic Drugs Advisory Committee (ODAC),” the company conducted a public offering in January 2013. In the runup to ODAC review, the AVEO CEO spoke at a February 27, 2013 investment conference and, in response to the question, “Have you—either your partner or the FDA discussed any further trials in kidney cancer so far?”—the CEO responded: “We have not had any formal discussions, no.” He added that there was “a whole range of possibilities” from “go forth and sell [the] drug … [to] we would like to see a confirmatory trial before you start marketing this.” And the company participated in a meeting with the FDA to discuss an additional study, with the FDA “‘encourag[ing]’ AVEO to ‘design the trial properly as soon as possible and [to] initiate it independent of the action taken on the current NDA submission.’” When the company asked whether that study was required before any drug approval, the agency “responded that the NDA remained ‘under review’ and that ‘no final decision ha[d] yet been made on the application.’”

When the FDA released the briefing documents for the ODAC and these documents “revealed to the public that the FDA had recommended at the May 2012 pre-NDA meeting that AVEO conduct another trial,” AVEO’s stock price declined 31 percent.

The SEC sued the CEO for violation of Rule 10b-5. A jury found for the agency. The court imposed an officer and director bar to last for two years, as well as a $120,000 civil penalty and ordered disgorgement of $5,677.

Affirming, the First Circuit held that a reasonable jury could have found that the CEO had a duty to disclose the FDA’s recommendation for a second study, made at the May 2012 pre-NDA meeting, because—without disclosing that recommendation—the statements by the CMO during the August 2, 2012 analyst call (prompted by the script that the CEO and the communications staff had prepared) and by the CEO himself at the February 27, 2013 investment conference were misleading. The CMO’s scripted response that he could not “speculate” on what the FDA was thinking “clearly impl[ied] that AVEO lacked knowledge short of speculation,” whereas “no speculation was necessary on these topics after the FDA recommended in May 2012 that AVEO conduct a second study.” The CEO’s own statement in February 2013 that the company had “‘not had any formal discussions’” of further trials but that another study was just one of a range of possibilities “communicated to investors a false statement about the past: that the FDA had not formally discussed, much less recommended, a second study.”

The First Circuit similarly held that sufficient evidence supported the jury’s conclusion that the CEO acted with scienter because, by his own testimony, “he learned of the FDA’s recommendation to conduct another study shortly after the pre-NDA meeting” in May 2012—before the CMO spoke in August 2012 and before the CEO himself spoke in February 2013. Though the CEO pointed out that “he and AVEO disclosed the TIVO-1 data, the FDA’s overall survival concerns, and their uncertainty about whether a second study would be necessary to obtain NDA approval,” the court held that “a defendant’s disclosure of a subset of unfavorable facts does not prevent that defendant from misleading investors, with scienter, about another known and material unfavorable fact.” While the CEO claimed good faith because counsel for the company and the underwriters provided negative assurance letters for the January 2013 offering, (i) those assurances predated the CEO’s misleading comment at the investment conference a month after the offering and therefore could not have approved that comment; and (ii) the letters had circumscribed their scope to refer only to “‘the Registration Statement,’ ‘the Pricing Disclosure Package,’ and ‘the Prospectus,’ which incorporated AVEO’s August and November Form 10-Qs by reference” and further by “the information the law firms gathered during their respective due diligence processes.” All in all, “because Johnston’s calculated statements were inconsistent with known facts, a reasonable jury could conclude that he made those statements at least with a high degree of recklessness” sufficient for Rule 10b-5 scienter.

Significance and analysis. The opinion deliberately skirts the question of whether the CEO was liable for the statement made by the CMO. The entire analysis, therefore, hung on whether the CEO committed a securities fraud by saying, in response to a question about “further trials,” that there had been no “formal discussions” with the FDA.

True, the pre-NDA meeting in May 2012 was sufficiently formal to be documented by minutes. On the other hand, the 10-Q that AVEO filed in August 2012 stated that the company “‘cannot be certain as to what type and how many clinical trials the FDA … will require us to conduct before we may successfully gain approval to market [the kidney cancer drug]’” and “that ‘[p]rior to approving a new drug, the FDA generally requires that the efficacy of the drug be demonstrated in two adequate and well-controlled clinical trials.’” Moreover, the agency had declined, even in March 2013, to say whether a second trial would constitute a requirement for drug approval. This SEC enforcement action suggests that risk warnings a life science company publishes may not cure failure to disclose what a court later finds to be material communications with the FDA, even when those risk warnings address the same subject as the communications.

Disclosure of manufacturing problems. Keryx Biopharmaceuticals, Inc. (“Keryx”) developed and sold one drug. Keryx outsourced production, with the active pharmaceutical ingredient (“API”) produced by multiple companies and a single company—Norwich Pharmaceuticals, Inc. (“Norwich”)—manufacturing the finished tablet. On August 1, 2016, Keryx disclosed “that [(i)] a supply interruption is going to occur due to a production-related issue” at Norwich; (ii) “current inventories of [its drug] are not sufficient to ensure uninterrupted patient access to this medicine”; (iii) “Keryx is working with its existing manufacturer to resolve the production-related issue and rebuild adequate supply”; and (iv) the company “has been working to bring a secondary manufacturer online to supply finished drug product,” having “recently filed for approval of this manufacturer with the [FDA].” After the price of Keryx stock dropped by 36 percent on this announcement, an investor who bought the stock in July 2016 brought a Rule 10b-5 action on behalf of all who purchased the stock between May 8 and August 1, 2016, on the theory that the company and its top officers misleadingly understated—in disclosures published in February and April 2016—the risk from relying on one manufacturer for the second stage of production, despite knowing of production problems at Norwich.

Affirming a defense judgment after the district court had granted judgment on the pleadings to defendants and denied plaintiff ’s motion to amend, the First Circuit analyzed the facts known to Keryx in February and April of 2016 to determine whether disclosures made then omitted a material risk that second-stage production problems would generate a finished tablet supply shortage.

In February, a company press release stated that “‘the fundamentals of [the Keryx drug] are solid,’” revealed that “‘[w]e currently depend on a single supply source for [our] drug product,’” cautioned that “‘[i]f any of our suppliers were to limit or terminate production, or otherwise fail to meet the quality or delivery requirements needed to supply [the drug] at levels to meet market demand, we could experience a loss of revenue, which could materially and adversely impact our results of operations,’” but also reassured that the company “‘believe[d] that [it had] established contract manufacturing relationships for the supply of [the drug] to ensure that [it would] have sufficient material for clinical trials and ongoing commercial sales.’” To support his position that this language misled by failing to disclose a looming supply deficit, the plaintiff pled “that in early February, Norwich was struggling to produce enough sample-size bottles of [Keryx’s drug].” But he did “not plead that a supply interruption actually occurred (including of sample-size bottles), that anyone at Keryx thought such an interruption was approaching, or that these production problems impacted Keryx’s revenue at all.” Moreover, the record revealed that (i) Keryx assessed in January that 90 percent of the tablets Norwich produced satisfied all quality standards; (ii) “Keryx was having no issues with production of [its drug] for commercial sales and finished February of 2016 with over one thousand commercial-use bottles beyond what the company predicted it needed for the coming month”; (iii) “Keryx understood from historical experience that occasional production stoppages at Norwich had not caused shortages of [the drug]” since “in 2014, 2015, and several times in 2016, Norwich stopped production, often due to issues with API produced by first-step manufacturers, and each time, Norwich resumed production before any supply shortage panned out”; and (iv) the plaintiff pled “no facts suggesting Keryx should have thought, for the first time, that a production stoppage would necessarily yield an uncorrectable supply interruption.”

On April, 28, 2016, Keryx published its first-quarter financial results, in which the company repeated the warnings that it “‘depend[ed] on a single supply source for [our] drug’” and that a supplier limitation or termination of production could lead to a revenue decline that “‘could materially and adversely impact our results of operations.’” In a related conference call, the COO reported “that Keryx was ‘off to a good start’ [for the current quarter] … that the company had ‘established solid fundamentals for [its drug], including enhancing brand awareness’” and “that Keryx had expanded its sales force and was ‘confident in [its] ability to achieve [its] net sales guidance.’”

The plaintiff alleged that Norwich had stopped production about a month earlier, on March 24, but the court pointed out that Norwich had successfully solved the problem, having to do with the API provided to it by a first-stage contractor, by switching API suppliers. The plaintiff also alleged that Norwich had advised Keryx on April 27—one day before the company published financial results and hosted the quarterly conference call—that it had found one batch of API it received to be contaminated and that tablet production did not recommence until June. Nevertheless, “Keryx’s supply exceeded demand until August.” Since the supply was on target with the company’s projections in mid-April, “it seemed Keryx had solved any production problem before anyone in the company thought the patient supply of [the drug] was at risk.” Moreover, the court read the complaint as meaning that Norwich “had given Keryx no reason to think there was a likely systemic production problem” at the time Norwich informed Keryx of the stoppage on the day before the release of the quarterly financial numbers and the accompanying analyst call. Indeed, Norwich had thought then that the matter was an “‘isolated incident.’” And by this time, Keryx “had even more reason than in February of 2016 (when it published the other challenged disclosure) to think that Norwich would rectify any production problems before they impacted supply, because Norwich had successfully done so in February and March.” The court concluded that “[a] risk disclosure is not fraudulent simply because a company makes reasonable assumptions that, in retrospect, prove incorrect.”

Significance and analysis. The First Circuit opinion contains some very unfortunate language. The panel analogizes risk warnings to cautions provided to a hiker, “where one cannot tell a hiker that a mere ditch lies up ahead, if the speaker knows the hiker is actually approaching the precipice of the Grand Canyon.” This in turn drives the court to define the question as whether the risk, should it materialize, “is akin to the Grand Canyon (and therefore a disclosure is misleading if it frames the risk as merely hypothetical) … [or] a situation merely risky (i.e., simply a ditch).” Warning of a mere risk is inadequate if “[a] securities fraud defendant is at the edge of the Grand Canyon where the alleged risk ha[s] a ‘near certainty’ of causing ‘financial disaster’ to the company.”

This is neither sound legal reasoning nor common sense. The danger from a risk—and whether a caution adequately discloses it to investors—depends on both the magnitude of the effect should the risk mature and the probability that it will mature. Thus, a reasonable investor would view a risk as relevant to his or her investment decision depending on the balance of both these factors. Plenty of risks would be important to an investor if the probability of their maturation is high, even if the matured risk would not wreak “financial disaster” on the issuer. Indeed, this is the message of Basic Inc. v. Levinson, which announced the probability/magnitude test for materiality of developments in the merger and acquisition context. Applying that test, the question in Keryx was not whether the company was approaching a company-killing event but whether the cautions Keryx published adequately warned investors of the probability that a manufacturing issue could occur that could so significantly affect the stock price that it could decline to an important degree (which the actual 36 percent surely was) when the issue was disclosed. The better focus would have been on the probability of the supply interruption, which could have been evaluated as so low (due to the history of Norwich overcoming previous problems) that the risk disclosures did not materialy mislead despite the significant degree to which a production interruption would damage this one-drug company.

The Keryx opinion warrants one further comment. The decision adopts a flippant style, with the court titling its analysis “Our Take” and ending its reasoning with the snappy tag line that it “may be a tough pill to swallow.” Taken in conjunction with its suspect homespun “Grand Canyon” analysis, this rhetoric suggests a too casual approach to a serious securities question, particularly since the majority of those who would read this decision would be specialty practitioners who would be unimpressed with the breezy work.

Insider trading. Rule 10b-5 imposes insider trading liability under multiple theories. In 2021, the Second Circuit affirmed the conviction of a tipper who provided information about a merger and who the government pursued on the misappropriation theory. The Second Circuit also affirmed the conviction of a defendant who participated in a conspiracy to steal press releases from business wire services before the services published those releases and who the government pursued on the theory that the hackers in the conspiracy committed Rule 10b-5 deception by using stolen employee login credentials and misrepresenting themselves as those employees when they hacked in to obtain the press releases.

Misappropriation theory used to convict tipper providing information about merger. The federal government brought a criminal case against Benjamin Chow (“Chow”), charging that he violated Rule 10b-5 by passing material nonpublic information about the acquisition of Lattice Semiconductor Corporation (“Lattice”) to Shaohua Yin (“Yin”). The case rested on the misappropriation theory of insider trading, which posits that the recipient of such information from a source to whom the recipient owes a duty of trust and confidence cannot then, for his own benefit and without informing the source, transmit the information to a third party who the recipient reasonably believes will use it for trading.

Chow led the negotiations for two companies that successively sought to acquire Lattice. Yin, “through accounts held in names other than his own,” purchased millions of Lattice shares as those negotiations proceeded, selling about half of them—for an approximate profit of $5 million—on the day after the Lattice acquisition was announced.

Affirming Chow’s conviction, the Second Circuit addressed four issues. First, it held that two confidentiality agreements—one a nondisclosure agreement (“NDA”) that Chow signed for the first company bidding for Lattice and the other an NDA that he signed for the second company—supplied the duty of trust and confidence sufficient to support that element of the offense.

Second, the court found the evidence sufficient for the jury “to infer that Yin’s investment of so many millions of dollars to buy Lattice stock immediately after communications with Chow was based on material nonpublic information he received from Chow.” Chow’s phone records “showed that he had known Yin since at least 2011.” On July 5, 2016, only two days prior to Chow providing the first offer to Lattice from the first of its suitors, Chow and Yin met at a Starbucks in Beijing, and one of the Yin accounts bought 248,268 Lattice shares hours before NASDAQ next opened for trading. On July 12, Yin sent Chow analyst reports on Field-Programmable Gate Arrays (“FPGAs”) semiconductor manufacturers, significant because Lattice produced FPGAs, and asked two investment bankers at Jeffries to connect Chow with a semiconductor analyst at that firm, telling the bankers that Chow would be on the West Coast of the United States (Lattice was headquartered in Portland, Oregon) for the next three weeks. On that same day, Chow and Yin talked by phone and texted, with Yin offering to connect Chow with “‘a CFIUS [Committee on Foreign Investment in the United States] lawyer,’” significant because purchase of Lattice by either of the suitors Chow represented would have to be cleared by the CFIUS. During the ten days following July 12, Yin accounts bought another 280,283 Lattice shares.

On August 10, 2016, Chow advised Yin via a chat message “that he was ‘making a deal [and] can’t come back,’” with Yin replying that “‘being [o]n the west coast is better than being in Beijing,’” and Yin accounts purchased 120,000 more Lattice shares “less than a minute after the NASDAQ next opened.” On September 12, the day before the second suitor provided a draft merger agreement to Lattice, Chow and Yin agreed to meet in Beijing, and the Yin accounts bought in excess of 100,000 Lattice shares at market open on September 13th, purchasing 1,005,111 more over the following three days. On September 21, a Yin voicemail to Chow said that Yin had received information that “‘the company that does FPGA’” “had ‘considerable concern with regard to CFIUS,’ that ‘they may not even consider the Chinese buyer,’ and that Chow should be ‘mentally prepared for it,’” with Chow responding that “‘right now we are over at this (unintelligible) company. We should already be signing the contract soon.’” During the next three weeks, Yin accounts acquired an additional 2,206,760 shares. After another Beijing meeting between Chow and Yin, there followed seven days during which the Yin accounts bought yet 1,931,102 more.

In addition to this chronology of contacts between the two and interspersed stock buys, Yin texted an associate—after the email exchange about the CFIUS concerns—“saying that [his] ‘friend’ had recently reported making progress with ‘LSCC’—the NASDAQ symbol for Lattice.”

With all of this “it was permissible for the jury to infer that Chow intentionally disclosed information to Yin about the existence and progress of his acquisition discussions with Lattice,” “especially in contrast to the prior lengthy periods when Chow and Yin apparently had had no contact.”

Third, the panel found sufficient evidence to support a conclusion that Chow tipped Yin for Chow’s personal benefit, noting that “‘as is clear from the purpose of the personal benefit element, the “broad definition of personal benefit set forth in Dirks,” and the variety of benefits we have upheld, the evidentiary “bar is not a high one.”’” Here, (i) “Chow had asked Yin to provide him with analyst reports on the semiconductor industry”; (ii) he “had asked Yin to recommend possible limited partners for [a venture capital fund with which Chow was associated]”; (iii) “Yin provided Chow with information on other manufacturers of FPGAs and on users of FPGAs”; (iv) “Yin used his contacts with two Jefferies investment bankers to connect Chow with a Jefferies analyst knowledgeable about FPGAs, and to link those investment bankers with Chow’s fund for profitable undertakings”; and (v) Yin sent Chow “gifts of wine and cigars.”

Fourth, the court of appeals concluded that the prosecution was properly venued in the Southern District of New York. The applicable statute provides that “‘[a]ny criminal proceeding may be brought in the district wherein any act or transaction constituting the violation occurred,’” giving expansive elaboration to the constitutional provision providing a defendant “the right to be tried in the ‘district wherein the crime shall have been committed.’” The southern district satisfied these standards because it was “the district in which the NASDAQ is located, where the shares of Lattice stock were listed and traded, where the brokers for the sellers in a significant number of Yin’s Lattice share purchases were located, and where Yin’s purchases of Lattice shares were executed, cleared, and recorded.”

Significance and analysis. Chow continues the Second Circuit’s questionable reliance on the notion that one of two contractual counterparties can become a “temporary insider” at the other counterparty, thereby owing a fiduciary duty of confidentiality simply by virtue of signing a confidentiality agreement. The circuit announced this somewhat startling notion in 2020 in its United States v. Kosinski decision. Not only has the Second Circuit imported the term “temporary insider” from the classical theory of insider trading—rooted in the fiduciary relationship of corporate insiders to their corporation and its shareholders—into the very different misappropriation theory, but the circuit’s use of the term in the misappropriation context involves judicial gymnastics to find a “fiduciary” relationship in virtually any contract including a confidentiality provision, even one in an acquisition in which the buyer is without question on the other side of the transaction with diametrically opposed interests to those of the seller. Far better to simply embrace SEC Rule 10b5-2(b)(1) that pronounces—without use of the word “fiduciary”—that, for purposes of the misappropriation theory of insider trading, the requisite duty of trust or confidence is present “[w]henever a person agrees to maintain information in confidence.”

Dorozhko theory used to convict trader who used electronically stolen information obtained through misrepresented identities. In addition to the misappropriation theory employed in Chow, Rule 10b-5 imposes classical theory insider trading liability on officers, directors, and employees of companies who trade in their company’s stock on the basis of material nonpublic information that they received for the purpose of benefiting the corporation and that they do not disclose—before the trades—to counterparties on those trades, in violation of the fiduciary duty that the insiders owe to those counterparties. But there is a third theory, enunciated by the Second Circuit in SEC v. Dorozhko, which creates liability for use of material nonpublic information for trading purposes—or transmission of that information to others for that purpose—where the defendant has used or transmitted information obtained through deceptive means, and this theory applies even when neither the defendant nor a fellow schemer owes a fiduciary duty to the individual or entity from which the information was extracted by that deceit.

In 2021, the Second Circuit employed this latter theory to affirm a conviction in United States v. Khalupsky. The government charged that Khalupsky and a second appealing defendant, Korchevsky, participated in a conspiracy involving Ukrainian hackers who intruded into the servers of business newswire services to steal the contents of press releases before the services published them, with the information passed to others in the conspiracy, including the two appellants, who used the information to buy and sell securities before the newswires distributed the releases.

Addressing his challenge to the sufficiency of evidence on the charges that he substantively violated Rule 10b-5, the court rejected Korchevsky’s challenge “that he did not engage in a ‘scheme or artifice to defraud’” because “he did not owe a fiduciary duty to investors or potential investors in the companies whose press releases were stolen, and because any deception employed to obtain the releases did not target the investors.” The proof showed that “the hackers extracted employee login credentials and used those credentials to intrude into the system’s more secure areas” and therefore “the subsequent use of stolen employee login credentials to gain further system access was deceptive. Every time the hackers attempted to access parts of the system by entering stolen credentials, they misrepresented themselves to be authorized users.” Given that straightforward deception, the government had no need to prove a violation of any “fiduciary duty” of the sort comprising the basis of other theories of insider trading.

Manipulation. Credit Suisse (“CS”) sold an exchange-traded note (“ETN”) product called XIV Notes that increased in value when the market displayed low volatility as measured by the VIX Futures Index, and decreased when the market displayed high volatility by that measure. Janus Index & Calculation Services (“JIC”) calculated a “closing indicative value” of the notes once each day, after the close of trading, “using a formula that automatically adjusted the notes’ value based on the inverse of price changes observed on the VIX Futures Index.” During the trading day, JIC “computed an ‘intraday indicative value’ every 15 seconds, which was used by investors trading their notes in the secondary market.”

The notes had an expected long-term value of zero. But holders could redeem their notes early based on a computed indicative value. The notes included an acceleration provision that permitted CS to declare an Acceleration Event if, among other things, “the intraday indicative value of the XIV Notes fell such that it was less than or equal to 20 percent of the prior day’s closing indicative value,” and, if CS so declared, “noteholders would receive a payment based on the closing indicative value on a predetermined date no earlier than five business days after receiving notice of the acceleration.”

Once in each of 2011, 2015, and 2016, volatility spikes quickly and significantly raised the VIX Futures Index. On each of these occasions, CS—“as well as other issuers of volatility-related ETNs[—]bought large quantities of VIX futures contracts, which were increasing in value, in order to offset or ‘hedge’ against potential losses in the ETNs they issued, which were decreasing in value.” Their purchases created a liquidity squeeze that itself raised the VIX Futures Index and lowered the price of the notes because they were inversely calibrated to that index.

In July 2016, CS offered additional XIV Notes, and did so again on June 30, 2017 (adding 5 million to the then outstanding 9 million) and on January 29, 2018 (adding more than 16 million, only a portion of which were sold before February 5) so that CS “flooded the market with millions of XIV Notes just days before their value collapsed.” On February 5, 2018, an abrupt 4.1 percent stock market decline drove the VIX Futures Index up and the value of the XIV Notes down, and beginning at 4:09 PM, CS purchased VIX futures contracts “to hedge its exposure in sales of XIV Notes.” Those purchases—comprising one fourth of the market for such sales on that day—“contributed to a liquidity squeeze that caused the prices of VIX futures contracts to skyrocket,” which in turn “caused the value of the XIV Notes to collapse.” Six minutes after CS began its VIX futures buys, its “purchases of VIX futures contracts drove down the value of XIV Notes to just over $4—a drop of more than 96 percent from the prior day’s closing indicative value.” During those six minutes and for a further fifty-four minutes, JIC failed to publish an updated intraday indicative value for the notes every fifteen seconds but “updated only sporadically and valued the XIV Notes at about $24 to $27 per note (the [‘]Flatline Value[’]),” even though the worth of the notes during that time sat “between $4.22 and $4.40.” By the time JIC published the $4.22 figure, “investors [had] purchased more than $700 million in XIV Notes at inflated secondary market prices based on their incorrect belief that XIV Notes had weathered the spike in market volatility without triggering an Acceleration Event” by retaining a value above 20 percent of the prior day’s closing indicative value.

Since the XIV Notes had in fact on February 5 dropped to less than 20 percent of their indicative value from the day before, the events of that day constituted an Acceleration Event, which CS then declared, ultimately paying each noteholder $5.99 per note.

A class consisting of those who bought XIV Notes on January 29 through February 5, 2018 sued CS and JIC and related entities, asserting that (i) CS manipulated the market for the XIV Notes and thereby violated Rule 10b-5 and Exchange Act section 9(a)—by selling millions of them into the market, knowing that, when volatility struck, its own hedging would drive the price of the notes down, permitting CS to accelerate redemption at a cheap price at a loss to noteholders and a profit to itself; (ii) CS and JIC violated Rule 10b-5 by materially misstating the Flatline Price during the critical time span on February 5; and (iii) CS violated Rule 10b-5 and Securities Act section 11 by misleading statements in the offering documents for the January 29, 2018 XIV Notes sale (the “Offering Documents”). Reviewing a dismissal entered by the district court that had adopted a report by a magistrate judge, the Second Circuit reversed the dismissal as to the first and third claims just listed and affirmed the dismissal as it pertained to the second.

Reciting the six elements of a manipulation claim, the court focused on two—whether the investors pled manipulative acts and whether they pled scienter. The Second Circuit found manipulative acts pled because the investors alleged that the 2011, 2015, and 2016 events showed that CS hedging purchases in the face of increased market volatility depressed the price of the notes and, “us[ing] this knowledge as part of an undisclosed scheme to profit at their investors’ expense,” CS “exacerbated the risk of illiquidity in the VIX futures market” by offering millions of additional notes in June 2017 and January 2018, and “creat[ing] conditions in which it knew that its hedging trades would destroy the value of XIV Notes during the next volatility spike.” Then, when volatility struck, CS bought “more than 105,000 VIX futures contracts, caused the price of XIV Notes to plummet by more than 96 percent, and declared an Acceleration Event to lock in its profit.” This “[i]f proven at trial, … was manipulative under our precedents.”

As to scienter, the panel held that circuit authority permitted that element to be pled by either facts (i) “‘constitut[ing] strong circumstantial evidence of conscious misbehavior or recklessness’” or (ii) “‘both motive and opportunity to commit fraud.’” The Second Circuit found facts raising a strong scienter inference under both theories, with that inference “at least as compelling as the competing inferences urged by [CS].”

As to conscious misbehavior or recklessness, “[a] juror could reasonably infer that [CS] was aware of this dynamic [that volatility would lead to hedging that would, in turn, lead to an increase in the price of VIX futures contracts that would, in turn, depress the price of XIV Notes] … because the bank is a highly sophisticated financial institution and had experienced it first-hand on prior occasions.” The complaint alleged that, despite this knowledge, CS falsely or misleadingly stated in the Offering Documents that “its hedging activity ‘could affect’ the value of the VIX Futures Index while at the same time affirming that it had ‘no reason to believe’ that any impact would be ‘material.’”

As to motive and opportunity, “the structure of the XIV Notes, which would allow Credit Suisse to profit if the value of the notes collapsed, provided both motive and opportunity for Credit Suisse to manipulate the market,” and the large offering of the notes in January 2018 “enhanced the opportunity for manipulative acts in the days leading up to the market’s collapse.”

The Second Circuit also reversed the dismissal of the Rule 10b-5 and section 11 claims based on asserted misrepresentations in the Offering Documents. The court conceded that those documents “warned investors of extensive risks related to the purchase of XIV Notes.” The Offering Documents also disclosed CS’s intention to hedge the exposure the notes created for it. However, the court found an adequately pled deceptive half-truth in the representation that “while ‘there can be no assurance that the level of the [VIX Futures] Index will not be affected [by CS hedging],’ [CS] and the Individual Defendants ‘have no reason to believe that [their] … hedging activities will have a material impact on the level of the [VIX Futures] Index.’” To the contrary, the investors alleged that “following three prior volatility spikes, Credit Suisse and the Individual Defendants knew with virtual certainty that, upon the next volatility spike, their hedging activity would significantly depress the value of XIV Notes.” And the same allegations of scienter that sufficed for the manipulation claims sufficed for the Rule 10b-5 claims of misrepresentation in the Offering Documents.

The Second Circuit, however, affirmed dismissal of the claim that CS and JIC violated the securities law by failing to correct the Flatline Price during the hour from 4:09 to 5:09 PM on February 5. Here, the court found scienter allegations inadequate. As to motive and opportunity, the complaint did “not identify specific evidence that [CS] profited by selling XIV Notes in the secondary market at prices reflecting the inflated Flatline Value … [or] that [CS] benefitted by delaying investors’ realization that an Acceleration Event had occurred.” And the complaint did “not allege facts demonstrating that JIC, which was simply a ‘Calculation Agent,’ materially benefitted by failing to correct the Flatline Value.” While the investors sought to plead conscious misbehavior or recklessness, their argument rested on an alleged failure by CS and JIC “to monitor the VIX Futures Index and compare it to the values of its underlying inputs—i.e., the real-time prices for VIX futures contracts.” But CS “was under no obligation to calculate or monitor the intraday indicative value.” And the Offering Documents “specified that JIC would rely on a third party, S&P, to accurately calculate the VIX Futures Index.”

Proxy statements. Exchange Act section 14(a) prohibits use of the mails or any means of interstate commerce to solicit proxies to vote securities registered under section 12 of that act where the proxy solicitation violates rules adopted by the SEC. Rule 14a-9(a) in turn prohibits including in such solicitations false or misleading statements about any material fact and statements that mislead because the solicitation omits a material fact. Aside from influencing voting at a company, a proxy statement can also affect the stock price of a merger participant before the merger closes, and those who trade in such stock may bring a Rule 10b-5 claim against the authors of a proxy statement, alleging that they acted with scienter by including falsehoods or statements that misled by omission.

In 2021, the Seventh Circuit affirmed dismissal of a section 14(a) claim based on the failure of a proxy statement to include the data underlying a discounted cash flow valuation prepared by an investment bank and included in that proxy solicitation. The Second Circuit reversed dismissal of a Rule 10b-5 claim where the complaint alleged that a proxy statement misled by stating that the buyout group in a going-private merger might develop a plan to relist the company after the merger but the plaintiffs plausibly pleaded that the group had such a plan when the proxy statement was published. The Ninth Circuit applied the Supreme Court’s Omnicare analysis to analyze the falsity of opinions in a case based on Rule 14a-9.

Omission of metrics underlying valuation of target company by its financial advisor. Vectren Corporation (“Vectren”) merged with CenterPoint Energy, Inc. (“CenterPoint”). Merrill Lynch (“ML”) served as Vectren’s financial advisor in the deal, contacting potential acquirors, participating in the negotiation with bidders, and providing the Vectren board with a fairness opinion for the transaction, which paid $72/share to Vectren stockholders—all in cash—constituting a 17.4 percent premium over the price of Vectren stock on the last day before public reports of a Vectren takeover.

The Vectren proxy solicitation for the vote by its shareholders on the merger “summarized [ML’s] fairness opinion, including three valuation analyses: one based on discounted cash flow, one using comparisons to other publicly traded companies, and a third comparing [the merger with] other similar transactions.” The discounted cash flow valuation computed the value of each of the three Vectren business segments, using “three discount rate ranges based on each business segment’s weighted average cost of capital: (i) 5.0 to 5.8 percent for the gas utility business; (ii) 4.7 to 5.4 percent for the electric utility business; and (iii) 7.8 to 9.6 percent for the non-regulated business.” After deducting the net debt of the segment from the present value of the segment’s future cash flow, ML added the values for the three segments together. Because the value for each segment was calculated as a range between the valuation resulting from use of high and low discount rates for each one, ML then “combined the low ends of the equity value ranges for each business segment to calculate a low estimate for Vectren’s implied equity value, and it combined the high ends of the equity value ranges for each business segment to calculate a high estimate.” The resulting valuation range for Vectren as a whole (which was what CenterPoint was buying) turned out to be between $59.00/share and $75.25/share.

Seven Vectren shareholders sued to stop the merger. After the district court denied a preliminary injunction, these shareholders amended their complaint to seek damages, “bas[ing their case] on the omission of two allegedly material financial metrics that they alleged rendered the Proxy Statement ‘misleadingly incomplete’ in violation of … Rule 14a-9.” The two metrics were: “Unlevered Cash Flow Projections, [which] showed the gross after-tax cash flow that Vectren was forecast to generate annually between 2018 and 2027” and “Business Segment Projections, [which] reflected individual financial projections for Vectren’s three main business lines: gas, electric, and non-regulated (engineering and construction).” In affirming dismissal of the complaint, the Seventh Circuit held that the omitted metrics “were immaterial as a matter of law in light of all the other information disclosed in the Proxy Statement” and, for the second and independent reason that the plaintiffs “fail[ed] to allege loss causation.”

As to materiality, the court took into account that the proxy statement included, in addition to the summary of the ML calculations for its discounted cash flow valuation, valuations based on comparable public companies and on comparable transactions. The statement also provided estimates of Vectren’s net income, depreciation and amortization, EBITDA, and capital expenditures for each year from 2018 through 2027. It provided as well “voluminous information about the background of the merger and its projected financial and community impacts.”

The summary of ML’s discounted cash flow analysis stated that ML had used projected unlevered cash flow numbers for each of Vectren’s business segments. The complaint sought “these projections not because of any alleged error in the disclosed [ML calculations] but because plaintiffs … wanted to replicate Merrill Lynch’s discounted cash flow analysis to make an independent determination of fair value.” The plaintiffs “argue[d] that the Proxy Statement could not provide a ‘fair summary’ of Merrill Lynch’s fairness opinion without disclosing all the key inputs used by Merrill Lynch in its valuation analyses.” Holding that this “reaches much too far, exaggerating Vectren’s disclosure obligations under Section 14(a),” the Seventh Circuit said it intended by its opinion to “emphasize that shareholders are not entitled to the disclosure of every financial input used by a financial advisor so that they may double-check every aspect of both the advisor’s math and its judgment.” Expanding, the court wrote: “Section 14(a) is not a license for shareholders to acquire all the information needed to act as a sort of super-appraiser: appraising the appraiser’s appraisal after the fact.” Allowing as how disclosure of inputs used in financial modeling might be required in other circumstances, the panel noted that there were “no … allegations that the merger between CenterPoint and Vectren was marred by bad faith, disloyalty, and disregard for shareholder value.” Instead, “[t]he Vectren board conducted a competitive sale, and there is no plausible claim here of hidden and unappreciated value of the Vectren shares.”

In the more targeted portion of its analysis, the Seventh Circuit reasoned that, given the many metrics the Proxy Statement provided, “[p]laintiffs simply have not articulated a plausible theory under which they needed disclosure of one more metric—the Unlevered Cash Flow Projections—to discover unrecognized value in their Vectren shares” and did not even “actually allege that the Consolidated Projections undervalued Vectren or that the company was worth more than the $72.00 per share paid in the merger.”

As for the Business Segment Projections, the court also “assume[d] that [ML] used [them] in its discounted cash flow analysis, but that fact does not automatically render them material for purposes of Section 14(a).” Since CenterPoint “was offering to acquire Vectren as a whole enterprise, not in individual business segments,” since “plaintiffs owned shares in Vectren as a whole enterprise … , not individual business segments,” and since the deal on which the shareholders were voting did not give them “the option of selling separate interests in separate business lines,” the complaint “failed to allege a substantial likelihood that a reasonable shareholder would have viewed the Business Segment Projections as significantly altering the total mix of available information material to whether to vote for or against the proposed merger.”

Turning from materiality to loss causation, the Seventh Circuit read the complaint as not alleging “any actual harm,” but only “that Vectren shareholders were impeded from realizing the scope of supposed economic harm.” One argument the plaintiffs made on value centered on “a Bloomberg chart in their amended complaint showing that Vectren’s weighted average cost of capital for the first quarter of 2018 was 5.3 percent,” which was below the 6.4 percent discount rate that plaintiffs calculated ML used in its discounted cash flow analysis. Had the lower discount rate been used in the discounted cash flow analysis, the discounted cash flow model would have yielded a higher Vectren valuation. But none of this “allege[d] plausible error with the disclosed discount rate ranges” that ML used for the different Vectren business segments, instead amounting only to identification of “another possible discount rate.” As the court saw it, the dispute over the discount rate was “a debate about the merits of the merger terms, not whether the Proxy Statement was misleading.”

The only other argument plaintiffs raised on valuation rested on “a ‘Simply Wall Street’ projection that Vectren’s standalone earnings growth was projected to be ‘in the teens’ in the coming years.” The plaintiffs extrapolated from this projection that Vectren could have garnered “an inevitable superior offer.” The court regarded this as “only speculation,” particularly given that no binding better offer than CenterPoint’s was ever made. Indeed, the plaintiffs failed to “even allege the existence of a viable superior offer.”

Significance and analysis. Vectren’s discussion of the unlevered cash flow lays out a responsible general rule that a proxy solicitation containing summaries of valuations need not include all the inputs into the valuation models. As the panel acknowledged, particular facts could forestall application of this general rule. But if a plaintiff could make out a section 14(a) case by simply speculating that the inputs might reveal a mis-valuation, there would be no practical end to the disclosure obligation because any input would itself derive from inputs.

The failure to disclose the discounted cash flow valuation of the company’s three business segments presents a more difficult issue, to which the Seventh Circuit devotes many fewer words. Providing those three numbers, which ML then summed to obtain the total company number, would have been no significant burden to Vectren. And the court’s simplistic analysis—that the segment projections were immaterial because the shares the stockholders held were in the company as a whole rather than in any of the segments and that the particular deal did not offer stockholders any shares in any of those segments—could too easily be read as a rule or presumption. The court would have done well to caution that in some circumstances such disclosure could be required. This might be appropriate in a case where shareholders raised a realistic alternative to a proposed merger, with the alternative being to sell or spin out one or more of multiple segments, with information relevant to that alternative then material to a vote on a whole-company cash-out merger because shareholders might reasonably vote against that merger to encourage the board to pursue the segment sale or spinout instead. Whether such reasoning would apply should depend on particular facts, including whether the board was considering such an alternative or significant shareholders were urging it.

Misrepresentation/omission regarding plan to relist following going-private transaction. Qihoo 360 Technology Co. Ltd. (“Qihoo”) listed ADRs on the NYSE. In May 2015, its CEO began discussing with investment bankers the possibility of taking the company private. In June, the CEO presented the board with a plan to do so and, after a Special Committee of the board reviewed that proposal with the assistance of J.P. Morgan Securities (Asia Pacific) Limited, the Special Committee and the board as a whole approved a merger with a Buyer Group, the agreement for which Qihoo signed on December 18, 2015. After the company distributed proxy materials, stockholders voted 99.8 percent of Qihoo shares to approve the deal, which closed on July 15, 2016, with the Qihoo shares purchased for a total of $9.4 billion.

The proxy materials stated that (i) after the transaction “‘the Surviving Company will become a private company’”; and (ii) “‘except as set forth in this proxy statement, the Buyer Group does not have any current plans, proposals or negotiations that relate to or would result in an extraordinary corporate transaction involving the Company’s corporate structure, business, or management’”; but (iii) “‘subsequent to the consummation of the Merger, the Surviving Company’s management and Board … may propose or develop plans and proposals, … including the possibility of relisting the Surviving Company or a substantial part of its business on another internationally recognized stock exchange.’”

After the merger, Qihoo spun out its principal business into 360 Technology Co. Ltd. (“360”), which then entered into a merger, announced on November 2, 2017, with a company listed on the Shanghai Stock Exchange, 360 being the surviving company. As the Second Circuit later summarized: “on February 28, 2018, the necessary asset restructuring was completed and Qihoo shares effectively began trading on the Shanghai Stock Exchange.” The restructured company reached a market capitalization on its first trading day of $62 billion.

Two plaintiffs who “traded Qihoo securities during the period from December 2015 to June 2016” sued Qihoo, its CEO, its president, and others, alleging that they violated Rule 10b-5 because, as the court of appeals summarized it, “the Buyer Group had a plan to relist Qihoo in the Chinese capital market at the time of the [going-private] Merger.”

After the district court granted a defense motion to dismiss on the basis that “the complaint did not adequately plead ‘that defendants, as of the Merger, had in place a concrete plan to relist Qihoo’ as opposed merely ‘to envisioning a possible future relisting,’” the Second Circuit vacated that dismissal. The appellate court pointed to allegations that (i) “according to ‘[a]n expert in Chinese and United States M&A and capitals market transactions,’ it ‘typically takes companies at least a full year on the quickest possible timeline, and usually longer, from the time they first start to consider a backdoor listing until they reach agreement with a shell company to conduct a reverse merger’” (contrasted with the July 15, 2016 going-private merger about sixteen months before the November 2, 2017 announcement of the reverse merger of 360 with the company listed on the Shanghai exchange) and (ii) “two news articles from 2015 … report[ed] that a privatization plan was provided to the Buyer Group that involved relisting the company on the Chinese stock market.” The Second Circuit found these “allegations create a plausible inference that a concrete plan was in place at the time Qihoo issued the Proxy Materials,” so that “the statement in the Proxy Materials that ‘the Buyer Group does not have any current plans’ to relist Qihoo—as well as its omission of any such plan—was misleading.”

Significance and analysis. The Exchange Act includes two special pleading rules applicable to private Rule 10b-5 actions. One provides that the complaint “state with particularity facts giving rise to a strong inference that the defendant acted with” scienter. The other requires that “the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” While both require the plaintiff to allege particular facts, only the first adds that the pled facts must “giv[e] rise to a strong inference” of the required element. Qihoo reminds us that the particular facts pled to show that a defendant’s statement was false or misleading need only be sufficient to “create a plausible inference.”

Omnicare analysis applied to section 14(a) claims. In Virginia Bankshares, Inc. v. Sandberg, the Supreme Court held, in a case under section 14(a) of the Exchange Act, that “statements of reasons or belief ” can be “facts” for purposes of Rule 14a-9. In Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, the Court held that an opinion can be false or misleading for purposes of section 11 of the Securities Act in any of three different ways. First, an opinion may be false because the speaker or writer does not believe it when he or she speaks or writes the opinion. Second, the opinion may be expressed in a manner that embeds in it statements of facts, and those factual representations may be false. Third, the opinion may mislead because the speaker or writer does not add facts—contrary to the opinion or about the manner in which the opinion was formed—that, in context, a reasonable investor would expect to accompany the opinion. The Omnicare decision rested this third alternative on the language of section 11 that imposes liability when a registration statement includes “an untrue statement of a material fact or omit[s] to state a material fact required to be stated therein or necessary to make the statements therein not misleading.”

In 2021, the Ninth Circuit held that, since Rule 14a-9 contains virtually the same language as section 11, the Omnicare analysis applies to determine whether opinions in proxy statements are false or misleading. Thus, a plaintiff may plead that an opinion in a proxy statement transgresses Rule 14a-9 by pleading that it is false or misleading in any of the three ways that Omnicare describes.

Significance and analysis. The Ninth Circuit similarly extends the Omnicare analysis to opinions challenged in Rule 10b-5 claims, based on the similarity of the language in that rule to the language in section 11. All of this seems correct.

SEC procedure. In a 9-to-7 en banc decision, the Fifth Circuit held that a respondent in an SEC administrative enforcement proceeding could sue in federal district court to enjoin that proceeding on the basis that the ALJ conducting it was unconstitutionally insulated from removal by the President. The Second Circuit held that (i) the five-year limitations period applicable to Commission actions for civil penalties could be extended by a tolling agreement because that limitation was not jurisdictional; and (ii) a district court decision to use the number of victims to determine the number of “violations” the defendant committed for purposes of computing the civil penalty cap in 15 U.S.C. § 77t(d) did not abuse the discretion the lower court possessed in computing that limit.

Federal court jurisdiction to enjoin SEC administrative proceedings before those proceedings conclude. Faced with an administrative enforcement proceeding alleging that she violated Public Company Accounting Oversight Board (“PCAOB”) auditing standards, Michelle Cochran filed a lawsuit in federal district court asserting that, “because SEC ALJs [(‘Administrative Law Judges’)] enjoy multiple layers of ‘for-cause’ removal protection, they are unconstitutionally insulated from the President’s Article II removal power.” After the district court dismissed for want of jurisdiction, a Fifth Circuit panel affirmed. In 2021, the circuit took up the jurisdictional issue en banc and reversed the district court by a 9-to-7 vote.

The majority turned first to the words of 28 U.S.C. § 1331, giving district courts “original jurisdiction of all civil actions arising under the Constitution, laws, or treaties of the United States.” Acknowledging that “Congress can limit district court jurisdiction if it so chooses,” the majority then turned to 15 U.S.C. § 78y(a)(1), providing that “[a] person aggrieved by a final order of the [SEC] … may obtain review of the order in the United States Court of Appeals … by filing in such court, within sixty days after the entry of the order, a written petition requesting that the order be modified or set aside in whole or in part.”

The nine-judge opinion rejected, for three reasons, the SEC position that, “[b]y giving some jurisdiction to the courts of appeals … , Congress implicitly stripped all jurisdiction from every other court—including district courts’ jurisdiction … under § 1331.” First, since § 78y(a)(1) applies only to persons “‘aggrieved by a final [SEC] order,’” it “says nothing about people, like Cochran, who have not yet received a final order of the Commission” or “people, again like Cochran, who have claims that have nothing to do with any final order that the Commission might one day issue.” Second, by using the word “may,” § 78y(a)(1) is permissive, and “[i]t would be troublingly counterintuitive to interpret [that] permissive language as eliminating alternative routes to federal court review, especially in the context of separation-of-powers claims of the sort at issue here.” Third, § 78y(a)(3) provides that the court of appeals’ jurisdiction “becomes exclusive” “on the filing of [(i)] the petition” and (ii) the underlying record, neither of which had happened yet here—“show[ing] that Congress knew how to strip jurisdiction when it wanted to—and … highlight[ing] that Congress did not strip § 1331 jurisdiction elsewhere.”

Significance and analysis. The seven-judge dissent argued that “every court of appeals to consider the question has answered that a person facing an SEC enforcement action may not mount a collateral attack against the agency proceeding in federal district court.” Cochran now creates a circuit split on this issue, and the SEC has sought certiorari review by the Supreme Court.

In addition to the majority opinion and the dissent, six of the nine judges comprising the majority filed an extraordinary concurrence. It took as its theme that the entire SEC enforcement scheme derived from (i) the animosity toward democracy displayed by Woodrow Wilson and his “acolyte” James Landis, “the SEC’s founding father [who] drafted § 78y into the original Securities Exchange Act” and (ii) their conviction that technical experts should govern in matters such as securities regulation without interference by courts. All this was relevant, the concurrence posited, to “underscore our conclusion that the words in § 78y enacted by Congress—as opposed to the unenacted purposes that motivated Landis—do not strip jurisdiction over Cochran’s removal claim.”

Limitation on civil penalty action. Under current law, the SEC must bring a claim for a civil penalty within the five-year period in 28 U.S.C. § 2462. The Commission must bring a claim for an injunction, or a bar, suspension, cease-and-desist order, or other equitable remedy, within the ten-year period in 15 U.S.C. § 78u(d)(8)(B). Per 15 U.S.C. § 78u(d)(8)(A), the SEC must file a claim for disgorgement within five years, unless the underlying violation requires the SEC to prove scienter, in which case the period extends to ten years.

In SEC v. Fowler, the Second Circuit addressed whether tolling agreements can extend the § 2462 five-year limit. The Commission filed its lawsuit on January 9, 2017, alleging that Fowler (a registered representative of a broker) had violated Rule 10b-5 and Securities Act section 17 by “recommend[ing] to customers a ‘high-cost, in-and-out trading strategy without having a reasonable basis for believing that this strategy was suitable for anyone,’” while he “‘knew or recklessly disregarded that the strategy … was bound to lose money,’” and “made ‘little or no mention of fees and costs’ that he knew would erase any gains.” Since the complaint claimed that Fowler’s scheme began in 2011, the five-year limitations period would have expired in 2016. But Fowler and the Commission made two agreements to extend that deadline, ultimately until February 9, 2017. Thus, the Commission filed its complaint outside the five-year statutory period but within the extension.

After a jury found for the Commission on all causes of action, the district court entered a permanent injunction forbidding Fowler from violating securities laws, ordered disgorgement of $132,076.40, and imposed a $1,950,000 civil penalty. Affirming, the Second Circuit rejected Fowler’s contention that the § 2462 time limit was jurisdictional and therefore beyond the parties’ power to enlarge. Beginning with the general rule that “[w]ithout ‘a clear statement, … courts should treat [statutes of limitations] as nonjurisdictional’” “‘even when [they are] framed in mandatory terms … however emphatic[ally] expressed those terms may be,’” the court found the statute’s language (“an action … shall not be entertained unless commenced within five years from the date when the claim first accrued”) “does not itself tell us that Congress intended § 2462 to be jurisdictional.”

In one other important holding, the Second Circuit addressed Fowler’s challenge to the amount of the civil penalty the court ordered him to pay. The Securities Act civil penalty provision defines three levels of such penalties and sets limits on the penalties that can be ordered for each. First-tier penalties—applicable to any transgression of the Act or accompanying regulations—could not exceed (at the time Fowler committed his fraud), for “each violation,” “the greater of ” (i) $7,500 for a natural person or $75,000 for any entity, or (ii) “the gross amount of pecuniary gain to such defendant as a result of the violation.” Second-tier penalties—applicable to such a violation if it “involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement”—could not exceed, for “each such violation,” the greater of $75,000 (natural person) or $375,000 (entity), on the one hand, or the gross pecuniary gain on the other. Third-tier penalties—applicable if the violation involved fraud, deceit, etc. and “directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons”—could not exceed, for “each such violation,” the greater of $150,000 (natural person) or $725,000 (entity), on the one hand, or the gross pecuniary gain on the other.

As the quoted words highlight, a key determinant of each limit is the number of “violations” the Commission can prove. In any fraud scheme running for a period of time and involving fraud on a number of different victims, it is possible to parse the facts in ways that increase or decrease the number of “violations” and therefore increase or decrease the limit on the total civil penalties the court can order. The district court in Fowler determined that the facts supported third-tier penalties against Fowler and multiplied the third-tier natural person limit of $150,000 times the thirteen customers Fowler defrauded—thereby counting each customer as a separate “violation”—to arrive at a total limit of $1,950,000, which was the civil penalty amount that the court ordered Fowler to pay. Fowler argued that, since the SEC contended that he orchestrated a single scheme, he committed only one “violation” for purposes of the civil penalty limit.

The Second Circuit acknowledged that “[t]he term ‘violation’ is not defined by the statutory scheme,” referred generally to the district court’s “‘broad equitable power to fashion appropriate remedies,’” and concluded that it would review the district court’s decision to view each customer as a “violation” only for abuse of discretion. Since the lower court had explained that “‘Fowler selected his victims … individually,’” that counting “‘each of his defrauded customers as a separate violation best effectuates the purposes of the statute,’” and “that a per-trade penalty ‘would be so substantial’ that Fowler would not ‘reasonably be capable’ of paying it,” the panel concluded that it would “not second-guess the District Court’s discretionary decision to resort to a per-customer unit of violation to determine the civil penalty in this case.”

Significance and analysis. Fowler leaves to the discretion of the district court the degree to which that court parses a set of facts to find the number of violations. Fowler also employs an abuse of discretion standard to review that number. Since the limit on civil penalties depends critically on the number of violations, this gives trial courts enormous discretion over the limit to the penalties it imposes. Such wide discretion seems inconsistent with the carefully calibrated limits to civil penalties in 15 U.S.C. § 77t(d)(2)—with three different tiers, dual limits within each (highest of either set dollar amount times number of violations or gross amount of pecuniary gain to the defendant) and periodic adjustments to the set dollar amounts.

Criminal cases. The four defendants in United States v. Harra had served as executives at Wilmington Trust Company (“Wilmington”), with one of them (Gibson) as the CFO. A jury convicted them of one count of conspiracy to commit fraud against the U.S. government or an agency thereof under 18 U.S.C. § 371, one count of securities fraud under 18 U.S.C. § 1348, fourteen counts of making false statements to the SEC and the Federal Reserve under 18 U.S.C. § 1001 and 15 U.S.C. § 78m, and three counts (against Gibson only) of falsely certifying periodic reports submitted to the SEC under 18 U.S.C. § 1350.

The case revolved around loans, primarily for building construction, that required debtors to make monthly interest payments until maturity, whereupon the debtor had to pay “‘all outstanding principal plus all accrued unpaid interest.’” The loans also provided that Wilmington could “‘renew or extend (repeatedly and for any length of time) [the] loan … without the consent of or notice to anyone.’” Until July 2010, Wilmington did not, internally, consider such a loan as past due when the debtor was current on interest payments and Wilmington was in the process of renewing the loan (the “Waiver Practice”). In 2009, debtors on something like $300 million of such loans could not pay their principal on maturity, and Wilmington reacted by approving mass extensions of such loans. Wilmington did not identify these loans as past due in reports filed with the SEC, the Federal Reserve (the “Fed”), or the Office of Thrift Supervision (“OTS”).

In February 2010, Wilmington sold stock by offering documents that “did not reflect the loans that would have matured but for the mass extensions” and “told prospective investors the Bank’s past-due loan liability was even lower at the end of 2009 than the prior year.” In July of that year, however, Wilmington “changed its waiver practice, resolving that ‘[a]ll matured/current loans’ would be ‘reported in [the] Past Due numbers.’” By the end of 2010, the Fed had “issued a ‘troubled condition’ letter,” and Wilmington had merged with M&T Bank.

Reversing all but the convictions on the securities count and the conspiracy to commit securities fraud, the Third Circuit concluded that “[e]very offense with which Defendants were charged involved the alleged falsity of the Bank’s reporting of ‘past due’ loans.” The “Defendants advanced a theory throughout the trial that their statements were not actually false because the SEC’s and Federal Reserve’s reporting instructions were ambiguous and, under an objectively reasonable interpretation of those instructions, Defendants were not required to report the waived loans as ‘past due.’”

The Third Circuit agreed that the reporting requirements were ambiguous. Though none of the agencies defined “past due,” each of them referred to contract terms in discussing the past due reporting obligation, with the Fed and OTS adding that the past due status of a loan was not affected by “grace periods.” The OTS issued guidance through a Q&A document that responded to “a situation—akin to the Bank’s waiver practice—where ‘construction loans that require interest-only payments due monthly with the principal due at maturity’ were past maturity but current on interest” by saying that: “‘If management has restructured or extended a loan—formally or informally[—]then the loan would not be past due.’” That guidance continued by defining “[a]n informal extension” to occur “‘when the bank has agreed to accept interest payments until the property is rented or sold.’” If “‘[t]he extension [is] for a limited and reasonable length of time[,]’” and if therefore, “‘[f]rom the borrower’s perspective, … he is doing what the bank has told him, the loan is not in default and does not have to be reported.’”

Since Wilmington had by contract “preserved [its] right to ‘renew or extend (repeatedly and for any length of time) th[e] loan … without the consent of or notice to anyone,’” thereby “giving the Bank a contractual right to, of its own accord, determine that a payment due under the contract is not due at all” and since Wilmington had “exercised this right—by making arrangements with borrowers to ‘waive’ the loan—whether the principal payment remained ‘contractually past due’ is ambiguous to say the least.” Nor was the ambiguity removed by two examples in the guidance from the Fed and OTS:

Single payment and demand notes, debt securities, and other assets providing for the payment of interest at stated intervals are to be reported as past due after one interest payment is due and unpaid for 30 days or more.

Single payment notes, debt securities, and other assets providing for the payment of interest at maturity are to be reported as past due after maturity if interest or principal remains unpaid for 30 days or more.

“[N]either of these circumstances clearly applies to loans—like those at issue here—that require interest to be paid both at regular intervals and at maturity. See A11755 (providing for the payment of both regular monthly payments and the payment of ‘all accrued unpaid interest’ upon maturity).”

Given the uncertainty of the reporting requirements and that the government had to prove that the defendants were responsible for submitting false reports, the court then wrestled with how the prosecution could “prove falsity in the face of [this] ambiguous reporting requirement.” The court of appeals rejected the government position that conviction should follow if the United States “prove[d] that a defendant understood an ambiguous reporting requirement to mean what the Government says it means and, in light of that meaning, intended to lie” because that view improperly “collapses subjective falsity—the defendant’s intent to lie—with objective falsity, i.e., the untruth of the statement in question.” The Third Circuit held, instead, that since “potential defendants [must] be given ‘fair warning’ of what conduct could give rise to criminal liability,” “where falsity turns on how an agency has communicated its reporting requirements to the entities it regulates and those communications are ambiguous, fair warning demands that the Government prove a defendant’s statement false under each objectively reasonable interpretation of the relevant requirements.”

In this case, therefore, “the Government bore the burden of proving beyond a reasonable doubt that either the alternative interpretation [of the reporting regulations offered by the defendants] was unreasonable or that Defendants’ statements were false even under that alternative and reasonable interpretation.” It was “quite plausible—given the terms of the loan agreements here—that the phrase ‘contractually past due’ would exclude a mature loan that is treated as ‘waived’ and that is in the process of being extended, even when no notice has been given [to] the borrower.” And, “other than relying on the purported ‘ordinary meaning’ of ‘contractually past due,’ the Government offer[ed] no evidence that this interpretation is unreasonable.” Accordingly, the prosecution had not carried “its burden to prove falsity.”

For the court, that disposed of the case insofar as it rested on reports to the SEC. The only complication raised by the Fed and OTS reporting arose from the examples quoted above, but the prosecution failed to show that “the only reasonable interpretation” of them was one that made the Wilmington reports false. Since the government concededly failed to prove that the defendants’ interpretation of the reporting requirements was either unreasonable or that the reports were false under that interpretation, the prosecution had failed to prove falsity as to the reports to the Fed and OTS as well.

This failure was “fatal” to all the counts except the conspiracy to commit securities fraud and substantive securities fraud. The Third Circuit therefore remanded “for the entry of judgments of acquittal” on the “false statement and certification convictions.”

As to the counts charging conspiracy to commit securities fraud and substantive securities fraud, the panel concluded that the government’s case blended both the theory that the Wilmington reports were false and the theory that the mass extensions of the loans were designed to keep them off the books while Wilmington prepared documents for the February 2010 offering. For this reason, even though “a rational juror could conclude that Defendants had knowingly caused maturing loans to be extended in order to push them off the books for 2009 and conceal the poor financial health of the Bank from investors, and that they had knowingly joined an agreement to do so,” the use—in proving the securities counts—of the evidence argued to support the “legally invalid” theory of the false reporting and the circumstance that the lower court wove that theory into the instructions forbade a finding that those instructions were harmless error with respect to the securities counts. The panel therefore vacated the convictions for conspiracy and securities fraud and remanded for a new trial on those counts.

Significance and analysis. Although rendered in a criminal case, the Third Circuit commented that “[e]ven in the civil context, fair warning requires that government agencies communicate their interpretation of their own regulations with ‘ascertainable certainty’ before subjecting private parties to punishment under that interpretation.” The requirement that the government must prove that a statement is false under each of all reasonable interpretations of an ambiguous reporting requirement may therefore apply in civil enforcement proceedings as well. But in the securities context, defendants may find its application limited. The SEC provides massive support to practitioners explaining the many SEC rules. Even more importantly, many securities statutes are phrased so that a statement that is literally true can impose liability if it is misleading.

Additional cases. The D.C. Circuit declined to review an SEC order—requiring participants in existing Data Equity Sharing Plans to submit a new plan with specific features—on the ground that the order was not a final one because the new plan itself, including the specific features, would be subject to SEC consideration and approval or modification after public comment. That same court held—in determining when the sixty-day period for filing a petition for review begins to run—that an SEC action styled as an “order” will be treated, regardless of its “substance or the procedure used to effectuate it,” as an order rather than a rule so that a petition must be filed within sixty days of the order’s entry.

Addressing claims under the California state securities law but applying principles from federal securities law, the Ninth Circuit affirmed dismissal of claims against Uber Technologies, Inc. (“Uber”), concluding that the plaintiffs failed to plead loss causation where the complaint alleged some sixty misstatements relating to multiple scandals that came to light over a period of many months and where the plaintiff ’s own chart showed that, after several of the damaging facts came to light, valuations of the issuer’s stock (held by funds, as Uber was at this time still privately held) increased, with the court finding that the complaint relied on a year-long decline in the valuations rather than linking particular valuation declines to specific misstatements and corrective disclosures.

The Tenth Circuit affirmed a defense judgment after a bench trial on claims that advisor fees violated Investment Company Act section 36(b).

Addressing a case in which the issuer filed a registration statement for a direct secondary offering on the NYSE by some shareholders and in which other shareholders offered their securities on the NYSE on the basis of the Securities Act section 4(a)(2) exemption, the Ninth Circuit held that purchasers of all those shares could sue under Securities Act sections 11 and 12(a)(2).

The First Circuit affirmed summary judgment for a defendant, applying section 29(b) of the Exchange Act and refusing to enforce a contract providing for a success fee for sale of a company where the defendant had assigned the engagement to an affiliate that was not a registered broker, the confidential information memorandum for the sale of the client company expressly referenced the possibility of an equity transaction as an alternative to an asset sale, and the client company’s equity consisted of LLC interests that might have been classified as securities.

The Second Circuit found a transaction was not “domestic” under Morrison v. National Australia Bank Ltd., even though it was reported to the TRACE system developed by FINRA and found a transaction in another case—in which a Bermudan investor bought preferred stock in a private placement by a Bermudan issuer—not “domestic” by applying that circuit’s Parkcentral Global exception to the place-of-irrevocable-commitment test. The First Circuit adopted that place-of-irrevocable-commitment standard, but not the Parkcentral Global exception.

The Eighth Circuit held that SLUSA precluded breach of contract and negligence class action claims against a broker based on delays in reinvesting the proceeds from automatically triggered tax loss sales. The Ninth Circuit found that SLUSA did not preclude a class action for breach of fiduciary duty where the plaintiff alleged that a broker—without conducting suitability analyses—had offered accounts charging an annual fee based on asset values to customers holding accounts charging trade-by-trade commissions.

The Eighth Circuit reversed certification of a class where the plaintiff alleged that a broker violated its duty of best execution by routing trades in a manner designed to maximize its own profits instead of to obtain the best prices for brokerage clients, holding that economic loss would have to be determined by factors affecting individual class members.

The Eleventh Circuit held equitable tolling applies to the requirement that a Securities Act section 12(a)(1) claim must be brought within “one year after the violation upon which it is based,” but affirmed dismissal because the plaintiff had possessed, since acquisition, all the facts determining that the tokens he purchased were investment contracts and therefore securities. The Third Circuit held that American Pipe tolling applies where a putative class member files an individual action before the court handling the putative class action decides the certification motion.

The Eighth Circuit found personal jurisdiction and venue proper in federal district court in Fargo, North Dakota, where Singapore citizens sued a Singapore resident on Securities Act claims and the defendant had marketed interests in a North Dakota limited liability company, received commissions from North Dakota, and traveled to North Dakota to sell the investments, taking pictures and videos during those trips to show that the company was conducting operations.