chevron-down Created with Sketch Beta.

The Business Lawyer

Summer 2023 | Volume 78, Issue 3

Section III: Caselaw Developments 2022

Subcommittee on Annual Review, Federal Regulation of Securities Committee


  • The caselaw section of the Federal Regulation of Securities survey looks at cases from the Supreme Court and Courts of Appeal.
Section III:  Caselaw Developments 2022

Jump to:

A. Overview

SEC rulemaking and orders. The D.C. Circuit denied a petition challenging a Securities and Exchange Commission (“SEC” or “Commission”) order approving fees for wireless services transmitting data from exchanges to market actors, holding that the Commission had jurisdiction over those services; denied a petition challenging SEC approval for a new order type intended to defeat latency arbitrage; granted a petition challenging a consolidated equity market data plan insofar as that plan provided for non-SROs to vote on the plan’s operating committee; and denied a petition challenging a new market infrastructure plan that the Commission had designed to foster competition in the provision of proprietary data feeds.

SEC administrative enforcement proceedings—Procedure. The Fifth Circuit held that (i) Commission administrative enforcement proceedings violate respondents’ Seventh Amendment jury trial right, (ii) the statute providing the administrative enforcement option violates the Constitution’s Article I command that all legislative power rests with Congress because the law grants the Commission carte blanche authority to choose that option over a federal court action, and (iii) the Administrative Law Judge (“ALJ”) removal scheme violates the Take Care Clause of Article II because the scheme requires two levels of for-cause removals in order for a President to fire an ALJ. The Fifth Circuit also held that the 2021 amendments to the Securities Exchange Act of 1934 (“Exchange Act”) created a new kind of disgorgement in SEC enforcement actions—legal disgorgement under 15 U.S.C. § 78u(d)(3)(A)(ii) and (d)(7)—different from equitable disgorgement under 15 U.S.C. § 78u(d)(5).

SEC enforcement actions—Substance. The Ninth Circuit employed a textual analysis of Exchange Act section 15(a) to affirm summary judgment for the Commission in an action charging the defendants as having acted as “brokers,” instead of using a multifactor test to reach that conclusion. The Tenth Circuit affirmed summary judgment for the SEC in an action alleging that a CEO made false and misleading statements about the possibility that Apple, Inc. would use his company’s technology.

Effect on federal jurisdiction of bylaw choice of forum provision. The Seventh Circuit held that, as applied to prevent a derivative lawsuit in federal court under Exchange Act section 14(a), a bylaw specifying the Delaware Chancery Court as the exclusive forum for a derivative suit violated Delaware General Corporation Law section 115.

Definition of statutory seller for Securities Act section 12 liability in the internet age. The Eleventh Circuit held that a person who encouraged website visitors to buy bitcoins and provided instruction on another website on how to open a bitcoin account could be a soliciting seller under the Pinter v. Dahl test and therefore a proper defendant on a Securities Act of 1933 (“Securities Act”) section 12 claim. The Ninth Circuit reached the same conclusion as to an individual who promoted an equity fund in an Instagram post and a YouTube video—with both the Eleventh and Ninth Circuits rejecting the argument that solicitation for purposes of identifying section 12 defendants requires personalized, targeted persuasion.

Purchaser/seller rule for standing in private Rule 10b-5 actions. The Second Circuit held that the Blue Chip Stamp purchaser/seller requirement for standing to bring a private action under Rule 10b-5 precluded investors who bought the stock of an acquiring company from suing for misstatements made before the merger by and about the target company.

Relationship between the three subparts of Rule 10b-5. The Second Circuit held that, even after Lorenzo v. SEC, conduct consisting of no more than making false or misleading statements cannot constitute a Rule 10b-5(a) or (c) violation.

Materiality. The Ninth Circuit found multiple statements to be inactionable puffery in affirming dismissal in a case based on statements about a company’s growth in the Chinese market. The Tenth Circuit similarly found most statements about the growth of a company’s sales force to be immaterial but reversed dismissal insofar as the action rested on a specific representation about the number of quota-bearing sales personnel.

False or misleading statements. The Fourth Circuit held that plaintiffs attacking a hotel company’s statements about cybersecurity failed to plead facts to show that the statements were false or misleading. The First Circuit found wanting, for the same reason, a complaint challenging an issuer’s post-acquisition statements and omissions centering on loss of customers at a business that the issuer had purchased and that it wrote down in steps in the three years after the purchase.

Scienter and scienter pleading. The Fourth Circuit affirmed dismissal of a Rule 10b-5 case alleging that a CEO had falsely represented that his company had a contract—finding insufficient facts in the complaint to raise a strong inference of scienter, where the pled facts showed (i) a lengthy negotiation between the CEO’s company and the counterparty, (ii) the counterparty had reported to a public agency that it was going forward with the contract, (iii) the head of the counterparty had signed but not returned the contract, and (iv) the counterparty’s board ultimately decided against the deal.

Duty to disclose. In a decision finding one duty to disclose but not another, the Second Circuit reversed dismissal of a Rule 10b-5 action to the extent that the complaint alleged that the issuer had, after reporting a material internal control weakness, failed to disclose an SEC investigation but affirmed to the extent that the complaint alleged that the issuer had not disclosed its role in online articles positive on the issuer’s stock. The Ninth Circuit affirmed dismissal of a Rule 10b-5 claim alleging that Twitter did not disclose problems with software prompting users to download advertisers’ apps.

Forward-looking statements. The Eleventh Circuit concluded that an issuer’s statement that it “believe[d] each year in the U.S. more than 1.4 million people suffer traumatic injuries to peripheral nerves” was forward-looking in context and affirmed dismissal of the Rule 10b-5 action challenging the statement because the complaint did not allege facts to raise the required inference that the issuer made the statement with actual knowledge that it was false or misleading.

Merger disclosures. The Seventh Circuit held that claims under Rule 10b-5 and Securities Act sections 11 and 12 failed to state a claim where the plaintiffs based their action on one merger participant failing to disclose that the other participant was taking an aggressive stance in divestiture negotiations with the government and the merger failed to close.

Life sciences. Finding in each action that the Rule 10b-5 complaints failed to allege falsity and that the district court properly dismissed them, (i) the Second Circuit addressed a case resting on a pharmaceutical company’s representation that a clinical trial targeted patients who “strongly” expressed a particular protein; (ii) the Ninth Circuit considered an action in which plaintiffs attacked a company’s report of extremely positive results in a Phase 1 trial and later announced much more modest results in a later Phase 1/2 trial; and (iii) the First Circuit ruled on a complaint that a press release announced the common adverse side effects suffered in a clinical trial without separately addressing severe side effects.

Criminal cases. The Seventh Circuit affirmed the conviction of a CFO on multiple counts where accounting problems were repeatedly brought to his attention by a variety of subordinates in written and oral communications over more than two years and the CFO failed to resolve them.

B. Courts of Appeals

1. SEC Rulemaking and Orders

The D.C. Circuit found the SEC had jurisdiction to regulate the fees of wireless services that were affiliated with exchanges and transmitted data from the exchanges to market participants. That same circuit denied a petition challenging SEC approval of an exchange rule creating a new order type designed to defeat latency arbitrage; granted a petition challenging a consolidated equity market data plan to the extent that the plan provided for voting participation on its operating committee by non-SROs; and denied a petition challenging a new market infrastructure plan designed to foster competition in proprietary data feed services, rejecting exchanges’ arguments that the new plan would harm them economically and thereby damage competition.

Regulation of wireless services providing data from exchanges. The Intercontinental Exchange, Inc. (“ICE”) owns (i) five exchanges (including the NYSE)—all ICE subsidiaries that are registered with the SEC—and (ii) two ICE subsidiaries that, together with a subsidiary of the NYSE, market data and connectivity services (with the two ICE subsidiaries and the NYSE subsidiary collectively known as ICE Data Services or “IDS”). IDS offers two services relevant here—Wireless Bandwidth Connections (“WBC”) and Wireless Market Data Connections (“WMDC”) (collectively, the “Wireless Connections”).

Customers used each of the wireless services for data transmission between a 400,000 square foot building at Mahwah, New Jersey (where the exchanges operate the engines by which they match buyers and sellers) and the customers’ own computer equipment at data centers. Market participants using the WMDC service bought data from the exchanges’ matching engines directly from the exchanges, and the exchanges sent that data to the IDS equipment in the Mahwah building. IDS then sent the data wirelessly to its equipment in one of the data centers. The IDS equipment there then transferred that data by fiber to the market participant’s matching engine equipment also located at the data center.

The WBC service worked in somewhat the same way, but the customers using this service co-located their own equipment in the Mahwah building, with data from an exchange matching engine going into that equipment. The data then traveled inside the Mahwah building to the IDS equipment there, then wirelessly to IDS equipment at a data center, then on by fiber to the customer’s equipment co-located at the data center. Importantly, the WBC service provided two-way connectivity so that the market participant could not only receive information from Mahwah but send buy and sell orders from its equipment at a data center to the market participant’s equipment co-located at the exchange’s premises, from which it could then transfer the orders into an exchange matching engine.

In each case, the wireless connection at issue comprised only a part of the communication chain. But the wireless portions were particularly important “[b]ecause light waves travel faster through air than through fiber-optic cable.”

The five exchanges filed the fee schedules for the Wireless Connections “because Commission staff informed them that the Commission viewed the fee schedules as ‘rules of an exchange.’” After the SEC issued an order approving the fees, the exchanges petitioned against the order on the ground that “the Wireless Connections ‘are not facilities of the Exchange within the meaning of the Act, and therefore do not need to be included in its rules.’”

In denying that petition, the D.C. Circuit found two provisions of the Exchange Act critical. Section 3(a)(1) defines an “exchange” as “any organization, association, or group of persons … which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange.” Section 3(a)(2) defines “facility” to “include[]” an exchange’s “tangible or intangible property whether on the premises or not, any right to the use of such premises or property or any service thereof for the purpose of effecting or reporting a transaction on an exchange (including, among other things, any system of communication to or from the exchange, by ticker or otherwise, maintained by or with the consent of the exchange), and any right of the exchange to the use of any property or service.”

First, the panel considered whether the Wireless Connections were “facilities” within the meaning of section 3(a)(2). Then it considered whether, if so, they were part of an exchange within the meaning of section 3(a)(1).

The petitioners argued that neither of the Wireless Connections were “facilities” of an exchange because neither was “directly connected to the Exchanges (i.e., to the matching engines) and are but a single link in the chain of communication between market participants and the matching engines.” But the D.C. Circuit found that “the statutory definition of ‘exchange’ encompasses more than just the matching engine, so there is no reason to think the plain meaning of a system of communication ‘to or from the exchange’ [in the definition of ‘facility’] is limited to a system that provides a direct connection to the matching engine of an exchange.” Indeed, the “Wireless Connections are very expensive, highly specialized connections, used exclusively by market participants for the sole purpose of effectuating trading strategies and facilitating market activity [and] … are offered by IDS, an affiliate of the Exchanges, and could not exist without the consent of the Exchanges—in other words, they clearly are ‘system[s] of communication … maintained by or with the consent of the exchange,’” thereby falling within section 3(a)(2)’s definition of “facility.”

As the court saw it, that still left the question of whether the Wireless Connections were “the type of facility that Section 3(a)(1) includes in the term ‘exchange.’” This issue arose because “the Wireless Connections are provided and maintained by IDS, and not by the Exchanges themselves.” Factually, IDS was composed of three companies, two of them subsidiaries of ICE and one (NYSE Technologies Connectivity, Inc.) a subsidiary of the NYSE, which itself was an ICE subsidiary. As a policy matter, there was “a unity of interests between IDS and the Exchanges,” and “overlooking corporate affiliation here would allow a company that controls an exchange to evade SEC oversight by making a simple change to its corporate structure; it could then use its control over access to exchange facilities to gain a competitive advantage for its subsidiary, which would be directly at odds with one purpose of the Exchange Act, viz., to prevent the imposition of unnecessary burdens upon competition.”

Statutorily, section 3(a)(1)’s definition of an “exchange” includes a “group of persons … which constitutes, maintains, or provides … facilities for bringing together purchasers and sellers of securities.” That, the court concluded, is exactly the function that the Wireless Connections performed, and “[t]herefore … the SEC correctly concluded that the fee schedules for the Wireless Connections are ‘rules of an exchange’ and hence must be filed with the Commission.”

Amended exchange rule permitting form of order designed to defeat loss to latency arbitrage. Rule 611 of Regulation NMS requires securities exchanges to prevent execution of protected trades that are worse for buyers or sellers than the national best bid or offer (“NBBO”), and the NBBO is determined by constant communications between the national exchanges. When a bid that is better than the NBBO comes into one exchange from a buyer or seller, it takes a split second for information about that bid to circulate to the other exchanges and therefore be recognized as the new NBBO. If—in that split second (called “latency”)—a trader can learn of the bid when it comes into the exchange on which it is entered (e.g., by a direct data feed from that exchange) and, for example, buy at the older lower NBBO, then immediately sell at the new, higher NBBO once it is recognized as such, then the trader can make a small but sure profit (say, a penny a share) at the expense of the seller to the trader. Such trading is called “latency arbitrage.”

Investors Exchange LLC (“IEX”) sought to defeat latency trading by (i) forcing all incoming orders to pass through thirty-eight miles of coiled wire to slow their delivery to IEX by 350 microseconds (the “speedbump”) and (ii) using a computer algorithm to predict imminent changes in the NBBO (the “crumbling quote indicator” or “CQI”). IEX asked the SEC to approve IEX’s change of its own rules to recognize as “protected quotations” (which must be “‘automated,’ publicly displayed, and the [NBBO]”) a new type of order by which a customer would authorize IEX to exercise its discretion to alter a limit order price by one tick for two milliseconds when the CQI determined that a change in the NBBO against the customer is imminent. This kind of order (called a “D-Limit order”) would thereby be protected from trades at stale prices to high-frequency traders during the latency period.

After the Commission approved the IEX rule change, Citadel Securities LLC—a high-frequency trader—unsuccessfully sought review in the D.C. Circuit. First, Citadel argued that the SEC had no substantial evidence to support its finding “that because the D-Limit order benefits ‘all market participants’ by ‘narrowly’ targeting latency arbitrage, it does not unfairly discriminate against liquidity takers or unduly burden competition.” The court responded that “[t]he [CQI] turns on for a given security for an average 0.007% of the trading day (about 1.64 seconds),” but that in that very limited time, “24% of IEX’s displayed liquidity is traded.” This was sufficient evidence “that short-term investors engage in latency arbitrage during the same ‘small increments of time’ that the [CQI] turns on” and that “the D-Limit order narrowly targets latency arbitrage because IEX changes a price only when the crumbling quote indicator turns on.”

Second, Citadel complained that the Commission’s favorable ruling on the IEX rule change arbitrarily departed from an unfavorable ruling on a proposed rule change by “Cboe EDGA Exchange, Inc., which had sought to impose an all-day, four-millisecond delay on incoming communications from liquidity takers, but not to similarly delay incoming messages from liquidity providers.” But the two proposals had differed, as the court saw it—the IEX rule being better targeted on latency arbitrage because “IEX’s delay, by contrast, (1) is 350 microseconds long, which is approximately 1/11th the length of Cboe’s delay; (2) applies to incoming communications from both liquidity providers and takers; and (3) permits D-Limit orders to automatically reprice, which occurs during just 0.007% of the trading day.”

Third, to be a “protected” bid or offer (the designation that IEX sought from the Commission for its D-Limit orders), the order must be “automated,” which in turn meant it must “[i]mmediately and automatically execute[].” Citadel challenged whether the Commission acted arbitrarily and capriciously by finding that the D-Limit order was both. The court found “no serious reason to question the reasonableness” of the SEC conclusion that the D-Limit was automated since “every part” of the order “is automatic” and the “process [by which it operates] involves no manual discretion.” While the “immediacy argument” was slightly more complicated, the panel concluded that the SEC “reasonably found [that] an order can be executed ‘immediately’ even if it is subject to a de minimis delay” and that the “mere 350 microseconds” fell into that category. In response to Citadel’s position that the D-Limit order delay could not be “de minimis because it has a substantial effect on the market,” the D.C. Circuit answered that the trades with which the D-Limit orders interfere “aren’t a normal part of the market.” Instead, the SEC reasonably concluded that they “involve latency arbitrage tactics that actually harm the market.”

Consolidated Equity Market Data Plan. In 2021, the SEC voted to replace the three existing equity data plans with a Consolidated Equity Market Data Plan (the “Consolidated Equity Plan” or “CT Plan”) to “govern[] the public dissemination of real-time consolidated equity market data for national market system (‘NMS’) stocks.” The Consolidated Equity Plan had an overall objective to reduce the information asymmetry between, on the one hand, market participants who rely on the “core data” that the exchanges are required to disseminate to securities information processors (“SIPs”), who then distribute it to subscribers and, on the other hand, market participants who buy “‘proprietary data products’”—“exchange-specific data that goes beyond the best bid and best offer quotes contained in the core data feeds and are generally delivered much faster than the core data feeds.”

Multiple national stock exchanges challenged the new plan on three bases. First, the Consolidated Equity Plan provided that it would be administered by an operating committee that would include members that were not “self-regulatory organizations” (“SROs”), a set of entities “comprised in large part of the various securities exchanges, including petitioners.” The non-SRO members “would include representatives of six classes of equity market participants: institutional investors, broker-dealers with a predominantly retail investor customer base, broker-dealers with a predominantly institutional investor customer base, securities market-data vendors, issuers of NMS stock and retail investors.” These members would collectively have one-third of the voting power on the committee. The D.C. Circuit concluded that “the Commission’s decision to include representatives of non-SROs on the CT Plan operating committee is unreasonable.”

The Commission purported to include these non-SRO members on the basis of its authority under Exchange Act section 11A(a)(3)(B), which gives the SEC the power “by rule or order, to authorize or require self-regulatory organizations to act jointly with respect to matters as to which they share authority under [the Exchange Act] in planning, developing, operating, or regulating a national market system.” But the court of appeals found “the Commission’s reading of section 11A(a)(3)(B) both to expressly identify SROs as those entities that can act jointly in developing and effectuating the national market system and to authorize by implication a non-SRO to exercise similar governance authority would render the former superfluous.” Moreover, the reference to the SROs “shar[ing]” authority evinces the intent to “share” such authority with entities having “statutory and regulatory obligations” that the non-SROs do not. And, although the Commission pointed also to Section 11A(c)(1)(B)—which provides that “[n]o self-regulatory organization, member thereof, securities information processor, broker, or dealer shall … collect, process, distribute, publish, or prepare for distribution or publication any information with respect to quotations for or transactions in any security … in contravention of such rules and regulations as the Commission shall prescribe to … assure the prompt, accurate, reliable, and fair collection, processing, distribution, and publication of information with respect to quotations for and transactions in … securities”—that language “says nothing about the national market system or its development or operation, [but] merely indicates that non-SROs … play enough of a role in the dissemination of market data to warrant granting the Commission antifraud authority to police [them].” Accordingly, “the Commission’s decision to include representatives of non-SROs on the [Consolidated Equity] Plan operating committee is unreasonable and therefore invalid.”

The petitioners’ second challenge attacked a voting protocol that blunts the voting effect of “‘exchange groups’—multiple exchanges operating under the same corporate umbrella.” Specifically, the Consolidated Equity Plan provided that an SRO not affiliated with another SRO would have one vote on the operating committee, while groups would have one vote collectively, unless the group had “a ‘consolidated equity market share’ greater than 15%,” in which case the group would have two votes. The Commission reasoned that the exchange groups, if each of their members were given a vote, would control much of the voting power by voting as blocks of four or five votes. Since the members of the exchange groups were also the “‘primary producers of exchange proprietary data products’”—the outsized voting power of these blocks “would create[] and exacerbate[] conflicts of interests between exchanges’ business interests and regulatory obligations under the Exchange Act,” with blocks incentivized to vote against improvements in the delivery of core data and expansion of core data content in order to maintain or expand the competitive advantage enjoyed by their proprietary services.

While the challenging exchanges argued that this voting protocol violated the law because section 11A(a)(3)(B) requires all SROs “be on equal terms,” the D.C. Circuit held that “nothing in section 11A appears to require the strict one-to-one voting representation by individual SROs.” In particular, the section’s reference to “act[ing] jointly” “simply means to act cooperatively, together or in conjunction … [and] does not require a particular level of involvement among the individual members—such as ‘one SRO, one vote,’ as petitioners seem to suggest—so long as all participants are involved to some degree.” Although the petitioners contended that the voting structure “subjects affiliated SROs to less favorable treatment than unaffiliated SROs, without adequate explanation,” the court of appeals held that the Commission had provided such an explanation by “citing the need to mitigate the Equity Data Plans’ practical dilution of unaffiliated exchanges’ voting power,” subjecting them to outsized influence by a small number of exchange groups whose sale of proprietary data products created a conflict of interest when considering upgrades to core data delivery and content.

Third, the challengers contested the Consolidated Equity Plan’s requirement that the plan have an “independent administrator”—“meaning ‘not … owned or controlled by a corporate entity that, either directly or via another subsidiary, offers for sale its own [proprietary-data products].’” The petitioning exchanges contended that this provision arose from the SEC’s “‘purely theoretical’ concern that a CT Plan administrator could misappropriate confidential information”—which the SEC did not support either by pointing to a current or past equity plan administrator committing such misconduct or by describing “shortcomings of existing safeguards.” But the D.C. Circuit found that (i) the Commission had “highlighted a plausible conflict of interest: the potential misuse of ‘sensitive SIP customer information of significant commercial value’ by administrators that sell competing market data products,” and (ii) it was “of little consequence” that “the Commission’s conflict of interest worry has not yet manifested itself …, as an agency has the latitude to ‘adopt prophylactic rules to prevent potential problems before they arise’—that is, ‘[a]n agency need not suffer the flood before building the levee.’”

The petitioners also pointed to the oddity that while the new plan would exclude an SRO that offered proprietary data products from serving as the administrator, it would permit selection of an administrator that was not an SRO but that sold market data, even though such a non-SRO “could have similar conflicts of interest.” But the court ruled that the SEC was not required to address all conflicts rather than attack targeted ones and that, in any event, the SROs on the operating committee would “have ‘sufficient voting power’ and ‘incentive’ to ensure that any non-SRO chosen to serve as administrator ‘would [not] face a financial conflict of interest and act as a direct competitor to the SROs’ proprietary data business.’” As to the contention that the independence requirement would prevent either the Nasdaq or NYSE from serving as the administrator under the new plan and thereby forfeit the opportunity to make use of the institutional knowledge they had gained by acting as the administrators of the preceding equity market data plans, the D.C. Circuit found that the Commission had considered this cost and concluded that elimination of the inherent conflicts outweighed it.

Having thereby determined that the provision requiring non-SROs to serve on the Consolidated Equity Plan’s operating committee exceeded the Commission’s authority, that the provision allocating voting rights on that committee so as to limit the power of exchange groups was neither contrary to law nor arbitrary and capricious, and that the provision requiring an independent administrator was not arbitrary and capricious, the D.C. Circuit turned to disposition. Ruling that the illegal addition of non-SROs to the Consolidated Equity Plan’s operating committee was not separable from the plan as a whole, the panel granted the petitions for review to the extent they rested on that challenge and vacated the Consolidated Equity Plan order in its entirety.

Significance and analysis. Putting aside the technicalities of market data distribution, the idea that the Commission can avoid arbitrary and capricious challenges by pointing to a “plausible” conflict of interest (here on the part of a plan administrator that might misappropriate confidential information to exploit for its own profit) without empirical support (nothing to show that the administrators of the existing plans—NASDAQ and an NYSE subsidiary—had done so) and that elimination of this “plausible” conflict outweighs acknowledged costs (such as the loss of the current administrators’ experience) raises serious questions. It suggests that the Commission can adopt virtually any rule within its legal authority simply because SEC lawyers conjure a possible justification and put it down in prose. Such a scenario recalls the scholarly criticism of “quack” lawmaking in the early part of this century that rested on hypotheticals that made sense to lawyers but lacked empirical justification.

New Market Infrastructure Plan. In a second market data distribution decision, the D.C. Circuit considered challenges by exchanges to a Market Infrastructure Plan (“Infrastructure Plan”) the SEC adopted in 2021. The Commission adopted the Infrastructure Plan out of concern that market participants faced a two-tier information choice. First, a participant could subscribe to a core data feed, provided to subscribers through two exclusive securities information processors that obtained raw information directly from exchanges and compiled it for transmission. That core data was limited to “(1) the price and size of the last sale and the exchange on which the sale took place; (2) each exchange’s current highest bid and lowest offer, and the number of shares available at those prices; and (3) the national highest bid and lowest offer for each stock on any exchange.” Second, a market participant could subscribe, for a higher price, to proprietary data feeds developed and marketed by the exchanges that “deliver data to subscribers much faster than the core data feeds” and that “may also contain much more detailed information about the range of transactions taking place on the exchanges, rather than just the best bid and best offer quotes.”

The Infrastructure Plan expands “core data” to include additional information, such as depth of book. The plan also “compels the exchanges to distribute” “underlying trading data” “to competing data consolidators for a fee set by a committee, consisting of the exchanges and other major market players and approved by the Commission,” so that those “competing consolidators, who must register with the Commission, may develop different kinds of data feeds in accordance with market demand based on the varied needs of investors.” The plan further “permit[s] market participants to ‘self-aggregat[e]’ by purchasing raw data directly from the exchanges and consolidating it for their own internal use.” The overall goal is to reduce information asymmetry between market participants and encourage the development and sale of a wide range of data feeds to meet the needs and budgets of different investors.

Exchanges challenged the Infrastructure Plan as (i) arbitrary and capricious and on the basis that (ii) the Commission adopted the plan without accounting for a variety of adverse outcomes, thereby “violating its statutory duties to weigh the Rule’s economic impacts, to protect investors and the public interest, and to promote the fair collection and distribution of market data.” The D.C. Circuit rejected all these arguments and denied the exchanges’ petitions.

The exchanges offered two contentions to support their position that SEC adoption of the plan was arbitrary and capricious. First, they averred that the plan would not reduce information asymmetries but simply turn a two-tiered system into a multitiered one, but the court responded that “the Commission aimed not to require that every market participant have access to the same data at the same speed, but rather to address a dearth of options for consumers with widely divergent data needs in the existing marketplace.” Second, the exchanges argued that the “Rule rests on speculation”—about the number of new entrants into the market for data distribution and the number of institutions that would decide to self-aggregate. But the court of appeals answered that, while “there was some uncertainty about the number of entrants to the market,” the Commission had engaged in an elaborate analysis including “the barriers to entry for would-be competing consolidators; the anticipated fees to be charged for the underlying data the consolidators would purchase, aggregate, and sell; the fixed ‘connectivity’ costs to competing consolidators, i.e., the fees charged to cover the cost of transmitting the underlying data to the competing consolidators; the anticipated demand for the competing consolidators’ data products; and the competing consolidators’ ability to offer differentiated data products.” That analysis was enough to show that the SEC had “‘considered the relevant factors and “articulate[d] a rational connection”’” between the facts considered and the prediction it made.

Addressing four arguments the petitioners raised contesting the Infrastructure Plan as inconsistent with the Commission’s statutory objectives to protect investors and promote competition, the court turned first to the exchanges’ position that the SEC had failed to reasonably conclude that the new plan would not adversely affect “the availability of a single, reliable ‘national best bid and offer’ quote to the detriment of retail investors.” This argument rested on the prediction that the many different data vendors the plan contemplates would produce different best bids and offers, thus destroying the uniformity of the NBBO numbers that ensure that retail sellers and buyers have their order executed at the most favorable prices. The D.C. Circuit answered that the Commission had recognized that, with the multiple data vendors already operating under the superseded data distribution plans, such “fragmentation already exists … [with] some market participants rely[ing] on the national best bid and offer as calculated by the exclusive processors, while others ‘calculat[e] their own version by aggregating petitioners’ faster proprietary-data feeds or hiring a third-party vendor to aggregate the data for them.’” The exchanges did “not explain[] how the national best bid and offer quote would be appreciably more fragmented under the new Rule than it is under the current regime.”

Second, the exchanges contended that the new plan “undermine[s] … [their] incentive to invest in … innovative data products,” thereby harming competition that would in turn harm investors. But this argument, the court of appeals concluded, focused narrowly on the exchanges’ own incentives and future actions, whereas the Commission was attempting to foster competition throughout the data distribution system as a whole that “would promote innovation in [that] broader data market and is designed to encourage a proliferation of new data products.”

Third, the exchanges contended that the Infrastructure Plan would also harm competition because it would reduce their revenues from their own proprietary data products, thereby weakening their ability to compete with off-exchange venues, increasing the proportion of trades on those darker trading platforms, and ultimately “reduc[ing] transparency in the marketplace as a whole,” but here again the court found that the exchanges were conflating their own position with that of the market overall. The fact that the plan might hurt them did not mean that the plan would not encourage competition in market data distribution in the aggregate. Moreover, the SEC had no obligation “to quantify each individual exchange’s anticipated revenue” loss.

Fourth, the exchanges averred more generally that their losing profits would produce “downstream harm” because that loss would “cripple their reinvestment in their own products” and limit their ability to fulfill their statutory duties. The court countered that funding for product development was “not limited to … internal cash-on-hand” because, “like any business, the exchanges can obtain external funding for promising opportunities to develop new products in the future” and any “notion that any reduction in revenue would necessarily compromise the exchanges’ bottom line so severely as to affect their ability to comply with their regulatory responsibilities is unsubstantiated.”

2. SEC Administrative Enforcement Proceedings—Procedure

Federal law permits the SEC to pursue enforcement actions in either federal court or before its own administrative law judges (“ALJs”), with remedies in both fora including prohibitions (in the form of injunctions in court and cease-and-desist orders in administrative proceedings), disgorgement, officer and director bars, and civil penalties. In 2022, the Fifth Circuit rendered an opinion throwing into doubt the future of the administrative proceeding option, holding that (i) administrative proceedings violated respondents’ Seventh Amendment right to a jury trial, (ii) the statute giving the SEC the unguided discretion to proceed against a putative securities law violator either in federal court or by administrative enforcement violated the U.S. Constitution’s Article I provision resting “all” legislative power in Congress, and (iii) the double for-cause layers insulating the SEC ALJs from removal violated the Take Care Clause of Article II. The Fifth Circuit also held that, with amendments to the SEC’s enforcement powers in 2021, Congress created a new “legal” disgorgement in 15 U.S.C. § 78u(d)(3)(A)(ii) and (d)(7)—different from “equitable” disgorgement in 15 U.S.C. § 78u(d)(5)—and affirmed the disgorgement in the case before it as permitted by the recent amendment.

Administrative enforcement proceedings and right to jury trial, delegation by Congress of unrestricted discretion to choose between federal lawsuit and administrative proceeding, and double-layer for-cause removal protection for ALJs. The SEC filed an administrative enforcement proceeding against George Jarkesy and an investment advisor to two hedge funds that Jarkesy had established. An SEC ALJ found that the respondents had committed securities fraud and, on review, the SEC agreed; the Commission (i) imposed a cease-and-desist order against further violations, (ii) ordered the investment advisor to disgorge $685,000, and (iii) barred Jarkesy from (a) associating with brokers, dealers, or investment advisors, (b) offering penny stocks, and (c) serving as an officer or director of a fund advisory board or as an investment adviser. The Commission also imposed a $300,000 civil penalty, for which both Jarkesy and the investment advisor were jointly and severally liable.

In 2022, the Fifth Circuit granted the respondents’ petition for review and vacated the SEC’s decision on three bases: “(1) the SEC’s in-house adjudication of Petitioners’ case violated their Seventh Amendment right to a jury trial; (2) Congress unconstitutionally delegated legislative power to the SEC by failing to provide an intelligible principle by which the SEC would exercise the delegated power [to proceed by court action or administrative proceeding], in violation of Article I’s vesting of ‘all’ legislative power in Congress; and (3) statutory removal restrictions on SEC ALJs violate the Take Care Clause of Article II.”

As to jury trial, the court of appeals reasoned that the Seventh Amendment right extends to “all actions akin to those brought at common law as those actions were understood at the time of the Seventh Amendment’s adoption.” “Whether Congress may properly assign [such] an action to administrative adjudication [and thereby foreclose a jury] depends on whether the proceedings center on ‘public rights.’” And whether such an assignment is proper depends on “(1) whether ‘Congress “creat[ed] a new cause of action, and remedies therefor, unknown to the common law,” because traditional rights and remedies were inadequate to cope with a manifest public problem’; and (2) whether jury trials would ‘go far to dismantle the statutory scheme’ or ‘impede swift resolution’ of the claims created by statute.”

Pursuing this analysis, (i) “[f]raud prosecutions were regularly brought in English courts at common law,” including those to “‘make the defendant liable in strictness to pay a fine to the king, as well as damages to the injured party’”; and (ii) jury trials would not dismantle the federal regulation of securities or interfere with swift disposition of Commission cases since the securities statutes expressly permit the SEC to bring such cases in federal court and the Commission “has in fact brought many such actions to jury trial over the years.” Accordingly, Jarkesy and the investment advisor to the hedge funds had a constitutional right to a jury trial “to adjudicate the facts underlying any potential fraud liability that justifies [civil] penalties.” Moreover, that right extended to the questions of fact that underlay the equitable relief that the Commission had sought, where those same questions underlay the legal relief. By filing the enforcement proceeding administratively, the SEC stripped the defendants of their right to a jury trial and thereby violated their Seventh Amendment rights.

Turning next to whether the statutory scheme—permitting the Commission to choose between filing an enforcement action in federal court or before the SEC’s ALJs—amounted to an unconstitutional delegation of legislative power to the executive branch, the Fifth Circuit observed that “Article I of the Constitution … provides that ‘[a]ll legislative Powers herein granted shall be vested in a Congress of the United States.’” And “power to assign disputes to agency adjudication is ‘peculiarly within the authority of the legislative department.’” Congress may delegate that power “only if it provides an ‘intelligible principle’ by which the recipient of the power can exercise it.”

Here, Congress “gave the SEC the ability to determine which subjects of its enforcement actions are entitled to Article III proceedings with a jury trial, and which are not. That was a delegation of legislative power.” Since “[e]ven the SEC agrees that Congress has given it exclusive authority and absolute discretion to decide whether to bring securities fraud enforcement actions within the agency instead of in an Article III court” and “said nothing at all indicating how the SEC should make that call in any given case,” the grant was made without an intelligible principle of how that discretion was to be exercised and, accordingly, was constitutionally impermissible.

Moving finally to whether the scheme for removal of ALJs violates the Constitution, the Fifth Circuit began with the constitutional requirement “that the President must ‘take Care that the Laws be faithfully executed.’” In order to discharge this duty, “the President must have adequate power over officers’ appointment and removal.” The Supreme Court ruled in Free Enterprise Fund v. Public Co. Accounting Oversight Board that the PCAOB statute violated the Take Care clause because (i) only the SEC could remove Board members and only then “for ‘willful violations of the [Sarbanes–Oxley] Act, Board rules, or the securities laws; willful abuse of authority; or unreasonable failure to enforce compliance—as determined in a formal Commission order, rendered on the record and after notice and an opportunity for a hearing’”; and (ii) the President “could only remove SEC Commissioners for ‘inefficiency, neglect of duty, or malfeasance in office.’” The Court held that these two stacked for-cause protections “insulating PCAOB members from removal deprived the President of the ability to adequately oversee the Board’s actions,” as the Take Care clause required him to do.

Similarly here, the “SEC ALJs may be removed by the Commission ‘only for good cause established and determined by the Merit Systems Protection Board (MSPB) on the record after opportunity for hearing before the Board[,]’ … [a]nd the SEC Commissioners may only be removed by the President for good cause.” Accordingly, “SEC ALJs are sufficiently insulated from removal that the President cannot take care that the laws are faithfully executed” and the statutes creating the double for-cause layers “are unconstitutional.”

Significance and analysis. Lay controversy over what some call the “administrative state” flourishes, with some arguing that vast bureaucracies now essentially make laws and then enforce them through their own internal “court” systems—all without accountability to the voting public and even without effective control by either Congress or the President. Legal battles on this idea have played out in securities cases. Perhaps this will prove a benefit, nudging the administrative state discussion away from such fraught subjects as immigration, pandemic responses, and student loan forgiveness and thereby encouraging more dispassionate discourse.

Creation of “legal” disgorgement by 2021 Exchange Act amendments—15 U.S.C. § 78u(d)(3)(A)(ii) and (d)(7). In 1971, the Second Circuit held that the SEC could seek “‘restitution of profits’” in enforcement actions, finding the authority to award it “in the ‘general equity power’ conferred by the Exchange Act.” One year later, that court referred to such relief as requiring a wrongdoer to “disgorge” profits. Seventeen years thereafter, the D.C. Circuit adopted a burden-shifting rule, ultimately accepted in all other circuits, by which the government has the initial burden of proving up “an amount [that] reasonably approximated a defendant’s unlawful gain,” which the defendant can then challenge “by demonstrating ‘a clear break in or considerable attenuation of the causal connection between the illegality and the ultimate profits,’” with opinions subsequently holding that a district court’s ultimate decision on the amount is reviewable only for abuse of discretion.

In 2002, the Sarbanes-Oxley Act amended the Exchange Act to include 15 U.S.C. § 78u(d)(5): “In any action or proceeding brought … [by the SEC] under any provision of the securities laws, [the SEC] may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.”

In 2017, the Supreme Court’s Kokesh v. SEC decision held that, “as it is applied in SEC enforcement proceedings,” disgorgement was a penalty subject to the five-year statute of limitations for penalties. In its 2020 Liu v. SEC opinion, the Supreme Court observed that Kokesh “evaluated a version of the SEC’s disgorgement remedy that seemed to exceed the bounds of traditional equitable principles,” and that, as properly bounded, equitable disgorgement must be limited to “net profits,” calculated to “deduct legitimate expenses before ordering disgorgement.” The Court also held that wide-ranging joint and several liability is inconsistent with proper limits on disgorgement, but that collective liability could reach “partners in wrongdoing,” and suggested that disgorgement recovery under 15 U.S.C. § 78u(d)(5) might—in order to fit within the statutory limits—have to be returned to victims instead of being deposited into the U.S. Treasury or some fund for whistleblower awards and the SEC’s Inspector General.

In 2021, Congress amended the Exchange Act again. The amendments (i) expressly conferred on district courts, by 15 U.S.C. § 78u(d)(3)(A)(ii), jurisdiction “‘to … require disgorgement under paragraph (7) … of any unjust enrichment by the person who received such unjust enrichment as a result of [an Exchange Act] violation’”; (ii) provided in 15 U.S.C. § 78u(d)(7) that “‘[i]n any action or proceeding brought by the [SEC] under any provision of the securities laws, the [SEC] may seek, and any Federal court may order, disgorgement’”; (iii) established by 15 U.S.C. § 78u(d)(8)(A) a five- or ten-year limitations period for “‘disgorgement,’” depending on whether the underlying securities law violation required scienter, while setting a ten-year period for “‘any equitable remedy’”; and (iv) mandated that all these amendments would apply not only to new cases but also to actions pending on the date the amendments were enacted.

Last year, the Fifth Circuit struggled to make sense of this history in SEC v. Hallam and, in the process, identified two different SEC disgorgement remedies.

Two members of the Fifth Circuit panel differentiated between what they called “legal disgorgement,” permitted by 15 U.S.C. § 78u(d)(3)(A)(ii) and (d)(7), and “equitable disgorgement,” permitted by 15 U.S.C. § 78u(d)(5)—the statute interpreted by Liu. This majority declined to decide “whether equitable disgorgement has survived the 2021 Exchange Act amendments” or whether legal disgorgement implicates the Seventh Amendment right to a jury trial.

They did hold, however, that proof of the amount owed by legal disgorgement is subject to the shifting burden of proof set out above and that legal disgorgement may be had without the SEC tracing the particular funds to be disgorged back to the money obtained from the securities violations. Such an award is not subject, they reasoned, to the Liu constraint that it include only “net profits,” but “an award including income that a defendant earned on his unjust enrichment is not permissible as legal disgorgement,” although interest on the unjust receipts is allowed.

In the case before the Fifth Circuit, the defendant had entered into an agreement with the Commission by which he did not contest liability but “agreed to certain remedies at a high level of generality,” including “‘disgorgement of ill-gotten gains.’” The district court ordered the defendant to disgorge $1,901,480 and pay $424,375.38 in prejudgment interest. Affirming, the Fifth Circuit majority held that “the award was permissible as legal disgorgement” and hence did “not consider whether it met the standards for equitable disgorgement … under Liu.” Following the analysis set out above, the court of appeals rejected the defendant’s argument that the order should be reversed because the SEC had not traced the proceeds to be disgorged back to the securities law violations, this argument having been “foreclosed” by Congress through the 2021 amendments. As to his argument “that the energy companies he helped run weren’t completely fraudulent,” the majority responded that this did not “change the fact that all of the securities transactions during the relevant period were unlawful” because they were sold by “‘misleading offering materials’” and that the district court’s “calculation of [the defendant’s] unjust enrichment was ‘the compensation Hallam received for his role in the sale of these securities.’” While, in order to be disgorged, “the payments must have been connected to the companies for which [he] sold securities,” the defendant “provided little detail and no proof for [the] assertion” that they were not, which was his burden because “[t]he district court concluded that the SEC had met its burden reasonably to approximate Hallam’s net profits from the securities violations at $1,901,480.”

Significance and analysis. The Fifth Circuit’s analysis suggests that (i) the Supreme Court found that SEC enforcement actions had been slipping the bounds imposed by equity in the disgorgement orders the Commission had been requesting; (ii) Kokesh and Liu, together, meant to correct this departure; (iii) Congress responded by amending the Exchange Act in 2021 to create a kind of disgorgement that (a) would not be limited by equitable boundaries but (b) would have other characteristics of previous federal disgorgement practice, such as the burden-shifting protocol governing proof of amount. Whether the Supreme Court will agree with this interpretation is an open question.

3. SEC Enforcement Actions—Substance

The Ninth Circuit affirmed summary judgment against three defendants on the ground that they operated as unregistered brokers, resting its analysis on the short statutory definition of “broker” instead of a commonly employed multifactor test. The Tenth Circuit affirmed summary judgment granted to the Commission on Rule 10b-5 violations based on a CEO’s false statements concerning discussions with Apple, Inc. about Apple possibly using technology that the CEO’s company had developed.

Definition of “broker.” Exchange Act section 15(a) makes it “unlawful for any broker … to effect any transactions in … any security … unless such broker … is registered” with the SEC. Section 3(a)(4)(A) defines “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”

The SEC brought an enforcement action against Sean Murphy, Jocelyn Murphy, and Richard Gounaud, alleging that they violated section 15(a) by failing to register as brokers while engaging in municipal bond trading for the account of a client, Ralph Riccardi. Riccardi provided capital for the trades by linking his prime brokerage account to accounts in the individual names of the three defendants. While the defendants and Riccardi testified that the defendants “had complete discretion to trade as they pleased and were ‘never obligated to buy’ the bonds requested by Riccardi,” the “record brim[med] with examples of Riccardi directing [the defendants] to buy certain bonds and [defendants] complying,” and the defendants “provided no evidence that they ever declined to purchase a bond requested by Riccardi.” When the defendants bought and sold bonds with funds that Riccardi provided, they shared both profits and losses with him.

Affirming the district court’s summary judgment for the Commission, the Ninth Circuit interpreted the statutory definition by holding that “when someone places another’s capital at risk by trading securities as his or her agent, he or she is trading securities ‘for the account of others,’ and is a ‘broker’ subject to § 15(a)’s registration requirements.” The defendants fit within this definition. They “made trades for ‘the account of [Riccardi]’ because they put Riccardi’s capital at risk on every trade they made” and “[i]f the trade was unprofitable, Riccardi would bear a portion of the loss.” And they “traded ‘for’ Riccardi because they acted as his ‘agents,’” under his control because “when Riccardi directed Appellants to place a trade, they complied.”

Significance and analysis. The district court had concluded that the defendants were brokers by applying a multifactor test enunciated by SEC v. Hansen. Two members of the Ninth Circuit panel filed a concurrence in which they generally excoriated such tests as providing too little ex-ante guidance to the relevant regulated population and too much ex-post discretion to district courts. They cautioned that “[w]e should avert our gaze from the temptations of a non-exclusive multifactor test when, as here, the statute provides enough guidance.”

Murphy includes one other holding of note. The district court imposed civil penalties. The amounts of the penalties were based on the number of violations multiplied by statutory penalty amounts. The Ninth Circuit acknowledged that “[t]he civil-penalty provision of the Exchange Act sets maximum penalties ‘for each violation,’ but does not define ‘violation’” and observed that “[d]istrict courts have discretion to determine what constitutes a ‘violation’ and have relied on various proxies.” Here, the SEC requested that the number of tier-one violations used to compute penalties for Sean Murphy and Gounaud match the number of months during which each traded as unregistered brokers—respectively, sixty-five and forty-six—and the court used that method to calculate the penalty limits but discounted off those limits by 20 percent, bringing the amounts down to $414,090.40 against Sean Murphy and $308,512.80 against Gounaud. The Ninth Circuit found no abuse of discretion in part because using the number of transactions conducted without registration would have resulted in “thousands of violations.” The district court imposed civil penalties on Jocelyn Murphy of $1,761,920, concluding that she committed twenty-one tier-two “violations” because she provided false zip codes to underwriters in twenty-one conversations, even though she argued that “her § 10(b) liability turned on only three fraudulent transactions.”

Counting the number of Rule 10b-5 violations by the number of conversations in which a defendant made material false statements makes some sense, but so would using the number of times the defendant repeated the false statements in those conversations (which here would have increased the number of “violations”) and so would the number of transactions that the false statements affected (which would have decreased the number). Computing the number of violations by the number of months a defendant operated as an unregistered broker, multiplying those months times the statutory penalty limit, then discounting by 20 percent, looks like backing into a number rather than a principled decision. Leaving all of this to the discretion of the district court smacks of rule by black-robed men and women rather than by law.

Liability for exaggerated representations of counterparty interest in technology purchase. The Commission pursued GenAudio, Inc. (“GenAudio”) and its CEO, Jerry Mahabub, in a federal court enforcement action, winning summary judgment against them for violations of (i) Rule 10b-5 by six statements that Mahabub made, (ii) Securities Act section 17(a)(2) by one of those statements, and (iii) Securities Act section 5 by two offerings (one in 2010 and the other in 2011). GenAudio produced software designed to change the perceived audio source from one location to a different location—to create the effect, for example, that the sound was coming from behind the listener even though the listener was facing the speaker. The violations grew out of an effort by GenAudio to convince Apple, Inc. to incorporate the GenAudio software into Apple products.

The district court ordered that GenAudio disgorge its proceeds from the two offerings (totaling $4,503,000) and pay a civil penalty in an equal amount. The judgment ordered Mahabub to disgorge $1,280,900 from his personal sales of GenAudio shares and pay a civil penalty of the same amount. The lower court also enjoined both defendants from further violations of the securities laws and barred Mahabub from serving as an officer or director of a public company.

Affirming, the Tenth Circuit reviewed summary judgment on each of the six statements. In a March 10, 2010 email to GenAudio shareholders, Mahabub wrote that “GenAudio was ‘starting to discuss the business side with the LCEC,’” which both the defendants and the Commission understood to mean Large Consumer Electronics Company—in all relevant communications here, Apple, Inc. (“Apple”). While Mahabub contended that, on the basis of discussions between the two companies, he believed the statement he put into the email, the Tenth Circuit held that “[t]he securities laws impose a personal obligation on corporate executives … to sufficiently ground their communications in facts.” The appellate court’s review convinced it that “[i]rrespective of the business overtures that Mr. Mahabub made to Apple’s executives, they had made it crystal clear that no business negotiations would take place between GenAudio and Apple until after there was ‘exec buy-in,’ and the record provides no basis for a reasonable belief that such buy-in had occurred when Mr. Mahabub sent the email on March 10.” This sequence supported not only the district court finding that Mahabub’s email was false but also that he sent the email with at least the recklessness that suffices for Rule 10b-5 scienter.

In the same March 10, 2010 email to GenAudio shareholders, Mahabub said “that he ‘expect[ed] to have a very substantial license deal in place for [the LCEC’s] Christmas Product Rollout.’” But the Tenth Circuit found “that GenAudio’s discussions with Apple had not reached the point—by the time Mr. Mahabub sent the March 10 email … —where Mr. Mahabub could have harbored any reasonable belief that any licensing deal was even on the table for discussion with Apple.” As to falsity, “any fanciful belief that may have led Mr. Mahabub to send the email regarding the purported Christmas product rollout did not ‘fairly align[ ] with the information’ in his ‘possession at the time,’ and his words—whether expressing an opinion or not—provide the foundation for liability under the securities laws.” As to scienter, “[t]he ‘Christmas product rollout’ statement at issue here was false—indeed, fabricated. And, at a minimum, Mr. Mahabub—the acknowledged fabricator of the statement—acted with recklessness in communicating it.”

The third liability-generating statement appeared in a cover letter sent with the 2010 offering documents, and represented that that offering “was ‘being conducted to provide bridge capital until we can “ink” a deal with … [the LCEC].’” Here the Tenth Circuit focused on use of the term “bridge capital,” reasoning that it “was intended to (falsely) communicate that a deal between GenAudio and Apple was imminent and that the 2010 Offering was needed to provide GenAudio with capital during the reasonably short period necessary to close the deal with Apple.” The disjunction between the reality of the GenAudio/Apple discussions and the normal meaning of “bridge capital” (temporary capital needed to bridge the liquidity gap before permanent capital arrives) led to the conclusion that Mahabub’s use of the term constituted a false statement made recklessly in a 10b-5 sense.

An April 30, 2010 email from Mahabub to an investor included the fourth statement found fraudulent—“that Apple was ‘looking to acquire GenAudio’s tech for integration into their entire lineup of product offerings … and we are now waiting [for the time] when we will initiate negotiations, pending the CEO[’s] [approval of] the integrated product rollout strategy and the technical implementation strategy that will be presented to the CEO next week!!!’” In fact, Mahabub by the date of this email “had received absolutely no confirmation from his Apple contacts … that in the near future (much less the following week) there would be a presentation to Apple’s CEO of an integrated product-rollout strategy regarding GenAudio’s technology and also regarding a related technical-implementation strategy.” To the contrary, he had been told that any business discussions would await “‘exec buy-in on the product side.’” And, in fact, the meeting in the week following the email would “address first principles, such as whether the ‘idea’ or ‘concept’ that GenAudio’s technology illustrated was a ‘great’ one.” Accordingly, the Tenth Circuit agreed with the district court that “Mr. Mahabub ‘could not have reasonably failed to perceive that he was simply making things up as he wrote’ the April 30 email. Notwithstanding any contrary subjective beliefs that Mr. Mahabub may have harbored, we conclude that he acted at least recklessly (if not knowingly).”

The fifth false statement came from an August 1, 2010 Mahabub letter “claiming that Mr. Jobs had requested ‘a “hand-shake” meeting’ with Mr. Mahabub ‘[i]n the very near future.’” While the defendants argued that this representation was not material in light of the “exec buy-in” meeting at which the defendants said Mahabub anticipated that Jobs would green-light a deal, the court of appeals panel found itself “hard pressed to understand why it would not have been material to a reasonable investor that the CEO of the company that GenAudio was negotiating with regarding the use of its technology affirmatively requested a hand-shake meeting in ‘the very near future’ with GenAudio’s CEO, Mr. Mahabub.” In any event, Mahabub had been advised by this time that the internal Apple meeting in early May had been devoted only to discussing whether Apple’s use of the GenAudio technology made sense as a concept. As to the specific statement that Jobs had, in fact, asked for a “hand-shake” meeting with Mahabub, the district court had found this to be a “blatant lie,” and the Tenth Circuit concluded that “at the very least, Mr. Mahabub made the statement in reckless disregard of the relevant facts.”

The sixth and last statement appeared in “Mahabub’s March 29, 2011, email to shareholders that certain new agreements would completely prohibit him from mentioning the LCEC in future correspondence, including in the upcoming 2011 Offering.” The panel agreed with the district court that “Mahabub well knew (or at least recklessly disregarded), the natural effect of the email was to ‘tease[] shareholders’ about forward progress in GenAudio’s business negotiations with Apple—which a reasonable investor would have deemed to be material information.” In fact, Mahabub “knew that the evaluation agreements he needed to sign [the ‘certain new agreements’ to which his email referred] pertained to the broken-down iMacs he himself requested from Apple,” “specifically, an iMac ‘with a bad screen or some form of prototype that has bad parts in it’—to create a demonstration of AstoundSound.”

Turning from the fraud counts to the claim that Mahabub and GenAudio had violated the Securities Act section 5 requirement that every stock sale be either registered or qualify for at least one exemption from registration, the Tenth Circuit leaned on the rule that a defendant contesting a registration violation has the burden of proving that the sale satisfied an exemption rather than the Commission having to prove that possible exemptions did not apply. As to the Securities Act section 4(a)(2) exemption for nonpublic offerings, the defendants did “‘not describe any evidence [they] may introduce to persuade a jury that the relevant factors favor application of the exemption in [their] favor.’” As to the Rule 506 exemption, the defendants could not prove that either the 2010 or 2011 offering had solicited no nonaccredited investors, which was integral to the exemption because it required that all nonaccredited purchasers must have been provided structured disclosure including audited financial statements, and GenAudio had provided no such audited statements.

Significance and analysis. GenAudio seems rightly decided, given its facts. But it highlights a real problem. Executives selling the technology or other asset of their own company to a counterparty may be unfamiliar with the counterparty’s internal processes. As a result, the selling company’s executives may misinterpret the significance of steps that the counterparty takes and pass that misinterpretation on to shareholders or the market. This may be a particular problem in the case where a small seller is selling to a large and bureaucratized buyer. Counselors to the seller should advise caution, conservative interpretations, and abundant warnings to all outsiders with whom the seller is communicating, with those warnings emphasizing that interim steps do not cement or guarantee any deal and, if appropriate, that the potential buyer’s internal considerations are opaque to the seller.

On the risk side, there was more to GenAudio than the six statements on which the district court awarded summary judgment. Most notably, Mahabub had altered emails from Apple before forwarding them on to others in ways that made a deal between GenAudio and Apple seem more probable. Those alterations may well have influenced the SEC’s decision to pursue an enforcement action. In short, and obviously, the risk of an enforcement action based on a misinterpretation of a counterparty’s interest increases with egregious conduct such as altering documents.

4. Effect on Federal Jurisdiction of Bylaw Choice of Forum Provision

Boeing Company (“Boeing”), a Delaware corporation, included in its bylaws a provision stating that “‘unless the Corporation consents in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware shall be the sole and exclusive forum for … any derivative action or proceeding brought on behalf of the Corporation.’” As part of a slew of lawsuits and investigations following two fatal crashes of Boeing’s 737 MAX airliner, a shareholder brought in federal court a derivative claim under Exchange Act section 14(a) alleging false statements in proxy materials in 2017–19 concerning the development and operation of that aircraft. Reversing dismissal by the district court after it granted a forum non conveniens motion resting on this bylaw, the Seventh Circuit reviewed the lower court ruling de novo because “the district court based its decision on its view of legal issues.” “[D]efendants conceded that enforcement of the forum bylaw [here] would foreclose the [plaintiff ’s] federal derivative suit entirely.”

Delaware General Corporation Law section 115 provided “that ‘bylaws may require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all of the courts in this State.’” A majority of the panel reasoned that the federal court in Delaware was one of “the courts in this State” within the meaning of section 115. Moreover, the synopsis covering section 115 when it was adopted stated that it “was ‘not intended to authorize a provision that purports to foreclose suit in a federal court based on federal jurisdiction.’” Accordingly, “[a]s applied here, Boeing’s forum bylaw violates Section 115 because it is inconsistent with the jurisdictional requirements of the Exchange Act of 1934, 15 U.S.C. § 78cc(a),” giving exclusive jurisdiction to federal courts over claims brought under that act.

5. Definition of Statutory Seller for Securities Act Section 12 Liability in the Internet Age

Section 12(a)(1) imposes liability on those who “offer or sell a security” without either registering the sale under the Securities Act or qualifying for an exemption from registration, and section 12(a)(2) imposes liability on those who “offer or sell a security” by a prospectus that contains material misstatements or omissions—with the liability running in each case “to the person purchasing such security from him.” In Pinter v. Dahl, the Supreme Court defined two categories of “sellers” who are proper defendants under section 12: (i) “the owner who passed title, or other interest in the security, to the buyer for value”; and (ii) those “who successfully solicit[ed] the purchase, motivated at least in part by a desire to serve [their] own financial interests or those of the securities owner.” In 2022, both the Eleventh Circuit and the Ninth Circuit held that those who promote securities on the internet can fall into the second category—soliciting sellers.

In the Eleventh Circuit case—Wildes v. BitConnect International PLC—the plaintiffs bought a cryptocurrency from BitConnect. It turned out that BitConnect was conducting a Ponzi scheme, with early investors receiving returns from money paid by later investors.

The cryptocurrency was sold through a multilevel marketing structure that offered investors the opportunity to become promoters, who could then offer the cryptocurrency to investors that they attracted—with some share of a new investment going to the promoter bringing in the new investor, another share to that promoter’s promoter, and so on.

Glenn Arcaro served as the “national promoter for the United States,” heading up “a team of regional promoters,” who “created an extensive U.S. marketing scheme” that “included multiple websites where Arcaro encouraged viewers to buy BitConnect coins.” When the scheme fell apart, investors filed a multicount complaint against Arcaro and five regional promoters, including a Securities Act section 12(a)(1) claim for selling unregistered securities. Reversing dismissal of that claim, the Eleventh Circuit disagreed with the district court’s conclusion that a soliciting seller must have “urged or persuaded” buyers “‘individually’ … to purchase BitConnect coins”; that is, by a “‘personal solicitation’ from the promoters.”

The court of appeals reasoned that (i) section 12(a)(1) imposes liability on a person who “offers or sells” a security in a transaction that is neither pursuant to an effective registration statement nor qualifies for an exemption from registration; and (ii) the statutory definition of “offer” includes “solicitation of an offer to buy.” The statutory definitions do not “limit solicitations to ‘personal’ or ‘individualized’ ones,” and the “Securities Act precedents do not restrict solicitations under the Act to targeted ones.” All that is needed is that the defendant “‘urge or persuade’ another to buy a particular security,” that the solicitation “succeed,” and that it “be motivated by a desire to serve the solicitor’s or the security owner’s financial interests.” The circumstance that technology permits mass solicitation via “podcasts, social media posts, or, as here, online videos and web links” makes no difference, “especially [since] the Act covers ‘any means’ of ‘communication.’”

Significance and analysis. BitConnect does not elaborate how the individual defendants received money from the cryptocurrency sales to individual plaintiffs, though that may not have been at issue given the multilevel marketing structure that BitConnect employed. More troubling, however, is that the Eleventh Circuit focuses only on the words “offers or sells.” Section 12 goes on to state that liability runs only from the seller to “the person purchasing such security from him.” As the Supreme Court put it in Pinter, the “clause of § 12[(a)], which provides that only a defendant ‘from’ whom the plaintiff ‘purchased’ securities may be liable, narrows the field of potential sellers” from all of those who might be swept in by the broad statutory definitions of “sale” and “offer to sell.” Illustrating what it meant by a soliciting seller, the Court provided this example: “A natural reading of the statutory language would include in the statutory seller status at least some persons who urged the buyer to purchase. For example, a securities vendor’s agent who solicited the purchase would commonly be said, and would be thought by the buyer, to be among those ‘from’ whom the buyer ‘purchased’ even though the agent himself did not pass title.”

The potential problem with disconnecting the solicitor from the purchaser through liability imposed simply on the basis that a defendant put a video pitch on the web that someone who later bought a security watched by clicking on a link is that it is unclear whether—even in our technologically advanced world—it “would commonly be said, and would be thought by the buyer” that the producer of the video or the speaker in it was “among those ‘from’ whom the buyer ‘purchased.’”

The Ninth Circuit followed the Eleventh in Pino v. Cardone Capital, LLC. Grant Cardone served as the CEO and sole manager of Cardone Capital, LLC, which managed Cardone Equity Fund V, LLC (“Fund V”) and Cardone Equity Fund VI, LLC (“Fund VI”)—both of which invested in real estate. Pino allegedly “invested a total of $10,000 in Funds V and VI.” Pino sued, purportedly on behalf of a class of all who purchased interests in the funds.

The operative complaint alleged as follows: Pino “attended the ‘Breakthrough Wealth Summit’ in Anaheim, California, hosted by Grant Cardone” on September 21, 2019. On September 23, Pino “invested in Fund V.” On September 26, 2019, “Cardone posted on the Cardone Capital Instagram account that Fund V is ‘the first Regulation A of its kind to raise $50 Million in crowdfunding using social media’ and that ‘[b]y accessing social media, I am offering investment opportunities to the everyday investor, like you!’” In a September 28 Instagram post, Cardone stated that funding for Fund V had closed and claimed that “[b]y using no middleman & going directly to the public using social media we reduce our cost. This ensures more of your money goes directly into the assets, resulting in lower promotional cost.”

Pino’s complaint alleged that Cardone and Cardone Capital violated Securities Act section 12(a)(2) by making “untrue statements of material fact or concealed or failed to disclose material facts in Instagram posts and a YouTube video posted between February 5, 2019, and December 24, 2019.” For example, Cardone allegedly stated in an April 22, 2019 YouTube video: “‘it doesn’t matter whether [the investor] [is] accredited [or] non-accredited … you’re gonna walk away with a 15% annualized return. If I’m in that deal for 10 years, you’re gonna earn 150%. You can tell the SEC that’s what I said it would be. They call me Uncle G and some people call me Nostradamus, because I’m predicting the future, dude; this is what’s gonna happen.’” And, in Instragram posts, Cardone advertised high rates of returns—e.g., a February 5, 2019 post asked rhetorically “‘[w]ant to double your money[?]’ and state[d] that an investor could receive $480,000 in cash flow after investing $1,000,000, achieve ‘north of 15% returns after fees’ and obtain ‘118% return amounting to 19.6% per year.’” Pino alleged that “none of the communications contained cautionary language either indicating that the promises were speculative, or identifying the risk associated with investing in Funds V and V[I] [sic].”

After the district court dismissed on the ground that the defendants had not “solicited” Pino’s purchase within the meaning of section 12 and the Pinter decision, the Ninth Circuit reversed insofar as the dismissal was based on that reasoning. There was “no question that Cardone and Cardone Capital had financial interests tied to the Funds. Cardone Capital received 35% of the Funds’ profits … .” There was accordingly no question that the social media communications set out above were motivated at least in part by the defendants’ own financial interests.

The key question was thus whether the social media communications constituted “solicitation” even though they were widely broadcast instead of personally directed to Pino or other purchasers in Funds V and VI. Leaning on the Eleventh Circuit’s reasoning in BitConnect, the Ninth Circuit concluded that “nothing in § 12 expressly requires that solicitation must be direct or personal to a particular purchaser to trigger liability under the statute. Put differently, nothing in the Act indicates that mass communications, directed to multiple potential purchasers at once, fall outside the Act’s protections.” And, from a policy viewpoint, including promoters’ social media posts within section 12(a)(2)’s liability net made sense because “the advertisements at issue in this case—Instagram posts and YouTube videos—are the types of potentially injurious solicitations that are intended to command attention and persuade potential purchasers to invest in the Funds during the ‘most critical’ first stage of a selling transaction, when the buyer becomes involved.”

6. Purchaser/Seller Rule for Standing in Private Rule 10b-5 Actions

In Blue Chip Stamps v. Manor Drug Stores, the Supreme Court adopted the Second Circuit’s Birnbaum v. Newport Steel Corp. holding that a private lawsuit to recover for a violation of Rule 10b-5 can only be brought by a plaintiff who was defrauded by the violation into purchasing or selling the relevant security. In Menora Mivtachim Insurance Ltd. v. Frutarom Industries Ltd., the Second Circuit applied that rule in a case where the target company in a merger allegedly made false statements about itself that led the plaintiffs to buy stock in the acquiring company.

Plaintiffs alleged that, from 2002 to 2018, Frutarom Industries (“Frutarom”)—an Israeli firm selling flavors and fragrances—bribed key employees to obtain business, as well as customs and quality assurance officials in Russia and Ukraine to facilitate importation of Frutarom products into those countries and secure certifications for the products there. After Frutarom agreed on May 7, 2018 to merge with Flavors & Fragrances Inc. (“IFF”) but before consummation of the deal, the IFF S-4 Registration Statement for the deal—filed on June 19, 2018—included Frutarom’s representation in the merger agreement “that since December 31, 2014, Frutarom had not ‘violated the [Foreign Corrupt Practices Act], the U.K. Bribery Act 2010, the [Organisation for Economic Co-operation and Development] Convention on Combating Bribery of Foreign Public Officials in International Business Transactions or any other applicable Law relating to anti-corruption or anti-bribery.’” Frutarom had also “attribut[ed] its financial growth in 2016 and 2017 to factors such as ‘organic growth,’ ‘acquisitions,’ and ‘positive currency effects’” without mentioning the bribery scheme.

The merger closed in October 2018. IFF “acknowledged” on August 5, 2019, “that Frutarom had ‘made improper payments to representatives of a number of customers’ in Russia and Ukraine.” IFF’s stock fell almost 16 percent.

Plaintiffs sued Frutarom and some of its officers under Rule 10b-5, with the plaintiffs purporting to represent those who acquired IFF stock between May 7, 2018 and August 12, 2019. Affirming dismissal, the Second Circuit panel majority held that the Blue Chip Stamps rule “requires plaintiffs to have bought or sold the security about which a misstatement was made in order to have standing to sue under Section 10(b).” Accordingly, plaintiffs “lack[ed] statutory standing to sue Frutarom based on alleged misstatements about Frutarom because they bought shares of IFF, not Frutarom.”

Significance and analysis. The third panel member concurred but would have decided the case on the narrower ground that the plaintiffs had failed to “demonstrate[] a sufficient relationship between Frutarom’s alleged misstatements and IFF’s stock price.” The majority reasoning seems preferable. Although the direct relationship language derives from a Second Circuit decision that interprets Blue Chip Stamps and therefore concerned standing, a “direct relationship” test sounds awfully close to the “in connection with” element of a Rule 10b-5 violation. The SEC must prove that element, but need not prove the additional standing element that a private plaintiff must satisfy. Accordingly, deciding the case on the standing question still leaves open the possibility that the SEC could bring a lawsuit in a case analogous to this one.

7. Relationship Between the Three Subparts of Rule 10b-5

Rule 10b-5 contains three subparts. Subpart (b) prohibits “mak[ing] any untrue statement of a material fact or … omit[ting] to state a material fact necessary in order to make the statements made … not misleading.” Subparts (a) and (c) do not include the word “statement” but respectively prohibit “employ[ing] any device, scheme, or artifice to defraud” and “engag[ing] in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.”

In Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., the Supreme Court held that liability under Rule 10b-5 in a private lawsuit is limited to primary violators of the rule and cannot encompass those who only aid and abet a violation. In Janus Capital Group, Inc. v. First Derivative Traders, the Court held that primary liability under Rule 10b-5 subpart (b) can be imposed only on defendants who “make” the prohibited statements, and that the “maker” of any such statement “is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” In Lorenzo v. SEC, the Court “recognized considerable overlap among the subsections of the Rule,” and held that a defendant who, with scienter, “disseminat[es]” a false or misleading statement violates Rule 10b-5(a) and (c), even if that defendant does not “make” the statement within the Janus definition of that word and even if “the only conduct involved concerns a misstatement.” On the other hand, the Lorenzo majority also “assume[d] that Janus would remain relevant (and preclude liability) where an individual neither makes nor disseminates false information—provided, of course, that the individual is not involved in some other form of fraud.” In 2022, the Second Circuit tried to reconcile these rulings in light of its own 2005 decision in Lentell v. Merrill Lynch & Co., holding that “where the sole basis for such claims is alleged misrepresentations or omissions,” a plaintiff cannot make out a case under Rule 10b-5(a) and (c).

The 2022 opinion considered an enforcement action brought against the Rio Tinto company (“RT”), its CEO, and CFO. The case centered on a Mozambique mine that RT bought in April 2011 for $3.7 billion, in the hopes that the company could mine coal there and transport it down the Zambezi River. As it turned out, the mine produced inferior coal, and Mozambique declined to permit shipment down the river, leaving only rail transport, which could only be accomplished with $16 billion in infrastructure improvements.

As the Second Circuit summarized it, the Commission alleged that “management from the Mine informed” the RT CEO and CFO on May 11, 2012 that “the Mine’s net present value was negative $680 million.” Two Controller’s Papers prepared for two different RT Audit Committee meetings—held respectively on June 18 and July 30, 2012 and both attended by the CEO and CFO—failed to “identif[y] impairment indicators or record[] impairments.” The company submitted an “Impairment Paper” to its outside auditor without any such indicators or impairment. RT filed a Half Year Report on August 9, carrying the Mine at more than $3 billion. The company sold $3 billion in bonds shortly thereafter through documents incorporating that report. A third Controller’s Paper prepared for a November 26 Audit Committee meeting “indicated a recoverable value of $4 to $5 billion (which meant that no impairment was likely to be required).”

After an RT valuation team disagreed with the $3 billion mine valuation, that team began a review in August 2012, which culminated in advice in late 2012 to the CEO and CFO “that valued the Mine in the range of negative ‘$4.9 billion to $300 million.’” At a January 15, 2013 meeting the RT board “approved an 80 percent impairment, valuing the Mine at $611 million.” A further impairment brought the stated value down to $119 million in 2014, and RT sold the Mine in October 2014 for $50 million.

The case thus revolved around RT’s failure to take the impairment earlier than it did. The trial court dismissed the Rule 10b-5(a) and (c) claim in the case and refused to reconsider that dismissal after the Supreme Court issued its Lorenzo opinion, the district court finding “no allegation that the Rio Tinto defendants disseminated false statements; the SEC alleged ‘only that [the defendants] failed to prevent misleading statements from being disseminated by others.’”

Affirming the order denying reconsideration, the Second Circuit panel held that Lorenzo did not abrogate Lentell. Acknowledging that “ramifications or inferences from Lorenzo” might “blur the distinctions between the misstatement subsection[] [Rule 10b-5(b)] and the scheme subsections [(a) and (c)] …,” the panel found that Lorenzo’s assumption that Janus retained vitality showed that Lorenzo “preserved the lines between the subsections.” And the panel concluded doing so was important for private cases because (i) “overreading … Lorenzo might allow private litigants to repackage their misstatement claims as scheme liability claims to ‘evade the pleading requirements imposed in [private] misrepresentation cases’” and (ii) effectively permit plaintiffs in private cases to pursue under subsections (a) and (c) those who were simply aiders and abettors of a (b) violation by another, thereby evading Central Bank. Most importantly, “[m]aintaining distinctions between the subsections of Rule 10b-5 … is consistent with the text.” As the Second Circuit majority summed it: “Lentell tells us that misstatements and omissions alone are not enough for scheme liability, and Lorenzo tells us that dissemination is one example of something extra that makes a violation a scheme.” Accordingly, “the district court did not abuse its discretion when it declined to reconsider the dismissal of the scheme liability claims in light of Lorenzo.”

8. Materiality

In many instances, securities law disclosure requirements apply only to material facts. In the context of a securities purchase, a fact is material “‘if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding’” whether to make the purchase, taking into account whether the fact “significantly altered the ‘total mix’ of information” otherwise available and relevant to the decision to buy or not. A claim under Rule 10b-5 based on a false or misleading statement requires that the action be based on either a false material fact or the omission of a material fact necessary for the statements made to avoid misleading. Securities Act sections 11 and 12(a)(2) incorporate the same materiality element in the same way when imposing liability under those provisions for false or misleading representations.

Last year, the Ninth Circuit affirmed dismissal in a case challenging statements about an issuer’s growth and market in China, finding multiple statements puffery. The Tenth Circuit held that most statements about an issuer’s sales force were immaterial but that a representation concerning the number of quota-bearing sales personnel could be material, given that the company had identified billings growth as its key business metric and given the relationship to that metric of the company’s productive salesforce headcount.

Puffery. In Macomb County Employees’ Retirement System v. Alignment Technology, Inc., the Ninth Circuit applied the definition of materiality to “distinguish between corporate braggadocio and genuinely false or misleading statements.” Align Technology, Inc. (“Align”) produced clear plastic braces. Largely driven by sales in China, Align’s year-over-year revenue grew from between 70 percent to 100 percent in every quarter in 2017 and 2018. Revenue continued to grow in 2019 but at a slower rate, falling to between 20 percent and 30 percent in the second quarter of that year, and Align’s stock price declined. Investors brought a Rule 10b-5 claim against the company and senior executives, alleging that the defendants “‘misrepresent[ed]’ Align’s growth in China throughout the second quarter of 2019, claiming strong numbers despite knowing (or recklessly disregarding) that the growth rate in China had slowed significantly.” The plaintiffs focused on twelve statements.

Although affirming district court dismissal, the Ninth Circuit found that the complaint “alleged sufficient evidence to support the inference that Align’s growth in China had slowed materially when the challenged statements were made in late April, May, and June 2019.” Nevertheless, six of the statements were non-actionable “‘puffery’ … ‘expressing an opinion’ that is not ‘capable of objective verification.’” These included answers to analyst questions during an April 24, 2019 earnings call that “‘[w]e still have a great business in APAC [Asia Pacific] from a growth standpoint overall,’ and ‘China is a great growth market for us’” and a June 5, 2019 description at a healthcare conference of China “as ‘a market that’s growing significantly for us’ with ‘[g]reat economics.’” The court of appeals reasoned that such “‘vague statements of optimism like “good,” “well-regarded,” or other feel good monikers, are not actionable because professional investors, and most amateur investors as well, know how to devalue the optimism of corporate executives.’” Important to this holding, however, was that “at the time Align’s executives made the six challenged statements, the company’s sales were still growing in China, albeit at a diminished rate, so these feel-good descriptions from Align’s executives did not ‘affirmatively create[] an impression of a state of affairs that differ[ed] in a material way from the one that actually exist[ed].’”

The Ninth Circuit held that the remaining six statements could not support a Rule 10b-5 claim because the complaint did not plead them false or misleading. As to three, “the complaint contains no allegations contrary to the assertions” that the statements contained. In a fourth, the Align CFO, “in response to an analyst question about competitors absorbing market share over a period of several years, … stated, ‘whether it’s in China or U.S. or other places, we’ve been competing against many of these companies that I mentioned for a number of years and still been able to grow as we have.’” Since “grow as we have” referred in context to “Align’s historical growth rate in China over at least the prior year if not longer,” it was “an accurate assessment” of that “past growth.” A fifth statement by the CEO responded to a question about a competitor so: “‘Straumann’s [the competitor] move with third- or fourth-tier player from a clear aligner standpoint, I don’t see that as dramatic effect on this market now or in the immediate future at all.’” The complaint “failed to plead sufficient facts to establish that this particular competitor’s presence in China caused the slowdown in Align’s growth, especially considering that the complaint referenced at least two other competitors in addition to Straumann (SmileDirectClub and Angel Align) that were putting pressure on Align in China.” The sixth statement appeared in the 10-Q that Align filed on May 2, 2019: “‘Demand for our products may not increase as rapidly as we anticipate due to a variety of factors including a weakness in general economic conditions.’” Since the plaintiff had not even bothered to contend on appeal that this representation could support the Rule 10b-5 claim, the Ninth Circuit found any such argument waived.

Specific statement about number of quota-bearing sales personnel. In a somewhat similar case, the Tenth Circuit affirmed in part but reversed in part a dismissal, holding that one alleged representation was sufficiently specific to be materially misleading while the other challenged statements were either generalized puffery or were not attacked with factual allegations to show that they were false.

Pluralsight, Inc. (“Pluralsight”) “told investors and analysts that Pluralsight’s sales force—including both the number of its sales representatives and their productivity—was the primary driver of Pluralsight’s billings growth” and “repeatedly stated that billings growth was Pluralsight’s ‘key business metric.’” On July 31, 2019, the company disclosed a decline in quarterly billings growth to 23 percent in the second quarter of that year, as compared to more than 40 percent in each of the preceding five quarters and acknowledged that this resulted from the company’s failure to add the planned number of additional sales personnel in the early part of the year—i.e., “until, kind of, early[-] to mid[-]second quarter.” Pluralsight’s stock price declined by about 40 percent.

Investors brought a Rule 10b-5 claim against the company, the CEO, and the CFO; and Securities Act section 11 and 12(a)(2) claims against them and all directors who had signed a registration statement for an offering in March 2019. The putative class for the Rule 10b-5 claims consisted of those who acquired Pluralsight stock between January 16 and July 31, 2019, and the class for the Securities Act claims consisted of those who could trace their stock to the March offering.

The complaint pled that eighteen statements were false or misleading in light of the number of the company’s sales force and the delay in increasing it. After the district court dismissed the entire case, the Tenth Circuit held that the plaintiffs adequately pled one statement false. In that one statement, the Pluralsight CFO said in a January 16, 2019 earnings call that the “‘aggregate quota-bearing sales reps went from about 80 [in recent years] to today we have about 250.’” The complaint pled that false “given [the CFO’s] later statement in January 2020 that Pluralsight had only 200 quota-bearing sales representatives coming into 2019.” Moreover, the CFO said on July 31, 2019 that Pluralsight “only had ‘about 250 quota-bearing reps right now,’ because it had been ‘dozens of reps’ behind until ‘early[-] to mid[-]second quarter’ of 2019”—which the court interpreted as admitting that the company had not had that number back in January.

The defendants did “not contest the materiality” of the “about 250” representation. Nor, in the Tenth Circuit’s view, could they, given that (i) the company itself had proclaimed that the number of its sales force was important in driving what Pluralsight identified as the key metric of billings growth and (ii) the allegations that “analysts consistently asked about Pluralsight’s sales force numbers, relayed [the CFO’s] representations in their reports to investors, and factored [his] statements into their investment recommendations.”

The Tenth Circuit also held that the complaint pled sufficient facts to allege that the CFO made the misrepresentation on January 16 with scienter. The panel interpreted the CFO’s remarks on July 31, 2019 and in January 2020 as “support[ing] the inference that in January 2019 [he] already knew that Pluralsight had only 200, not about 250, quota-bearing representatives.” In addition, “[t]he complaint allege[d] [that the CFO] consistently represented to analysts and investors that he carefully monitored sales force data, including the number of sales representatives and their productivity,” and the CFO knew that “investors consistently asked him about the size of the sales force at conferences and during earnings calls.” Moreover, during the class period, the CFO sold almost 40 percent of his Pluralsight stock for some $519,000, while he sold stock for only about $19,000 afterward.

As to the remaining statements, the Tenth Circuit found some inactionable puffery—Pluralsight “was ‘seeing some of the efficiencies in [its sales] model’”; the company had “‘built out some of the infrastructure around sales to scale’”; it “‘had a lot of great sales reps. They’re killing it’”; it expected “more goodness” from the sales force; it had “‘been able to drive substantial increases in the productivity and effectiveness of our sales personnel over time as they gain more experience selling subscriptions to our platform’”; it had “‘significantly expanded our direct sales force to focus on business sales’”; and, on May 1, 2019, that Pluralsight was then “‘on pace … to having 300-plus reps by the time we exit the year.’” As for plaintiffs’ contention that four risk factors—set out in the company’s 10-K filed in February 2019 and included in offering documents for Pluralsight’s March offering and a 10-Q it filed in May—misled because they warned of risks that had already materialized, the Tenth Circuit concluded that “even if Pluralsight had already fallen behind its sales ramp capacity plan by February 2019, that problem could still be remedied at the time Pluralsight disclosed the risk to investors” and found “nothing in the complaint support[ing] the inference that Defendants knew Pluralsight was so far behind in its sales ramp capacity plan that it was virtually certain to cause harm to the business.”

9. False or Misleading Statements

For a statement to violate Rule 10b-5, or section 11, or section 12(a)(2), it must not only be material but also false or misleading. Last year, the Fourth Circuit affirmed dismissal of a Rule 10b-5 action in which the plaintiffs challenged statements by a hotelier concerning a cybersecurity breach, finding insufficient facts alleged to show false or misleading the defendants’ statements that (i) protection of customer data was important; (ii) the hotelier had sought to protect that data; and (iii) a breach was possible, coupled with—after the breach at issue—a further statement that the hotelier had “experienced cyber-attacks.” The First Circuit affirmed dismissal of a Rule 10b-5 action constructed around post-acquisition representations about a pharmaceutical business made while the acquiring company incrementally wrote down the goodwill associated with that business.

Cybersecurity failure. In November 2018, Marriott International, Inc. (“Marriott”) disclosed a security breach putting 500 million guest records from its Starwood hotels at risk. Investors brought a Rule 10b-5 claim against the company and officers and directors, challenging seventy-three statements they made before announcing the breach. In affirming district court dismissal, the Fourth Circuit divided those statements into three categories and held that the complaint did not adequately allege that any of them were false or misleading.

First, Marriott stated that data protection was important. But those statements were not false for failing to “disclose severe vulnerabilities in Starwood’s IT systems” because the affirmations of privacy protection’s salience “did not ‘assign a quality to Marriott’s cybersecurity that it did not have.’” Moreover, “Marriott repeatedly warned [that it] may ‘fail[] to keep pace with developments in technology’; its systems ‘may not be able to satisfy’ the ‘information, security, and privacy requirements’ imposed by laws and regulations; and there were risks of ‘significant theft, loss, or fraudulent use of ’ company and customer data and ‘[b]reaches in the security of our information systems.’” As a result of such warnings, no “reasonable reader of Marriott’s public statements [could] have understood the company to be overrepresenting the extent to which it was ‘securing and protecting the customer data.’”

Second, Marriott’s statement that it sought to protect guests’ personal data and invested in efforts to secure that data failed to support a claim. “[T]he complaint concede[d] that Marriott devoted resources and took steps to strengthen the security of Starwood’s systems.” And Starwood “cautioned” on its website “that ‘“guaranteed security” does not exist either on or off the Internet.’” Similarly, the “remaining privacy statements” that the complaint challenged “were accompanied by such sweeping caveats that no reasonable investor could have been misled by them.”

Third, while Marriott disclosed data breach risks, the plaintiff contended the company “twice warned generally about events that could occur when it knew those events had in fact already occurred.” In the first instance, the plaintiff alleged that Marriott said it was possible that it might not be capable of satisfying standards promulgated by the credit card industry while knowing that it was not meeting those standards. But the complaint alleged only that a consultant “reported that Starwood’s ‘[b]rand standards did not mandate PCI compliance,’ not that Starwood’s systems were, in fact, not compliant” so that the report said only “that Starwood’s systems might not satisfy PCI DSS requirements—which is what Marriott stated in its risk disclosures.” In the second instance, the plaintiff charged that after learning of the data breach at issue in the case, “Marriott’s SEC disclosures from November 6, 2018 ‘warned generally of the risk that Marriott could face disruptive cyber security incidents,’ such as ‘[e]fforts to hack or circumvent security measures’ and ‘attempts to affect the integrity of our data.’” But, in fact, “after learning of the breach, Marriott updated its disclosure to state: ‘[W]e have experienced cyber-attacks, attempts to disrupt access to our systems and data, and attempts to affect the integrity of our data, and the frequency and sophistication of such efforts could continue to increase.’”

Significance and analysis. Marriott contrasts with the lawsuit against Alphabet, Google’s parent, in which the Ninth Circuit in 2021 held the plaintiff had adequately pled a Rule 10b-5 claim that Alphabet’s 10-Qs had misled because they stated that there had been no material changes in the company’s risk factors addressing cybersecurity since it had filed its 10-K even though the company had discovered—after the 10-K was filed but before the 10-Qs were filed—a three-year-long security breach possibly affecting the information of hundreds of thousands of users. But the claim against Alphabet differed from that against Marriott in that the complaint against Alphabet included a lengthy and specific chronology that featured internal consideration of whether to disclose the breach and a supposed decision not to do so, which the company only reversed after a Wall Street Journal article brought the cyber penetration to light.

Customer loss at acquired business; value of that business during incremental write-down. CVS Health Corporation (“CVS”) acquired Omnicare Inc. (“Omnicare”) in 2015. Omnicare provided pharmaceutical services to long-term care facilities (the “LTC business”). CVS subsequently wrote down the goodwill associated with the LTC business in a series of steps beginning in November 2016 and ending with a February 2019 announcement of Q4 2018 financials—a decline from $8.6 billion at the time of the deal to $431 million by the close of 2018. Plaintiffs filed a Rule 10b-5 claim against CVS and officers alleging that the defendants made what the First Circuit grouped into five categories of assertedly false or misleading statements during a class period stretching from February 2016 through the announcement of the last write-down.

Affirming dismissal, the First Circuit held that the complaint “fails to allege sufficiently specific facts about the state of the LTC business at particular points in time to enable us to conclude that any of the goodwill write-downs were too late or that any of defendants’ alleged misstatements contradicted the state of that business as it then stood.”

First, the plaintiffs attacked statements about the state and financial results of the LTC business, such as the representations in a CVS 10-K filed in February 2016 (and in periodic filings for the rest of the year) that CVS “‘segments benefited from the Omnicare acquisition’” and that net revenues in the segment into which the LTC business had been integrated were higher, and “‘primarily driven by the acquisition of Omnicare.’” The complaint asserted that “these statements were misleading because they gave a positive impression of the business without disclosing that Omnicare LTC customers were fleeing.” Second, the plaintiffs challenged statements by the CVS officers in 2016 and 2017 that CVS, through Omnicare, was a leader in the LTC market. Again, the complaint argued that these amounted to fraud “because they omitted information about customer exodus.”

Third, the plaintiffs averred that CVS misled by statements about its understanding of LTC customers—e.g., “tout[ing] CVS Health’s ‘deep understanding of [consumers’, payors’, and providers’] diverse needs,’” “‘[w]ork[] with our LTC clients to address currently unmet needs of their residents,’” and “‘invest[ment of] the time and capital … to get the right technology and processes in place in order to differentiate our offering to make it more compelling for our clients as well as the residents at these facilities.’” Such claims, the complaint contended, “were false and misleading because defendants did not in fact understand their LTC customers’ needs and many of these customers were fleeing CVS Health due to poor customer service.”

Fourth, the complaint labeled false claims of realized or anticipated synergies from the acquisition, on the grounds that “it was in fact the ‘synergies’ implemented by CVS Health that caused LTC customers to leave.” Fifth and finally, the plaintiffs alleged that the risk warnings in CVS’s SEC filings—cautioning, for example, that the company could not assure investors that existing business would be renewed and that integration problems could create difficulties in retaining customers—“misleadingly purported to alert investors to only future risks that were, in fact, ‘already occurring.’”

Since all of the attacks centered on the failure to disclose loss of LTC customers, the court then attempted to match the timing of the challenged statements against the timing of customer loss that the complaint contained. The court could find only six allegations that tied customer loss to dates within the class period. Two of them—referring respectively to a competitor taking customers in unspecified number “‘since 2015’” and a regional Omnicare division losing customers “‘from 2015 to 2019’”—“cover[ed] such broad swaths of time that they effectively provide no date limitation.”

The other four “paint[ed] with only a slightly finer brush”—“one competitor poached customers ‘in 2015,’ two others did so ‘in 2016,’ and an Omnicare affiliate pharmacy in New York lost most of its customers ‘immediately after the Acquisition’ such that a particular site of that affiliate closed ‘18 months after the Acquisition.’” But only the alleged customer decline in 2015 dated before the first CVS write-down (in November 2016), and the complaint did not allege facts providing any “reason to think that that 2015 loss by itself was both material and not offset by new business.” As to alleged customer departures in 2016, the complaint did not include facts to show that these were “anything but consistent with the general negative trend of CVS Health’s goodwill write-offs beginning in 2016 and its statement in 2017 that issues with ‘client retention rates’ contributed to declining revenues in the prior year.”

Overall, then, “[p]laintiffs’ failure to establish a reasonably clear timeline of customer losses inconsistent with the company’s goodwill disclosures is representative of the complaint’s overarching failure to allege material facts inconsistent with defendants’ public statements.” Nor did the complaint fare better if interpreted not as a challenge to CVS affirmations but as one based on omission of facts related to customer loss, as that theory “provides too little basis for comparing any material conclusions implied by the statements against the contemporaneous state of the LTC business.”

10. Scienter and Scienter Pleading

A Rule 10b-5(b) violation requires not only that a fact be misstated or misleadingly omitted and that the fact be material, but also that the misstatement or omission be made with scienter—i.e., either an intent to defraud or recklessness as to whether it will mislead. In a private lawsuit seeking Rule 10b-5 damages, the Exchange Act requires that the plaintiff must plead facts raising a “strong inference” of this guilty state of mind. In Tellabs, Inc. v. Makor Issues & Rights, Ltd., the Supreme Court interpreted this statutory mandate to mean that a complaint must plead facts that support “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.”

K12, Inc. (“K12”) “furnishe[d] schools with curricula, administrative support, virtual-learning software, and other educational services.” Anticipating an increase in business resulting from school closures due to the COVID virus, the company and top officers made bullish statements around its April 27, 2020 and August 11, 2020 earnings releases. K12’s stock “underwent a months-long climb in tandem with the broader stock market[—[f]]rom a closing price of $25.04 on April 27, … to an all-time high of $52.84 on August 5.”

Beginning with newspaper stories that the Miami-Dade school district would not go forward with a K12 contract, the company’s stock price declined, and after news that another school district had ended its relationship with K12, the stock price “eventually reached a low of $20.39 on December 29.” Investors filed a Rule 10b-5 action against K12, its CEO, and its CFO.

Affirming district court dismissal, the Fourth Circuit found some of the alleged misstatements to be immaterial puffery—e.g., K12’s “claiming [that] its ‘academic experience’ had remained ‘essentially school as usual’ [and] … touting its technological ‘core competency,’ ‘expertise,’ and ‘flexibility.’” Since “[t]he company offered no quantitative metrics, qualitative comparisons, or other specifics” to support such claims, no reasonable investor would have relied on them when deciding whether to buy K12’s stock.

The court of appeals found other statements to be opinions—e.g., “‘[a]s an innovator in K-12 online education, we believe we have attained distinctive core competencies that allow us to meet the varied needs of our school customers and students.’” Besides looking like puffery, that opinion was not, as the Fourth Circuit saw it, pled false under any of the three alternative ways in which an opinion might be false or misleading, as identified in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund. First, plaintiffs did not “deny, in more than conclusory fashion, that K12 ‘actually h[e]ld[]’ its stated belief.” Second, “[w]hile it is true that the prefatory clause contain[ed] an embedded assertion—that K12 [was] ‘an innovator in K-12 online education’—plaintiffs do not seriously contest this point.” Third, “plaintiffs fail[ed] to show that K12’s opinion omitted necessary context” because this “opinion was not simply emitted into the ether. It was made within the framework of a 10-K filing, where investors could have parsed the ample disclosures at their fingertips before succumbing to K12’s stated view.”

The court of appeals determined that still other challenged statements fell within the statutory protection for forward-looking statements—e.g., the K12 CEO’s claim “that a shift toward online instruction ‘positions us well.’” While that statement “employed the present tense, it [was] apparent from [the CEO’s] statement—read as a whole—that he was referring to K12’s future prospects ‘given how the education market is likely to change,’” and hence was forward-looking.

The heart of the plaintiffs’ case, however, was the charge that the defendants misled investors by claiming that K12 had a contract with the Miami-Dade County Public Schools (“Miami-Dade”) when, in fact, the company did not. Plaintiffs based this charge on (i) the CEO’s statements in an August 11 earnings call that (a), “alluding to a reported deal with Miami-Dade[,] … ‘K12 will provide customized services, including curriculum, assessment tools, teacher training and data management’” and (b) “‘[w]e are seeing [an] increase … in school districts who call us and want to use our content and our curriculum with more of those contracts this year than we’ve ever had in any one year before. I mentioned Miami-Dade, there’s others we’re working on, not yet disclosed, but maybe not as large as Miami-Dade’”; and (ii) an August 19 interview in which the CEO said “that Miami-Dade was ‘using online tools to reach their students.’” Two securities “analysts covering K12 applauded the company, respectively, for having a ‘contract signed’ and a ‘contract win.’”

In fact, K12 and Miami-Dade began negotiations in early July 2020, “with K12 taking steps then ‘to set up the platform, integrate its systems, train personnel, and roll out the temporary [software] in time for the first day of school.’” The counterparties agreed on price by July 10. A Miami-Dade “official then announced on July 29 that the district ‘intend[ed] to purchase’ K12’s platform, even specifying the source of funding to be tapped,” and Miami-Dade “informed the Florida Department of Education on July 31 that it would be partnering with K12.” The company and the district reduced the contract to writing by August 10, and the Miami-Dade superintendent signed the contract on August 17, though he did not return the executed contract to K12. Thus, as the Fourth Circuit put it, “after a long and extended series of negotiations, a contract with Miami-Dade was well on its way when [K12’s CEO] made his statements.”

Problems between K12 and Miami-Dade only surfaced after the CEO spoke—first in an August 25 news story “quot[ing] a district official as saying K12’s platform ‘fell below the expectations we set,’” followed by “the leader of the Miami-Dade teachers’ union [telling] CBS Miami [on August 26] that K12’s training had been ‘ineffective,’” a September 2 news story “that the K12 platform had suffered twelve cyberattacks,” and finally a September 10 Miami-Dade board vote to terminate the district’s relationship with K12.

The Fourth Circuit questioned whether, against this background, the complaint even pled the CEO’s statements false, because “plaintiffs nowhere allege that [the CEO], for all his enthusiasm about the Miami-Dade partnership, ever attested unambiguously to having a signed agreement.” Without resolving that matter but instead turning to scienter, the court of appeals noted that falsity and scienter are “interrelated,” here because the CEO’s “statements were not spun from whole cloth.” Instead, “[t]he timeline is consistent with his anticipation in mid-August of a consummated deal with Miami-Dade”—which was apparently the view of the Miami-Dade superintendent who actually signed the K12 contract on August 17. Moreover, if the CEO “aimed to inflate K12’s share price at all costs, he could have chosen far less ambiguous language than he did.” Putting it all together—and considering that the plaintiffs did not plead suspicious insider trading at K12 or that the CEO or CFO “would personally benefit from a special bonus or an impending performance review” by the challenged statements—the “more cogent inference” was “that [the] defendants ‘believed they could profit from pandemic-related disruptions and secure the Miami-Dade deal,’” and that a “fraudulent inference” was not “‘at least as compelling’ as one of innocence.”

11. Duty to Disclose

The securities laws do not impose a general obligation to disclose all material facts as soon as an issuer knows them but only to disclose certain facts under certain circumstances. Silence absent a duty to disclose does not violate Rule 10b-5.

In 2022, the Second Circuit affirmed dismissal of an action to the extent it was based on an issuer’s failure to disclose its role in positive online articles touting its stock but reversed dismissal insofar as the action rested on the issuer’s failure to disclose an SEC investigation after the issuer had revealed material weaknesses in internal control over financial reporting. The Ninth Circuit affirmed dismissal of a case based on Twitter’s failure to disclose a bug in software that prompted users to download advertisers’ apps.

Duty to disclose SEC investigation in light of reported material weaknesses in internal controls. 22nd Century Group, Inc. (“22nd Century”) paid authors, directly or through a consulting firm, to publish positive online articles about the company during February through October 2017. 22nd Century also disclosed in a 10-K filed in February 2016 “that its ‘internal controls over financial reporting were not effective and that material weaknesses exist[ed] in [its] internal control over financial reporting as it related to segregation of duties,’” repeated that disclosure in all three 10-Qs later that year, reprised this language in the 10-K filed in 2017 with the caveat that 22nd Century was taking remedial steps, and concluded with the 10-Q for the second quarter of 2017, announcing “that it had ‘completed the implementation and testing of a remediation plan that was targeted at eliminating our previously reported material weakness in our internal controls over financial reporting primarily resulting from a lack of segregation of duties.’” Investors filed a purported class action against 22nd Century and its former CEO and CFO alleging that the defendants violated Rule 10b-5 by failing to (i) disclose that it had paid for the online articles and (ii) reveal an SEC investigation during the time it publicly acknowledged material weaknesses in its internal controls.

In a mixed decision, the Second Circuit affirmed dismissal of the claim insofar as it was based on failure to make public the role that the company played in preparation and publication of the positive online reports. Addressing first whether the allegations stated a claim under Rule 10b-5(b), the court of appeals relied on the Supreme Court’s rule that liability under that subsection may be imposed only on the “maker” of a statement and that “‘the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.’” The complaint did not plead facts to place the defendants within this definition because, although it alleged “that ‘[d]efendants furnished information and language for, prepared, reviewed, approved, and/or ratified the articles,’” it did not “adequately allege that [the CEO, who supposedly ‘“reviewed, edit[ed], and/or approved” the paid stock promotion articles’] directly wrote the articles, controlled what the authors put into the articles, or even saw them before their publication.” And “even if [the CEO] had provided some input on the content of the articles, the complaint does not support the conclusion that [he] had the ‘ultimate authority’ necessary to brand him the articles’ maker.”

The court also found that the stock promotion allegations stated no claim pled under the two other subsections of Rule 10b-5—subsections (a) and (c). The plaintiffs formulated that claim as one of market manipulation, but the Second Circuit found no facts pled “that the market was manipulated by either the information in the articles, the payments to the writers, or the non-disclosure of the payments.” Nondisclosure of payment to the online authors for their complimentary articles did “not equate to market manipulation,” as, “even if the payments were material, which we have determined not to be the case, because defendants were not the articles’ ‘makers,’ they had no responsibility for the payments’ disclosure. And there is no allegation that defendants directed the authors not to disclose the payments, or that defendants were anything but indifferent as to whether the authors did so.”

Although the Second Circuit affirmed dismissal on the above analysis insofar as the plaintiffs asserted a claim based on the online touting, the court vacated the dismissal insofar as the Rule 10b-5 claim rested on 22nd Century’s failure to disclose the SEC investigation during the period its SEC filings reported that the company had material weaknesses in its internal control over financial reporting. The court reasoned that the “[d]efendants had a duty to disclose the SEC investigation in light of the specific statements they made about the Company’s accounting weaknesses” because, “once a company speaks on an issue or topic, there is a duty to tell the whole truth” and “the fact of the SEC investigation would directly bear on the reasonable investor’s assessment of the severity of the reported accounting weaknesses”—i.e., the materiality of the disclosure about the internal control issue.

Significance and analysis. The 22nd Century opinion’s principal importance lies in its seeming rule that if a company reports a material weakness in internal control over financial reporting and an SEC investigation about that weakness follows, the company must disclose that investigation in its next statement that the weakness exists.

Duty to disclose software problems. Twitter makes its money by selling to advertisers access to Twitter’s users, with advertisers paying more for tailored information about users that can be used to target users most likely to be interested in the advertisers’ products or services. Twitter’s Mobile App Promotion (“MAP”) is a special advertising service that permits advertisers to prompt users to download the advertisers’ apps, and “is most effective when an advertiser knows information about the user’s device settings, such as its operating system or which apps the user has already downloaded.” After having highlighted MAP as a key revenue driver, Twitter announced on October 24, 2019 disappointing revenues and disclosed software problems affecting MAP. Twitter’s stock price lost more than 20 percent.

Plaintiffs filed a Rule 10b-5 lawsuit against the company and two executives, alleging that they committed securities fraud from July 26, 2019 through October 23, 2019 by failing to disclose the MAP software problems and, specifically, that statements in a July 26, 2019 shareholder letter and a Form 10-Q that Twitter filed on July 31, 2019 were false or materially misleading for failing to tell investors of those problems. Affirming dismissal, the Ninth Circuit pronounced broadly that “[s]ecurities laws … do not require real-time business updates or complete disclosure of all material information whenever a company speaks on a particular topic. To the contrary, a company can speak selectively about its business so long as its statements do not paint a misleading picture.”

Specifically as to the July 2019 shareholder letter and 10-Q, the plaintiffs “argue[d] that Twitter’s failure to disclose the software bugs’ impact on MAP in [that month] was materially misleading because its prior statements had allegedly left a ‘misimpression’ that the work to improve MAP was ‘on track.’” But the “shareholder letter and 10-Q stated that Twitter is ‘continuing [its] work to increase the stability, performance, and flexibility of [its] ads platform and [MAP] … but we’re not there yet.’ Similarly, the CFO explained that the company is ‘still in the middle of that work’ relating to MAP.” The court found “none of these statements [to] suggest[] that Twitter’s MAP program was ‘on track,’” rather “a vaguely optimistic assessment that MAP, like almost all product developments, ha[d] had its ups and downs, even as the company continue[d] to make progress.” These “qualified and vague” pronouncements imposed “no legal duty to disclose immediately the software bugs in its MAP program.”

12. Forward-Looking Statements

Both the Securities Act and the Exchange Act protect forward-looking statements, which include “projections of revenues” or “income” and “statement[s] of future economic performance,” as well as the “assumptions underlying” them. With certain exceptions not applicable to the case discussed below, a private plaintiff cannot recover damages, based on such a statement, in a lawsuit under either act against a public company issuer or a person acting on its behalf if either (a) the statement was accompanied by cautionary language “identifying important factors that could cause actual results to differ materially from those in the forward-looking statement” or (b) the plaintiff cannot prove that the statement was made with actual knowledge that it was false or misleading.

Axogen, Inc. (“Axogen”) produced what it characterized as “peripheral nerve repair and protection solutions.” During a class period stretching from August 7, 2017 to December 18, 2018, Axogen stated in prospectuses, registration statements, and periodic Exchange Act filings that it “believe[d] each year in the U.S. more than 1.4 million people suffer traumatic injuries to peripheral nerves” and that it “believe[d]” or “estimate[d]” that these injuries “result[ed] in over 700,000 extremity nerve repair procedures.” After a short seller reported only 28,000 as the true annual number of peripheral nerve injury repair procedures in the United States and Axogen’s stock price declined, investors sued under both Securities Act section 11 and Exchange Act section 10(b).

Affirming district court dismissal, two of the three Eleventh Circuit panel members held that the statements were statutorily protected forward-looking statements. They read circuit authority to lean on “context” “[t]o differentiate ‘historical observations,’ which are not forward looking, from ‘assumptions about future events,’ which are forward looking,” and to mean that “[e]ven a statement that depends in part on present-tense observations is due safe-harbor protection so long as the conclusion it supports is forward looking.”

The two judges found “the critical phrase in the challenged statements is Axogen’s assertion that a certain number of peripheral nerve injuries and procedures occur in the United States ‘each year.’” While they could “imagine using the phrase ‘each year’ to refer solely to an existing or historical fact,” they found that “as Axogen used the phrase, it is inherently forward looking; it was addressed to future years just as much as to past years or the present year.” The context tipped the balance decisively, for even “[t]he plaintiffs concede[d] that the statements were used to support Axogen’s predictions about the size of the market that ‘could be serviced’ by its products,” which amounted to “market-size predictions,” which were “about ‘future economic performance’ and are defined as forward-looking statements under the statute.” While the plaintiffs argued that the challenged statements were a mix of separable forward-looking and historical parts, with the safe-harbor statutory provisions inapplicable to the latter, the panel majority responded that it could not “sever the meanings of ” the single critical phrase, “each year.”

Applying, therefore, the safe harbor statute, the two judges noted that the plaintiffs could prevail only if they could plead and prove that an Axogen executive officer who approved the statements actually knew that they were false or misleading. Since the plaintiff “d[id] not argue on appeal that it met the ‘actual knowledge’ standard,” did not plead any facts to suggest such knowledge, and in fact “disclaimed any allegation that Axogen ‘intentional[ly]’ misrepresented anything,” the statutory safe harbor required dismissal.

13. Merger Disclosures

Tribune Media Company (“Tribune”) announced a merger with Sinclair Broadcasting Group (“Sinclair”) in May 2017. The agreement required Sinclair “to ‘use reasonable best efforts’ to satisfy demands of the Antitrust Division of the Department of Justice and the Federal Communications Commission [‘FCC’], both of which had authority to block the merger or request the judiciary to stop it” (the “best efforts clause”). While the merger was under antitrust scrutiny, Oaktree Capital Management (“Oaktree”) sold some of its Tribune stock through Morgan Stanley in a registered public offering.

The Department of Justice wanted Sinclair to sell stations (at first ten, later reduced to eight) in markets where both it and Tribune operated. After first refusing, Sinclair agreed after a Justice threat that it would sue to block the deal. But the transactions Sinclair proposed to accomplish the divestitures would not, as Justice saw it, deprive Sinclair of control. Fed up with Sinclair’s aggressive tactics in the antitrust negotiations, Tribune terminated the merger in August 2018 and sued Sinclair for violating the “best efforts clause,” eventually settling that action for $60 million.

Investors sued Tribune and its directors under Securities Act section 11 and Rule 10b-5 and Morgan Stanley under Securities Act section 12(a)(2), alleging that “[w]hen the previously concealed risk—that regulators would decline to grant approval, and the Merger would therefore fail—materialized, the price of Tribune stock declined dramatically, and Plaintiffs and other investors lost hundreds of millions of dollars.” In affirming dismissal, the Seventh Circuit characterized the complaint as charging that the defendants “fail[ed] to disclose that Sinclair was playing hardball with the regulators, increasing the risk that the merger would be stymied.”

The court of appeals held that the Securities Act claims failed because “the Antitrust Division did not propose divestiture of eight to ten stations until November 17, 2017, and Sinclair did not reject that demand until December 15,” which was “two weeks after plaintiffs say that they purchased shares from Morgan Stanley.” Since “[s]ecurities law requires honest disclosures but not prescience or mind reading,” it was “impossible to rest any liability on the 1933 Act” for failure to disclose what had not yet occurred and what negotiating position Sinclair would take.

Turning to the Rule 10b-5 claims, the panel held that “statements about prospects for the merger’s success were forward-looking.” The Exchange Act shields such statements, with exceptions not applicable here, from private lawsuits if they are “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement[s].” In this case, “[t]he press releases, proxy materials, and other statements issued in connection with the proposed merger, plus the quarterly reports filed before the merger was abandoned, all correctly stated the terms of the deal, including Sinclair’s promise to use ‘reasonable best efforts’ to win approval.” Tribune added multiple cautions, which included: (i) the merger was “subject to a number of conditions, including conditions that may not be satisfied or completed on a timely basis, if at all”; (ii) there could be “no assurance that the actions Sinclair is required to take under the Merger Agreement to obtain the governmental approvals and consents necessary to complete the Merger will be sufficient to obtain such approvals and consents or that the divestitures contemplated by the Merger Agreement to obtain necessary governmental approvals and consents will be completed”; and (iii) “[f]ailure to obtain the necessary governmental approvals and consents would prevent the parties from consummating the proposed Merger.” All this constituted sufficient “cautionary” language to activate the Exchange Act safe harbor protection.

Turning to scienter, the panel continued that, even “suppos[ing]” that Tribune concluded as early as December 2017 that Sinclair was “not doing enough” and that “the cautions about contingencies were no longer enough to meet the requirements of the safe harbor,” “during the negotiations Sinclair assured Tribune that it would keep its promise, which makes it hard to say that Tribune acted with intent to defraud when it didn’t disclose that Sinclair was balky.” Moreover, the complaint did not say “when, if at all, Tribune learned about the ‘entanglements’ (the parties’ word for the conditions on divestiture) that led to the merger’s demise,” thereby “mak[ing] it impossible to see how Tribune could have had fraudulent intent on the dates it made statements.”

14. Life Sciences

In 2022, three different circuit courts ruled in Rule 10b-5 cases that statements by life sciences issuers about clinical trials were not false or misleading. The Second Circuit affirmed dismissal where the plaintiffs alleged a drug manufacturer misrepresented the participants in a clinical trial by stating that they were limited to patients who “strongly” expressed a certain protein. The Ninth Circuit affirmed dismissal where a pharmaceutical company announced a thirty-fold increase in cancer-fighting cells in ten patients in a Phase 1 trial but, in presenting results from a later Phase 1/2 trial, disclosed far less impressive results. The First Circuit affirmed dismissal where a press release about clinical test results recounted the common adverse side effects in a clinical trial but did not separately discuss severe adverse effects.

Description of patient population in trial. In 2009, Bristol-Myers Squibb Company (“Bristol-Myers”) acquired the rights to develop a cancer drug called Opdivo. On January 19, 2014, Bristol-Myers announced a clinical trial designed to determine whether Opdivo showed better results in patients with non-small cell lung cancer than chemotherapy. The company thought that this might be true because Opdivo inhibited the interaction of two proteins in cancer cells that interfered with the immune system’s ability to fight the cells. The drug’s efficacy in inhibiting that interaction, however, depended on the percentage of a patient’s cancer cells having one of the proteins—PD-L1. “[T]he higher the percentage of cancer cells with PD-L1, the ‘stronger’ the patient’s PD-L1 ‘expression,’ and the more effective the drug in treating that patient.”

In selecting the patients to participate in the clinical trial, Bristol-Myers had to balance the probability that the test would show efficacy (which would increase as the eligibility floor for PD-L1 expression increased) against the size of the potential market for the drug if efficacy were shown (which would increase as the eligibility floor for PD-L1 expression decreased). Bristol-Myers decided that patients in the trial needed to meet only a 5 percent expression threshold.

But the company did not disclose that threshold numerically when it announced the trial in January 2014, saying only “that the Opdivo trial would focus on results among patients ‘strongly’ expressing PD-L1.” In August 2016, Bristol-Myers announced that Opdivo had “failed to meet its primary goal—i.e., the drug did not show better results than chemotherapy in those ‘strongly’ expressing PD-L1” and that the company had defined “strong” expression as 5 percent or more. Bristol-Myers’s stock price declined, and investors filed a Rule 10b-5 action against the company and executives based primarily on the allegation that they misled the public by characterizing the clinical trial as restricted to patients whose cancer cells “strongly” expressed PD-L1.

Affirming dismissal, the Second Circuit determined the claims to rest on the allegation that the 5 percent threshold fell below an “industry consensus,” that “strong” PD-L1 expression could not include 5 percent expression and that, indeed, “‘strong’ PD-L1 expression meant 50%.” But the court found that the complaint itself showed that “there was no general understanding of what constituted strong expression, and therefore no reason for the Investors to interpret ‘strong expression’ to mean any specific threshold—nor any reason why the description was false or misleading.” A “journal quoted in the Complaint observed in May 2016 that ‘[t]he best cut-off percentage … to determine PD-L1 positivity … remains an unresolved question.’” And the complaint “detail[ed] varied thresholds used for PD-L1 positivity, ranging from 1% to 49%, depending on the study.” Moreover, while the Bristol-Myers trial was proceeding and before the company disclosed that it had employed the 5 percent threshold, “investment analysts at Alliance Bernstein and Goldman Sachs correctly predicted that Bristol-Myers defined strong expression as 5%.”

While Merck used the term “strong” PD-L1 expression in describing a successful clinical trial of its competing drug—a trial limited to patients with at least 50 percent expression—Merck announced its trial a few months after Bristol-Myers disclosed its Opdivo trial, and Merck did not reveal its 50 percent threshold for “strong” expression until February 2016, two years after Bristol-Myers announced its Opdivo trial. Accordingly, Merck’s “description of its study as targeting strong expression, while using a 50% threshold, cannot reasonably be understood to bear upon Bristol-Myers’s own internal definition of that term.”

Positive announcement based on a small sample in early trial results, followed by more modest results in later trial. The Ninth Circuit also found allegations against a life sciences company wanting last year because investors failed to adequately plead that a company’s statements about a clinical trial were false. Nektar Therapeutics (“Nektar”) developed a drug called NKTR-214 to stimulate the production of cancer-fighting cells. Nektar conducted a Phase 1 clinical trial with the drug (the “EXCEL trial”). During that trial, the company prepared a chart that “show[ed] that cancer-fighting cells increased an average of about 30-fold among 10 patients after taking Nektar’s drug” and “presented this 30-fold chart at many conferences.”

After the successful results from the EXCEL trial, Nektar conducted a second clinical trial of NKTR-214 (the Phase 1/2 “PIVOT trial”) to determine the effect of using the drug with the Opdivo drug. On June 2, 2018, Nektar released data from this trial that “showed that ‘the overall response rate for NKTR-214 in treating melanoma had declined from the 85% rate presented the previous November to 50%.’” Nektar’s stock price dropped 42 percent on the next trading day. Four months later, “anonymous short-sellers”—through what they called the Plainview Report—claimed that another Nektar chart (what the court called “Figure 6”) showed that a single outlier patient who the Plainview Report claimed to have been one of the ten patients included in the thirty-fold chart had experienced an outsized increase in cancer-fighting cells while the other patients in Figure 6 showed more modest increases. Nektar stock price then declined 7 percent.

Two pension funds filed a Rule 10b-5 lawsuit against Nektar and individuals from that company, claiming that the thirty-fold chart was misleading because its presentation omitted to state that the average results included the outsized score from the outlier patient. After the district court dismissed the case, the Ninth Circuit affirmed. Noting the statutory requirement that, where the allegation that a statement was false is made on information and belief in a private action under the Exchange Act, “the complaint shall state with particularity all facts on which that belief is formed,” the court of appeals found that the complaint here “does not allege with specificity what the Phase 1 EXCEL results would have been without outlier data.”

While the Plainview Report allegedly said “that the result ‘would look very different’ if one calculated the fold change based on only three patients found in Figure 6,” “cherry-picking data from only three patients does not plausibly show the falsity of the 30-fold claim.” Though the complaint alleged that a confidential witness “contended that the results would have been ‘nowhere near’ the 30-fold result without [the outlier patient’s] data, … it does not specify any further details.” And, while the plaintiffs also “rel[ied] on a statistical analysis by an expert who estimates, after making many assumptions, that the fold change experienced by the other patients in the 30-fold chart could not have topped 5.55,” they “provided no plausible justification for the assumptions underlying how this expert precisely derived that 5.55-fold estimate.” Finally, the plaintiffs failed to show “whether a somewhat lower fold-change would have been material to investors,” so that, for example, if “the number of cancer-fighting cells would have increased 15-fold … [p]erhaps investors would not care about such a difference if it turned out that a 30-fold increase provides little marginal benefit over a 15-fold increase for most cancer patients.”

Omission of severe adverse effects from announcement of results including most common adverse effects. Karyopharm Therapeutics, Inc. (“Karyopharm”) developed a drug called selinexor to treat cancer patients “suffering from relapsed or refractory multiple myeloma and acute myeloid leukemia”—i.e., suffering from cancer “which has not been eradicated despite treatment, or which has returned at least once following initially successful treatment.”

In a Phase 1 trial with patients who had received “at least three prior lines of treatment or therapy without success,” the drug “evinced a substantial level of toxicity.” Among patients treated only with selinexor, only one in fifty-six showed “a ‘partial response’—in other words, a decrease in the extent of the patient’s cancer.” Among those treated with selinexor plus a steroid called dexamethasone, only 8.6 percent showed a partial response or full remission.

Karyopharm initiated two Phase 2 trials. Begun in June 2014, the first terminated prematurely in March 2017 when the company announced that the trial would not show, with statistical significance, that selinexor alone was a superior treatment for acute myeloid leukemia. That study, called SOPRA, “also evinced substantial toxicity: 100% of the patients treated with selinexor suffered from adverse events (‘AEs’) of varying degrees, including some which resulted in death.”

Before SOPRA concluded, Karyopharm began a second Phase 2 trial, called STORM. On April 30, 2018, Karyopharm issued a press release “announcing top-line data from the second half of the STORM trial, which stated in relevant part that: ‘Oral selinexor demonstrated a predictable and manageable tolerability profile, with safety results that were consistent with those previously reported from Part I of this study … and from other selinexor studies. As anticipated, the most common [AEs] were nausea, vomiting, fatigue and reduced appetite and were primarily low grade and manageable with standard supportive care and/or dose modification.’” On May 1, 2018, the Karyopharm CEO stated on a conference call “that ‘[t]he success of the STORM study is an important milestone for Karyopharm[, a]nd these data represent a significant step in establishing the efficacy and safety of selinexor as a new treatment option for patients with myeloma.’”

On February 22, 2019, the FDA released a briefing document for a meeting of its Oncologic Drug Advisory Committee (“ODAC”). That report “highlighted three primary issues with the submitted study data: first, that the single-arm nature of the STORM trial [i.e., that it was conducted without a control group] could not provide conclusive data regarding the efficacy of selinexor; second, that the single-arm nature of the STORM trial could not provide conclusive data regarding the toxicity of selinexor; and finally, that while the STORM trial indicated that lower doses of selinexor were better-tolerated, it did not conclusively establish an optimal dose.” Karyopharm’s stock price fell from “a closing price of $8.97 per share on February 21, 2019, to a closing price of $5.07 per share on February 22.” The stock price declined again when the ODAC voted to delay approval of selinexor until after a Phase 3 trial that Karyopharm had underway.

Investors brought a putative class action against the company and officers alleging a Rule 10b-5 claim. While the trial court had ruled that the complaint adequately alleged that the challenged statements were misleading but that the action should be dismissed because the plaintiffs did not plead sufficient particular facts to support a strong inference of scienter, the First Circuit affirmed on the different ground that the plaintiffs had not “plausibly alleged” a material misstatement or omission.

As to the April 30, 2018 press release, the plaintiffs alleged that it misled “because it omitted known information regarding the serious risks of selinexor treatment.” In particular, it failed to disclose that “‘nearly 60% experienced a severe [AE], more than 25% of patients permanently discontinued the drug due to its side effects and approximately 18 on-study deaths were attributed to it.’” In context, however, the STORM trial involved patients who suffered from relapsed or treatment-resistant multiple myeloma, “a disease which Karyopharm explicitly acknowledged in public filings typically results in ‘nearly all patients … eventually relaps[ing] and succumb[ing] to their disease.’” Moreover, half of the STORM trial “specifically focused on treatment of ‘heavily pretreated patients with penta-refractory myeloma’—i.e., patients whose cancer had continued to progress despite extensive and varied treatment and who were ultimately left with no other medical options.”

Perhaps more to the point, Karyopharm stated, “through Form 10-Ks issued both before and during the class period, that treatment with selinexor had resulted in ‘serious’ AEs in at least a ‘small percentage’ of patients. The 10-Ks filed in March of 2016, 2017, and 2018, each clarify that such serious AEs are those which ‘result in death, are life threatening, require hospitalization or prolonging of hospitalization, or cause a significant and permanent disruption of normal life functions.’” And the filings warned that “‘as a result of these adverse events or further safety or toxicity issues … we may not receive approval to market any drug candidates,’” adding that the FDA “‘may disagree with our clinical trial investigators’ interpretation of data from clinical trials and the conclusion by us or our clinical trial investigators that a serious adverse effect or unacceptable side effect was not drug-related.’”

Against this “background information, it is difficult to imagine that any investor would read the defendants’ statements that Karyopharm had a ‘predictable,’ ‘manageable,’ and ‘consistent’ tolerability profile to indicate that selinexor was benign, or that the FDA would find it so.” Put in doctrinal terms, omission of the distribution of AEs and particularly the severe AEs in the press release on the STORM trial was not material because the market was already aware of the critical information—i.e., that selinexor could produce terrible side effects when used by the target population of extremely sick patients making their last stand against a fatal disease.

Turning to the less troublesome May 1 conference call comments, the First Circuit found them to be “non-actionable puffery.” The CEO’s “assertions that the results of the STORM study constitute ‘an important milestone for Karyopharm’ and represent ‘a significant step in establishing the efficacy and safety of selinexor as a new treatment option for patients with myeloma,’” were “vague optimism about a product’s future” that “cannot constitute a material misstatement for purposes of the pleading requirements set by” statute.

Significance and analysis. Another court might have reached a different conclusion as to the materiality of information about the severe AEs among STORM study participants. It might have ruled that, particularly in light of the drug’s previous record of toxicity and the vulnerable population at which it was aimed, investors would have been keen to know that almost 60 percent of the study patients experienced severe AEs during the trial. Finding as a matter of law on pled and judicially recognizable facts that information about side effects is not material is a tricky business in light of Matrixx Initiatives, Inc. v. Siracusano, where the Court held that such information could be material even if it does not rise to the level of statistical significance.

15. Criminal Cases

The jury in Unites States v. Armbruster convicted the named defendant on four of eleven counts and acquitted two codefendants. Armbruster had served as the Roadrunner Transportation Systems, Inc. (“Roadrunner”) CFO. His convictions revolved around two balance sheet items on the books of Morgan Southern, a subsidiary that Roadrunner acquired: (i) an account receivable from IKEA Maersk carried at above its realizable value and (ii) “prepaid” taxes recorded as such even though the amounts were already due and owing. Armbruster was convicted on two counts of knowingly falsifying the Roadrunner accounting records (into which the Morgan Southern numbers were consolidated) in violation of Exchange Act section 13(b)(2) and (5); one count of submitting a false representation letter to Roadrunner’s outside auditor relating to Roadrunner’s third-quarter 2016 numbers and thereby misleading the outside accountant in violation of Rule 13b2-2(b); and one count of violating 18 U.S.C. § 1348 by submitting false financial numbers to the SEC for that quarter. The counts also involved 18 U.S.C. § 2, which provides for aiding and abetting liability so that Armbruster would have been liable even if he did not himself commit the substantive violation but aided and abetted another—e.g., the company—in that other’s substantive violation. On appeal, the Seventh Circuit affirmed the convictions against Armbruster’s challenge to the sufficiency of the evidence at trial, employing the standard that required affirmance unless “‘no rational trier of fact could have found the defendant guilty.’”

The trial evidence included the following: A May 2014 email from a Roadrunner financial analyst to several accountants, including Armbruster, attached a spreadsheet containing “the notation ‘probably a full write off ’ next to the IKEA Maersk receivable line item.” A former Morgan Southern controller (who departed in April 2016) “told the jury that he informed Armbruster of the results of his assessment of Morgan Southern’s accounting practices, including its overstatement of the collectability of the IKEA Maersk receivable and inflation of the prepaid taxes account.” He also “walked the jury through Roadrunner’s plan to write off the uncollectable and overstated account balances over time, describing email threads with Armbruster that discussed the need to record material adjustments to both accounts.” When that controller’s successor “promptly noticed the company’s accounting problems, including the overstatement of the IKEA Maersk receivable and prepaid taxes account” and “relayed his concerns … to Roadrunner’s vice president of finance,” that finance VP “provided Armbruster with the results” of this analysis, including those relating to the receivable and the prepaid taxes. At a November 2016 meeting “shortly before Armbruster submitted a letter to Deloitte representing that he had no knowledge of material misstatements or irregularities in Roadrunner’s financial accounting and reporting,” Roadrunner’s executive vice president “listed on a whiteboard the many accounting challenges the company faced, including those with respect to Morgan Southern accounts receivable and prepaid taxes,” “emphasiz[ing] the need to make adjustments to allow the company to report both account balances in accordance with [Generally Accepted Accounting Principles].” Armbruster attended that meeting. The audit partner for Roadrunner’s outside accountant testified that “he was alarmed to learn about the whiteboard meeting and related email correspondence.”

This evidence was sufficient to convict on the two counts for falsifying books and records because “the jury could—and did—reasonably find that Armbruster knowingly and willfully allowed the Morgan Southern IKEA Maersk receivable and prepaid taxes account to remain overstated in the company’s accounting records and, in turn, in Roadrunner’s consolidated balance sheet during the relevant periods.” It was sufficient to convict on the 18 U.S.C. § 1348 securities fraud count because “[t]he jury had enough to conclude that Armbruster knowingly allowed the company’s 3Q-2016 financial statements to include material misstatements by leaving the Morgan Southern IKEA Maersk and prepaid tax accounts overstated, as reflected in Roadrunner’s consolidated financial statements.” It sufficed for conviction on the representation letter to the outside auditor because it “allowed the jury to infer that Armbruster understood his responsibility to communicate honestly with auditors and that he knowingly shirked his duty by signing a management representation letter that failed to notify Deloitte of the clear concerns many within Roadrunner held about the two accounts in question.”

Significance and analysis. Exchange Act section 13(b)(5) provides that “[n]o person shall knowingly circumvent or knowingly fail to implement a system of internal accounting controls or knowingly falsify any book, record, or account” of an issuer with securities registered under section 12 of that act or required to file reports under section 15. The Seventh Circuit affirmed conviction on two violations of this statute because the evidence permitted the conclusion that Armbruster “knowingly and willfully allowed” the two accounts at the subsidiary “to remain overstated” in the subsidiary’s accounting numbers, which were consolidated into the public company financials. His conviction reminds us that a CFO can run afoul of section 13(b)(5) even if the false numbers are inside a subsidiary’s financial statement that is consolidated into the public company’s reports and even if the CFO does not himself or herself keystroke the false numbers into either the subsidiary or public company balance sheet, income statement, or cash flow report.

The conviction also emphasizes, from a counseling point of view, that a CFO who did not himself or herself initiate a fraud can risk criminal liability if that CFO fails to affirmatively address an accounting problem that is brought to his or her attention, with the risk that the government might institute a prosecution and that the CFO might suffer a conviction both mounting with the number of different finance and accounting professionals bringing the problem to the CFO’s attention and the number of accounting periods during which the CFO delays a response.

16. Miscellaneous

The Fifth Circuit affirmed a bench trial judgment for the Commission and against brokers on alleged violations of multiple securities laws based on cherry-picking from block trades to allocate profitable transactions to favored accounts and unprofitable ones to disfavored accounts. The Ninth Circuit held that SEC Rule 16b-3(d)(1)’s exemption from Exchange Act section 16(b) short-swing profit recovery—for acquisitions from the issuer approved by the board of directors—does not require that the acquisition be unanimously approved by a board of directors but is satisfied if the board approval complies with state corporate law, in this case at a meeting attended by four of the five directors and a vote by three of them to approve (the fourth being the officer receiving the options/warrants grant, who did not vote on the matter). The Eleventh Circuit affirmed dismissal of a state fiduciary law class action against an investment adviser who urged customers to invest tax-qualified retirement accounts in variable annuities, holding the gravamen of the claim to consist of misrepresentations and omissions regarding suitability of the investments and that the Securities Litigation Uniform Standards Act therefore barred the lawsuit.

The caselaw developments cover opinions decided in 2022. Where this portion of the annual review expresses opinions, they are those of the author of the caselaw developments, William O. Fisher, and not necessarily the opinions of other authors contributing to the annual review, or of members of the subcommittee producing the review, or of the American Bar Association.