April 11, 2014 Top Story

Securities Fraud Plaintiff Need Not Show Reliance

Recovery available despite agreeing to merger prior to issuance of misleading reports

Natasha Saggar Sheth

In a decision that may have many in the plaintiffs’ securities bar cheering, the U.S. Court of Appeals for the Ninth Circuit ruled that a shareholder could pursue a claim under Section 11 of the Securities Act of 1933 for losses incurred as a result of fraudulent misrepresentations made during the merger process, despite the fact that the shareholder agreed to the merger before the alleged misrepresentations were made, and, thus, did not rely on those misrepresentations in his decision to vote in favor of the merger. Hildes v. Arthur Andersen LLP, et al.

Securities Act of 1933

The Securities Act of 1933 aims to ensure that complete and accurate information is available to buyers before they invest in securities. For that purpose, any company offering shares for sale must file a registration statement with the Securities and Exchange Commission (SEC) unless otherwise exempt. Section 11 of the Securities Act holds an issuer of securities liable for registration statements containing material misstatements or omissions.

Background of Hildes

Plaintiff Hildes was a shareholder of Harbinger Corporation but acquired shares of Peregrine Systems, Inc. when the two companies merged. Prior to the merger, and prior to the filing of Peregrine’s required registration statement, Hildes entered into a voting agreement and irrevocable proxy voting his shares in favor of the merger. Hildes’ proxy was irrevocable “to the fullest extent permissible by law.”

After the merger, the SEC charged Peregrine with financial fraud for materially incorrect financial statements; further civil litigation ensued. Hildes opted out of a class action settlement against Peregrine and brought his own claims against Arthur Andersen, the auditor, and certain outside directors of Peregrine who signed the registration statement. Hildes sought leave to amend his complaint to add a claim under Section 11 of the Securities Act against additional former Peregrine outside directors.

Loss Causation

The U.S. District Court for the Southern District of California denied Hildes’ request to amend his complaint as futile, based on the affirmative defense of “negative causation” or “loss causation.” Under this theory, articulated in 15 U.S.C. Section 77k(e)(3), a defendant can limit his liability for losses that are not attributable to the alleged misrepresentations or omissions in a registration statement.

The district court reasoned that, in agreeing to vote his shares in favor of the merger, Hildes had clearly manifested his intent to exchange his Harbinger stock for Peregrine shares. Thus, any loss he suffered could not be attributed to the registration statement, which was issued after Hildes entered into the voting agreement. Even if Hildes relied on false financial statements in making the decision to commit his shares, the court explained, that reliance was unrelated to the fraudulent registration statement at issue in the Section 11 claim.

Broad Liability under Section 11

On appeal, the Ninth Circuit reversed. In doing so, the court emphasized the broad scope of liability under Section 11 and the minimal burden on a plaintiff bringing a Section 11 claim. A plaintiff who purchases a security within 12 months of the registration statement need not show reliance to bring a Section 11 claim. Additionally, no scienter is required for liability under Section 11; defendants are responsible for innocent or negligent material omissions or misrepresentations.

As for the defendants’ loss causation argument, the court concluded that the defendants failed to meet their “heavy burden” of proving that the depreciation of value in Hildes’ stock was a result of factors other than the alleged misstatements in the registration statement.

Ultimately, the court determined there was causation between the two events, since “misrepresentations contained in the registration statement played a role in the causal chain that resulted in the exchange of stock.” The court explained further:

[A]lthough the voting agreement and irrevocable proxy irrevocably committed Hildes to have his shares voted in favor of the merger, it did not irrevocably commit him to exchange his Harbinger shares for Peregrine shares. Any exchange of shares remained contingent on the consummation of the merger.

In other words, had the registration statement been truthful, the merger and resulting exchange of shares may not have occurred. Thus, the court concluded that the plaintiff could pursue his Section 11 claim against the former outside directors.

More Section 11 Claims May Survive

Although the court’s decision involved a proposed amendment to the complaint at the early stages of litigation, its holding may have broader implications. “This decision, at least in the Ninth Circuit, will make it more difficult for defendants to get these types of Section 11 claims dismissed. Parties will wind up in discovery, and that obviously has a cost and an implication as to when these claims will settle,” says William M. Lafferty, Wilmington, DE, cochair of the M&A/Proxy Litigation Subcommittee of the ABA Section of Litigation’s Securities Litigation Committee. “Securities claims are potentially big exposures, and the practical reality is that when claims survive motions to dismiss, that often result in more settlements. That tilts playing fields in favor of the plaintiffs’ bar.”

Looking Ahead

Other Section leaders wonder what impact the case will have on the affirmative defense of negative causation. “Negative causation is a significant burden to prove. It’s not clear whether in a different procedural stance that would have made a difference,” says Zesara C. Chan, San Francisco, CA, former cochair of the Section of Litigation’s Securities Litigation Committee.

“The court here was looking carefully at the voting agreement and what types of rights were being negotiated in connection with voting agreement,” says Chan. “To the extent you have parties who are entering into voting agreements, you have to be very careful about which rights you really want irrevocable, and writing it in such a way that you are going to be able to fit into the analysis that the court used.”


Natasha Saggar Sheth is an associate editor for Litigation News.

Keywords: negative causation, loss causation, Section 11, securities litigation, mergers and acquisitions

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