9th Circuit Again Rules Against Securities Defendant

For the third time in the last seven months, the nation’s largest federal appellate court has reinstated a securities fraud lawsuit that a trial judge had dismissed under a 1995 statute meant to weed out costly suits.

In reviving a complaint against the corporate successors to the investment bank Schroders & Co., the San Francisco-based 9th Circuit set a relatively low bar for plaintiffs in terms of what they have to allege regarding a company’s intent to defraud investors. The court also addressed, but ultimately ducked, an issue concerning the extended statute of limitations for securities fraud actions under The Sarbanes-Oxley Act of 2002.

In enacting the Private Securities Litigation Reform Act in 1995, Congress sought to reduce frivolous securities suits by requiring plaintiffs to be specific about misleading statements or omissions. The law also requires plaintiffs to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind,” which in legal lingo is referred to as “scienter.”

Until recently, the 9th Circuit—which includes California and a number of other western states—had been considered by many to be the friendliest jurisdiction in the country for companies being sued under federal securities laws. That’s because the circuit had applied the toughest test for plaintiffs trying to meet the “heightened pleading standard” under the PSLRA.

But the pendulum may have swung in the 9th Circuit. In addition to the April 6 ruling in the Schroders case, the court decided Nursing Home Pension Fund, et al. v. Oracle Corp. in September 2004 and In re: Daou Systems, Inc. Securities Litigation in February 2005, cases in which the appellate court reinstated suits that had been dismissed under the PSLRA.

Ericson

Bruce Ericson, who chairs the securities litigation group at Pillsbury Winthrop Shaw Pittman in San Francisco, told Compliance Week that “it’s normal human temptation to read a lot” into a series of decisions that break one way or another, but said that trends are particularly difficult to pinpoint in the 9th Circuit because so much depends on which judges sit on a particular panel. (Federal circuit courts hear most cases in three-judge panels and the 9th Circuit has more than two-dozen judges from which panels are selected.) Ericson noted that the Schroders panel was “very liberal,” and that earlier defense victories in the circuit had been handed down by more conservative panels.

Although the Schroders case involved a private company rather than a public one, the heightened pleading standard issue would have been similar if the defendant had been a public company, Ericson said. “You could make an argument that the court was lowering fairly significantly the scienter requirement [of the PSLRA],” he said. However, the fact that this wasn’t a typical securities fraud class action could have impacted the outcome in other important ways, Ericson observed.

Alderman

According to William Alderman, who represents the successors to Schroders & Co., the 9th Circuit “got the facts wrong” in its decision and said that he would be petitioning the court for a rehearing.

Alderman, a partner in the law firm Orrick, Herrington & Sutcliffe, said the court “gave short shrift” to the issues of “loss causation” and scienter. He also said that the suit should have been barred by the pre-SOX statute of limitations. “I believe the record is clear that [the plaintiff] knew about the problem [in question] more than a year before it filed its case,” he said.

Suit Centers On One Sentence

The Schroders case arose out of a December 1999 purchase of $10 million worth of shares in Purely Cotton, by plaintiff Livid Holdings. In January 1999, Schroders helped PCI arrange a private placement of $25 million worth of its stock. For this purpose, Schroders created a Confidential Offering Memorandum outlining PCI’s operations, business plan and financial position. After the distribution of the memorandum to potential investors, a company called UAE allegedly agreed to purchase more than 98 percent of the offering, and various officers and directors of Schroders agreed to purchase the remaining stock.

In September 1999, PCI asked Schroders for additional copies of the memorandum in order to solicit additional investors. According to the lawsuit, the managing director at Schroders in charge of the offering amended the memorandum by attaching the following notice:

“This Memorandum was written in January 1999 and represents the original Offering Memorandum distributed to potential investors in the Company’s $25 million private equity fund raising. Subsequent to the writing and distribution of this document the Company may have undergone various changes including but not limited to management changes, ownership changes and business strategy changes. This document

has not been updated or amended to reflect any events that have occurred since January 1999. As such, it does not reflect the fact that the above-mentioned $25 million private equity fund raising has been completed.”

In its lawsuit, Livid contended that the last sentence of this notice implied that the proceeds of the initial $25 million sale had been received by PCI, but that the memorandum had not yet been updated to reflect this additional capital. At the time this

notice was written, however, UAE and the officers and directors of Schroders had actually paid less than $2 million to PCI. Livid alleged that additional payments on UAE’s balance were conditional on approval of a PCI business plan and a new chief executive officer, meaning that UAE was not actually bound to pay for the PCI stock.

A federal judge in Washington state dismissed Livid’s claim under Section 10(b) of the Securities Exchange Act of 1934 on the ground that it failed to plead adequately that the notice statement was a material misrepresentation, upon which it reasonably relied in purchasing PCI stock. In addition, the judge found that Livid’s complaint did not satisfy the heightened pleading standard under the PSLRA.

But, in reinstating the lawsuit, the 9th Circuit said that the “most obvious interpretation” of the last sentence in the amended September 1999 memorandum “is that this cash had already been received, but that this ‘fact’ and the resulting cash increase was not yet updated in the memorandum.” The court rejected the trial judge’s finding that the statement by Schroders was immaterial and said the plaintiff’s complaint was sufficiently “particular” to satisfy the PSLRA.

In its decision, the 9th Circuit addressed briefly a potentially important statute of limitations issue under Sarbanes-Oxley, which extended the filing period for Rule 10b-5 actions.

Here, Livid filed its complaint on Aug. 1, 2002, two days after the effective date of SOX. “This fact alone does not bring the complaint within [SOX’s] longer statute of limitations period as the [statute] also contains a statement warning that the new limitations period should not be interpreted as ‘creat[ing] a new, private right of action,’” the court said, noting that Schroders argued that the pre-SOX limitations period had already run when the suit was filed.

However, the court disagreed with Schroders that the pre-SOX limitations period had expired when the complaint was filed and refused to determine whether the “new statute of limitations period [in SOX] revives dead claims.”

Justices Lack Law Expertise?

Fisch

Jill Fisch, a professor at Fordham University School of Law, told Compliance Week that the 9th Circuit’s reputation in some circles as friendly to securities defendants is not necessary justified. She noted that the U.S. Supreme Court recently heard arguments in a case called Dura Pharmaceuticals vs. Broudo, in which the 9th Circuit applied a very liberal test in terms of what investors have to plead and prove in order to recover for securities fraud on a “fraud on the market” theory. That issue—referred to in legal shorthand as “loss causation”—is also an important issue in the Schroders case, Fisch noted.

What distinguishes the Schroders case from some of the other securities fraud suits is that it involves a “statement of present fact” with respect to the amended PCI memorandum. “It’s much easier to satisfy the pleading requirement when you’re dealing with a statement of fact than when you’re talking about characterizations or projections or inferences,” she said.

Ericson, of Pillsbury Winthrop, agreed. “This [case] seems to have gotten unusually factual. Ultimately, this is the case of the sticky sticker. The bottom line is that the [9th Circuit] panel seemed to be offended by what was on that sticker—that the previous private placement had been completed,” he said.

Although a lot of lawyers hope that the Supreme Court will at some point step in and clarify the heightened pleading standard issue under the PSLRA, the high court in recent years has “not gotten involved in that many technical securities law cases and when it does its opinions have been heavily criticized,” Fisch said, noting that the current justices have limited securities law expertise.

And all of the current justices have been out of law practice since the PSLRA became law in 1995, Ericson noted. “[The PSLRA is] the sort of thing that, unless until you dig into it, you don’t appreciate how much of a sea-change it made in the law,” he said.