As of July 2010, the United States Supreme Court has issued several opinions during 2010 in the securities litigation context. Indicating that it will continue to address securities matters, the Court also has granted certiorari in several cases. The Dodd-Frank Wall Street Reform and Consumer Protection Act, recently passed by Congress, addresses issues raised by one of these cases.

This article summarizes: (1) the Court's rulings during 2010 in the securities context as of July 15, 2010; (2) additional Court rulings during 2010 with some relevance to securities cases; and (3) the cases for which the Court has granted certiorari as of July 15, 2010.

Decisions Affecting Securities Litigation

Morrison v. National Australia Bank Ltd., No. 08-1191, 561 U.S. ___ (June 24, 2010)

In Morrison, the Supreme Court held that Section 10(b) of the Securities Exchange Act of 1934 (and Rule 10b-5, which cannot extend beyond Section 10(b)) provides a private cause of action only in connection with the purchase or sale of securities on an American stock exchange or the purchase or sale of any other securities occurring in the United States. A private cause of action does not exist for purchases or sales outside of the United States that are not made on an American exchange-regardless of whether the alleged misconduct underlying the claim occurred in the United States. The decision arose in the context of what is known as a "foreign-cubed" or "f-cubed" case: foreign plaintiffs who purchased shares of a foreign company on a foreign exchange. The Court emphasized that the focus of Section 10(b) is not on the place where the alleged misconduct occurred, but rather the location of the purchase or sale.

The plaintiffs in Morrison were non-U.S. investors who purchased shares of National Australia Bank (NAB)-an Australian company-on the Australia Securities Exchange, the London Stock Exchange, the Tokyo Stock Exchange and the New Zealand Stock Exchange. [FN 1] The plaintiffs filed lawsuits after NAB announced write-downs in 2001 of $450 million and then $1.75 billion. Following the announcements, NAB's shares fell by 5 percent and 11.5 percent respectively. The write-downs were the result of NAB's need to recalculate the value of mortgage servicing rights, which previously had been miscalculated by Homeside Lending, Inc., a Florida-based mortgage service provider that NAB had acquired in 1998.

The foreign plaintiffs sought to represent a class of foreign purchasers of NAB common stock. To determine whether the foreign plaintiffs had a right of action under Section 10(b), the Second Circuit applied a "conduct-and-effects" test, which analyzes "(1) whether the wrongful conduct occurred in the United States, and (2) whether the wrongful conduct had a substantial effect in the United States or upon United States citizens." Applying this test, the Second Circuit held that NAB and Homeside's acts within the U.S. did not "compromis[e] the heart of alleged fraud" and upheld the dismissal for a lack of subject matter jurisdiction.

Justice Scalia, writing for five Justices, held that §10(b) (and Rule 10b-5, which cannot extend past §10(b)) does not provide a cause of action to foreign plaintiffs suing foreign and American defendants for misconduct in connection with foreign exchanges, even if there are allegations of misconduct in America. Rather, "Section 10(b) reaches the use of a manipulative or deceptive device or contrivance only in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States."

Central to the Court's opinion was its holding that the extraterritorial application of the statute is controlled by the canon of statutory construction requiring an affirmative intent on the part of Congress to give a statute extraterritorial effect and treating silence on the issue as withholding extraterritorial application. Since Section 10(b) is silent as to extraterritorial effect, the Court held that Section 10(b) does not have extraterritorial application. In doing so, the Court rejected the "conduct-and-effects" test-overruling Second Circuit cases going back to 1968 that had ignored the canon of statutory construction central to the Court's ruling. The Court traced how the conduct-and-effects test's jurisprudence had developed as the Second Circuit's north star: "pointing the way to what Congress would have wished." The Court noted, however, that the Second Circuit had done so by judicial divination without offering a textual or even extra textual basis for its tests. These impossible-to-administer tests had been adopted by other Circuits, such as the Third (in 1977), the Ninth (in 1983), and the Seventh (1998). Only Judge Bork, in the D.C. Circuit (in 1987), had seen fit to question this, although he ultimately deferred to the Second Circuit's greater expertise on the topic.

The Court rejected the plaintiffs' arguments that their claims fell within the purview of Section 10(b) because the claims involved alleged fraudulent activity that occurred within the United States-the miscalculation of the mortgage servicing rights occurred at Homeside, which was located in Florida. The Court reasoned that the focus of the '34 Act "is not upon the place where the deception originated, but upon purchases or sales of securities in the United States." Since the purchases at issue occurred outside the United States, plaintiffs' claims based on such purposes did not fall within Section 10(b)'s application. The Court reasoned that the standard advanced by plaintiffs-to construe the Exchange Act to reach conduct in the U.S. affecting exchanges or transactions abroad, each of which have their own regulations and legal procedures, as was noted in the amicus briefs filed by several nations and international and foreign organizations-would raise a danger of inconsistency with foreign law. The Court further noted that while there is "no reason to believe that the United States has become the Barbary Coast for those perpetrating frauds on foreign securities markets, some fear that it has become the Shangri-La of class-action litigation for lawyers representing those allegedly cheated in foreign securities markets."

The Court also rejected several text-based arguments advanced by the plaintiffs and the Solicitor General. The arguments did not overcome the fact that Section 10(b) is devoid of any provision regarding extraterritorial application.

Justice Breyer wrote a brief concurring opinion to the effect that non-U.S. purchases involving only non-U.S. investors did not invoke the statute, and that no other issues need be decided. Justice Stevens wrote a longer opinion concurring in the judgment, which supported the conduct-and-effects test essentially on the basis that the courts had long been involved in construing §10(b), whose text and history "are famously opaque" as to transnational securities frauds. If the conducts-and-effects jurisprudence had become un-cohesive, as Justice Stevens acknowledged, the remedy would be to adhere more closely to the Second Circuit, which had done the best job of trying to discern what Congress meant. Justice Stevens also contended that the presumption against extraterritorial application was more flexible than the majority credited. In the end, he concurred in the judgment because the "case has Australia written all over it."

The Dodd-Frank Wall Street Reform and Consumer Protection Act, recently passed by Congress, addresses some of the issues raised by Morrison. [FN 2] First, the Act resolves any uncertainty as to the SEC and Justice Department's extraterritorial jurisdiction, codifying the "conduct-and-effects" test as to them. The Act provides that the SEC and Justice Department possess extraterritorial jurisdiction with respect to "(1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States."

While the Act does not directly impact the Court's decision in Morrison with respect to private causes of action, it does require the SEC to undertake a study to determine whether Congress should restore extraterritorial jurisdiction for private causes of action, either under the conduct-and-effects test or another standard. In addition to an analysis of the appropriate jurisdictional test, the study would analyze and consider: (1) the scope of any such private cause of action-whether it should extend to all private actors or should be more limited to extend to just institutional investors; (2) the impact of any such private cause of action on international comity; and (3) the economic costs and benefits of extending a private cause of action for transnational securities fraud. The SEC would have to submit its report no later than 18 months after the Act's enactment.

Merck & Co. v. Reynolds, No. 08-905, 559 U.S. ___, 130 S. Ct. 1784 (Apr. 27, 2010)

In Merck, the Supreme Court held that the two year statute of limitations for private securities fraud claims, as set forth in 28 U.S.C. § 1658(b)(1), is triggered upon the earlier of a plaintiff's "actual discovery" of facts constituting a violation, or when a reasonably diligent plaintiff "should have discovered" such facts, including facts showing scienter. The court rejected the "inquiry notice" standard and other variations of the standard articulated by various lower courts.

Merck involved the risk of heart attacks accompanying the use of Merck's pain drug Vioxx. Plaintiffs filed their action in November 2003, alleging that that Merck made materially false statements or omissions regarding the risks. The statements related to Merck's March 2000 announcement of studies that found that patients taking Vioxx had an increased risk of heart attacks as compared to patients taking another pain medication. Although it recognized the study, Merck suggested that the increased risk could be explained by benefits conferred by the other drug, not problems with Vioxx.

Merck moved to dismiss the action, arguing that the two year statute of limitations under 28 U.S.C. § 1658(b)(1) had lapsed prior to the plaintiffs' filing of the lawsuit. Merck maintained that two items placed the plaintiffs on "inquiry notice," which thus triggered the two-year statute of limitations: (1) a published May 2001 "warning letter" from the FDA to Merck, which stated that Merck was not adequately disclosing the increased risk of heart attacks associated with Vioxx in its Vioxx marketing materials, given the public debate regarding the reason for the increased cardiovascular risks associated with Vioxx; and (2) products liability lawsuits filed in May 2001 alleging that Vioxx failed to disclose facts regarding the cardiovascular risks of Vioxx. Merck argued that, at a minimum, these facts should have provided plaintiffs with sufficient notice of possible wrongdoing, requiring them to undertake a further inquiry into possible securities fraud. In November 2004 (after the filing of the lawsuit) Merck withdrew Vioxx from the market following the release of an additional adverse study concerning cardiovascular risks associated with the drug.

Key to the Court's ruling is the interpretation of the term "discovery" as used in the statute. The Court held that the two year statute of limitations period does not start on "inquiry notice" -if that term is read to mean sufficient facts suggesting to an investor that he should conduct a further inquiry-and before "discovery" of the facts. Nor is there a carve-out for plaintiffs who do not conduct an investigation-again, the word "discovery" controls. The Court explained that phrases like "inquiry notice" and "storm warnings" may be useful to the extent they identify a time when the facts would have prompted a reasonably diligent person to begin investigating, but they do not replace the statute-i.e., the term "discovery."

The Court further held that the "facts constituting the violation," whether through actual discovery or constructive discovery, include facts of the Section 10(b) element of scienter. If discovery of facts of scienter was not required, a defendant could avoid liability by concealing for two years the fact that it had made a misrepresentation with an intent to deceive. Contrary to Vioxx's argument, facts tending to show a materially false or misleading statement (or omission) do not ordinarily suffice to show scienter.

Under these standards, the Court held that the FDA warning letter and the product liability complaints did not constitute actual or constructive discovery of facts constituting a violation. The FDA's warning letter said little or nothing about scienter -"i.e., whether Merck advanced the naproxen hypothesis with fraudulent intent"-and indeed, the FDA had called it a possible explanation for the facts. The product liability complaints also did not talk about the company's state of mind: "i.e., that [it] knew the naproxen hypothesis was false even as it promoted it." Thus, these events did not trigger the two-year statute of limitations, and plaintiffs' action filed in November 2003 was timely.

Justice Stevens concurred in the "excellent opinion" even though he said that much of it was unnecessary. Justices Scalia and Thomas concurred in part and in the judgment. In their view, the company had not shown that the plaintiffs actually had discovered scienter more than two years before filing. Moreover, they contended that "discovery" does not include constructive discovery. The separate statute of limitations for the '33 Act (Section 13) explicitly contains constructive discovery language: "or after such discovery should have been made in the exercise of reasonable diligence . . . ." 28 U.S.C. § 1658(b)(1) does not contain such language, and the omission must have been intentional-or at least operative-as the text trumps any supposedly collective intent on the part of Congress.

Skilling v. United States, No. 08-1394, 561 U.S. ___ (June 24, 2010)

While not a decision under Section 10(b), the Court's decision in Skilling is relevant to most securities litigators' practice. In Skilling, the Court addressed the federal "honest services" fraud statute, 18 U.S.C. § 1346, which the government has often coupled with securities fraud claims. Skilling, who had been convicted under that statute, challenged the statute as unconstitutionally vague.

The Court held that § 1346, "the intangible right to honest services," is confined only to bribery and kickback schemes, and that because Skilling's alleged misconduct included no bribe or kickback, it did not fall within the Court's interpretation of § 1346's proscription. Furthermore, the Court held that § 1346, as confined to its core cases, is not unconstitutionally vague.

Justice Ginsburg, writing for the majority, reviewed the origin and subsequent application of the honest-services doctrine. While conceding that Skilling's vagueness challenge as to the entire statute had force, the Court decided, rather than strike the federal statute, to consider whether the prescription was amendable to a limiting construction. After paring down the body of precedent to its core in an attempt to preserve the statute, the Court held that there exists "no doubt that Congress intended § 1346 to reach at least bribes and kickbacks." The Court then considered the Government's argument to proscribe another category of conduct: "undisclosed self dealing by a public official or private employee," which it rejected, absent Congress' clear instruction otherwise, due to the "relative infrequency of conflict-of-interests prosecutions in comparison to bribery and kickback charges, and the intercircuit inconsistencies they produced." After interpreting § 1346 to encompass only bribery and kickback schemes, the Court held that the statute is not unconstitutionally vague. Moreover, a prohibition on fraudulently depriving another of one's honest services by accepting either bribes or kickbacks presents neither a fair-notice nor an arbitrary prosecution issue. Under this construction of the statute, the Court held that Skilling did not violate § 1346.

Justice Scalia agreed with the Court's opinion that Skilling's conviction for "honest services" fraud must be reversed, but for a different reason: the speculation that "scheme or artifice to defraud" includes "a scheme or artifice to deprive another of the intangible right of honest services" is vague and thus violates the Due Process Clause of the Fifth Amendment.

Black v. United States, No. 08-876, 561 U.S. ___ (June 24, 2010)

Justice Ginsburg, writing for all the Justices, referred to Skilling to hold that the honest-services jury instructions given by the trial court in this well-publicized prosecution were incorrect. In his concurrence, Justice Kennedy joined the Court's opinion except for those parts stating that § 1346 "criminalizes only schemes to defraud that involve bribes or kickbacks." In doing so, Justice Kennedy referred to the same reasons set forth in Justice Scalia's concurrence in Skilling.

Free Enterprise Fund v. Public Company Accounting Oversight Board, No. 08-861, 561 U.S. ___ (June 28, 2010)

While not a decision regarding federal securities fraud, the Supreme Court's decision in Free Enterprise Fund tangentially relates to a securities litigator's practice and could prompt questions from clients. In Free Enterprise, the Court held unconstitutional a provision in the Sarbanes-Oxley Act-the provision that members of the Public Company Accounting Oversight Board (PCAOB) can only be removed "for cause" by members of the Securities and Exchange Commission-because it interfered with the constitutional requirement that the President oversees the execution of federal law. Key to the Court's decision was that the President cannot remove members of the SEC at will, only for cause (a dissenting opinion questioned whether this was necessarily the case). The Court reasoned that the provision renders the President unable to ensure that the laws are faithfully executed because it "withdraws from the President any decision on whether . . . good cause exists" and renders the President "[w]ithout the ability to oversee the [PCAOB], or attribute the [PCAOB's] failings to those whom he can oversee." The Court upheld the constitutionality of the PCAOB with the offending provision severed.

Certiorari Granted

The Court recently granted certiorari in two cases: Siracusano v. Matrixx Initiatives, Inc. (decision below: 585 F.3d 1167 (9th Cir. 2009)), and Janus Capital Group v. First Derivative Traders (decision below: 566 F.3d 111 (4th Cir. 2009)).

Siracusano v. Matrixx Initiatives, Inc.

In Siracusano, the Court will address the issue of whether a plaintiff can state a claim under Section 10(b) and Rule 10b-5 based on a pharmaceutical company's nondisclosure of "adverse event" reports, even though the reports are not alleged to be statistically significant.

Matrixx Initiatives manufactured an internasal cold remedy called Zicam. In April 2004, plaintiffs filed a securities class action lawsuit in Arizona against Matrixx and three of its directors and officers, alleging that the defendants were aware of, and concealed, information that Zicam caused users to lose their sense of smell. The complaint alleged that the defendants knew of these problems as a result of more than a dozen grievances from doctors and users about a loss of sense of smell, negative academic research communicated to the company, and product liability lawsuits that had been filed against the company.

The United States District Court for the District of Arizona granted the defendants' motion to dismiss: finding that the complaint failed to adequately allege that the omissions were material because the complaint did not state that the number of customer complaints was "statistically significant"-a requirement for materiality in the First, Second and Third Circuits. See New Jersey Carpenters Pension & Annuity Funds v. Biogen IDEC Inc., 537 F.3d 35 (1st Cir. 2008); In re Carter-Wallace, Inc. Securities Litigation, 220 F.3d 36 (2d Cir. 2000); Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000).

The Ninth Circuit reversed, holding that the district court "erred in relying on the statistical significance standard" in concluding that the complaint did not plead materiality. The Circuit said that a court "cannot determine as a matter of law whether such links [between Zicam and loss of smell] was statistically significant, because statistical significance is a matter of fact." The Ninth Circuit, citing Twombly, wrote that the appropriate test is whether the claim is "plausible on its face." See Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 570 (2007). Based on this standard, the Ninth Circuit held that the complaint's allegations of materiality were sufficient to "nudge" the plaintiffs' claims from "conceivable to plausible."

Determining statistical significance is one of the key factors in establishing whether information is scientifically meaningful and, ultimately, required to be disclosed. By granting certiorari, the Supreme Court most certainly will resolve the apparent split in the Circuits that now exists: whether "statistical significance" must be established at the pleadings stage of a securities fraud lawsuit as a matter of law, or whether Twombly, as the Ninth Circuit concluded, only requires "facial plausibility" of the claim-leaving "statistical significance" to the trier of fact. Some commentators have also suggested that a broad review of the requirements for pleading materiality could be in the works, and that the Supreme Court could examine the scienter determination of the Ninth Circuit in this case. As for scienter, the Ninth Circuit emphasized what the executives of Matrixx "would have known" without allegations of actual knowledge. The Court held that the executives "would have known" about products liability cases and the fact that customer complaints and negative academic research were communicated to the company's director of research. Some have also suggested that the question of whether scienter can be established based on an individual officer's position, notwithstanding what they actually knew or what information they had access to could be addressed-this could lead to a significant clarification in the law.

Janus Capital Group v. First Derivative Traders

In Janus, the Court will address the issues of: (1) whether the Fourth Circuit erred in concluding-in direct conflict with decisions of the Fifth, Sixth and Eighth Circuits -that a service provider can be held primarily liable in a private securities fraud action for "help[ing] or "participating in" another company's misstatements; and (2) whether the Fourth Circuit erred in concluding-in direct conflict with decisions of the Second, Tenth and Eleventh Circuits-that a service provider can be held primarily liable for statements that were not directly and contemporaneously attributed to the service provider. [FN 3]

The plaintiffs in Janus are shareholders of Janus Capital Group (JCG), the holding company of several Janus funds. They filed their securities fraud action against JCG and Janus Capital Management Group (JCM), which is the investment advisor to the funds. Plaintiffs' claims were based on alleged misstatements in the prospectuses for several Janus funds stating that the funds' managers did not permit "market timing" of the funds. The investors claim they lost money when the "market timing" practices that JCM and JCG allegedly authorized became public.

In 2007, the District Court for the District of Maryland dismissed the shareholder suits. The Fourth Circuit reversed, holding that plaintiffs had sufficiently pled their Section 10(b) claim against JCM and their Section 20(a) control person liability claim against JCG. The Court held that the alleged misstatements were sufficiently attributable to JCM and JCG "because 'as a practical matter [JCM] runs' the Janus funds, defendants disseminated the prospectuses on a joint Janus-JCG-JCM website and, consequently, the public would attribute the misstatements in the prospectuses to defendants." Plaintiffs argued that JCM was not simply a "service provider," but that because it handles all of the Janus funds' operations "including preparation, filing, and dissemination of the Fund prospectuses and prospectus statements," and because all of the funds' officers were executives of JCM, they had every reason to believe that the Fund prospectus statements were prepared by JCM.

At bottom, the Fourth Circuit held that a service provider can be held liable in a private securities fraud action for "helping" or "participating" in another company's misstatements. As described above, this ruling is at odds with other Circuit courts. [FN 4] It remains to be seen whether the Supreme Court will limit primary violator liability by creating a bright line rule that only extends primary violator liability to those who speak or have statements attributed to them, or if it will substantially expand primary violator liability by adopting a "substantial participation" test as followed in other circuits (and which is similar to the 4th Circuit ruling). Still further, some have speculated that the Court will seek to bring primary violator liability in line with its secondary liability jurisprudence recently affirmed by the Court in Stoneridge.

Conclusion

As the cases discussed above establish, this Court has exhibited a keen interest in securities fraud matters. It is to been seen whether the Court will continue to grant certiorari in other securities cases, in which case securities litigation practitioners may see a significant shift in the law governing their cases.

Footnotes

[1] In this case, the named petitioner was a U.S. investor who had purchased the foreign issuer's ADRs (these depository receipts represent the right to receive a specified number ordinary shares) that were listed on the NYSE. His claims, however, were dismissed for failure to allege damages before the case reached the Court. Thus, only the foreign plaintiffs who had purchased ordinary shares remained in the case by the time it reached the Court.

[2] At the time of this article, Congress passed the Dodd-Frank Act, and it was expected that President Obama would quickly sign it into law.

[3] The circuit cases that established the "majority rule" from which the Fourth Circuit has split are as follows: Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA) Inc., 482 F.3d 372 (5th Cir. 2007); Fidel v. Farley, 392 F.3d 220 (6th Cir. 2004); In re Charter Communications, Inc., Sec. Litig., 43 F.3d 987 (8th Cir. 2006); Wright v. Ernst & Young LLP, 152 F.3d 169 (2d Cir. 1998); Sec. & Exch. Comm'n v. Wolfson, 539 F.3d 1249 (10th Cir. 2008); Ziemba v. Cascade Int'l, Inc., 256 F.3d 1194 (11th Cir. 2001). In contrast to the majority rule established in the preceding circuits, the Fourth Circuit appears to have aligned with the Ninth Circuit. In its ruling in In re Software Toolworks, the Ninth Circuit held that Rule 10b-5 liability may be imposed on a defendant who merely "played a significant role in drafting and editing" the misleading statement. In re Software Toolworks, Inc. Sec. Litig., 50 F.3d 615, 626 n.3 (9th Cir. 1994).

[4] The Fourth Circuit's decision also appears to be at odds with the First Circuit's recent en banc decision in Tambone, which reversed the denial of a motion to dismiss an SEC lawsuit against the officers of mutual fund advisers on the ground that the plaintiff failed to allege that the defendants "made" a false statement. Sec. & Exch. Comm'n v. Tambone, 597 F.3d 436 (1st Cir. 2010). The plaintiff's claim was that a broker-dealer's two senior officers approved and knowingly permitted certain customers to engage in excessive mutual fund trading (market timing) or "round tripping" without disclosing such arrangements to the other mutual fund customers (and when the mutual fund prospectuses decried the practice). A prior First Circuit panel had written that liability under Rule 10b-5(b) could exist upon the "implied statements" by the officers, and that they had a reasonable basis to believe that the statements in the prospectuses were true-regardless of whether the defendants actually crafted the statements, which in fact had been made by separate entities-when they "used" and "employed" the prospectuses in order to sell mutual funds. The en banc court rejected this contention as being inconsistent with the structure of the rule and statute, and in "considerable tension with Supreme Court precedent" (namely Central Bank's dichotomy between primary and secondary liability, and subsequent decisions). See Cent. Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994). This theory of liability also would extend liability beyond the text of §10(b) and go beyond even the substantial participation standard for private civil liability under Ninth Circuit law, as it would allow liability for persons who had no involvement whatsoever in creating, composing, or causing the existence of an untrue statement. Indeed, reasoned the Court, the SEC would impose an unprecedented duty on securities professionals who work for underwriters-a free-standing duty to disclose that "flies in the teeth of Supreme Court precedent" under Chiarella. See Chiarella v. United States, 445 U.S. 222, 228 (1980).