Securities Compliance Sentinel - Analysis of Cutting Edge Securities Industry Issues

I do not envy any attorney who attempts plead a Section 10b-5 claim.  Courts throughout the country have made pleading scienter extremely difficult, and the benefit of any doubt favors the defendants.  Under the PSLRA, a plaintiff must plead a strong interference of scienter by alleging sufficient facts to show that the defendant had both motive and opportunity to commit fraud and/or facts sufficient to show that there is strong circumstantial evidence of intentional or reckless behavior. 

In a recent opinion, the Court of Appeals for the Tenth Circuit dismissed the plaintiffs’ Section 10b-5 claims.  The plaintiffs alleged that the officers made false statements relating to the progress of an important network integration project, which would significantly impact the financial condition of the firm.  The Tenth Circuit acknowledged that the defendants made false statements of material fact relating to the network integration project, but held that competing plausible inferences indicated that the officers may have been merely careless and did not adequately track the progress of the project.

The Tenth Circuit’s ruling is consistent with the trend around the country.  Merely pleading a false statement of material fact is not enough, and courts generally rule in favor of the defendants when analyzing competing plausible inferences.  Plaintiffs’ attorneys can meet this high burden by specific and detailed allegations of intentional behavior – a burden that can be difficult to meet without discovery. 

In the years that I have defended broker-dealers and investment advisors from customer-initiated complaints, a common theme has emerged.  The bulk of the complaints seem to come from older clients.  Unfortunately, the aging baby boomers may exacerbate this issue.

In a recent Investment News article by Mary Beth Franklin, she reported on a recent study reflecting that the number of Alzheimer patients is expected to triple by 2050.  She noted that one of the first skills to go is the high-level function required to perform financial tasks like reviewing account statements.  The article further noted that the aging population and the move toward a uniform fiduciary duty standard will only make this issue even bigger.

So how can you protect yourself from the pitfalls of an aging client base.  Ms Franklin noted a number of worthy action items, including:

1. Having the client update estate and legal documents (like a power of attorney).
2. Encouraging your clients to seek timely medical care.
3. Assisting your clients in selecting a worthy advocate in the event the client becomes incapacitated.
4. Building a relationship with that advocate.
5. Focus your clients on developing a plan for the future.

The key takeaway is early intervention.  Do not wait until your client is incapacitated to plan for the future.  At that point, it is likely too late, and you have set yourself up for a claim in the future.  Act now, or pay the price in the years to come. 

photo from freedigitalphotos.net

A California federal court refused to dismiss negligence and other state law claims against a law firm for allegedly helping its client commit federal securities law violations.  See Donell v. Nixon Peabody, LLP, C.D. Cal., No. CV 12-04084 DDP (JEMx), 9/5/12.

In this suit brought by the receiver of a defunct investment firm, the court rejected the law firm’s constitutional arguments regarding the right to bring such claims as well as its jurisdictional and standing challenges.  The lawsuit arose out of a SEC enforcement action against an investment firm, its principal and others.  The receiver accused the law firm of assisting in the principal's scheme of looting assets from the investment firm's clients.  The court found the receiver properly plead its complaint against the law firm, and found a sufficient basis for it preceding against the law firm given the alleged conduct.  Intriguingly, one of the law firm’s partners was also indicted along with the main fraudster.

In short, law firms are clearly a target when fraudulent activity occurs.  Law firms and their attorneys, therefore, must take precautions or trouble will follow them.

The U.S. Court of Appeals for the Third Circuit found that two founders of a metal components business were not liable in a securities fraud lawsuit although both had improperly looted millions of dollars of corporate assets. See Gallup v. Clarion Sintered Metals Inc., 3d Cir., No. 11-4004, 7/26/12, and http://federal-circuits.vlex.com/vid/paul-gallup-clarion-sintered-metals-390620030.

Essentially, the investors had not shown reliance to prove their Securities Exchange Act of 1934 Section 10(b) claim.  However, the court did allow them to continue -- albeit in state court-- with their other claims after documenting a pretty elaborate scheme to depress the price of the stock and cover-up their fraud.  Interestingly, the court did indicate that the plaintiffs had not read any of the financial statements the company issued.  Thus, although they may have a claim for breach of fiduciary duty or improper management, those claims are not sounded in federal securities law.

Consequently, the moral of the story, if you want to sue, at the very least, keep up-to-date with the company's newsletters and financials!!

As many regular blog readers know, I have participated as an expert witness before.  It is fascinating to share with our readers other epxert experiences as well.  

Nonetheless, a number of issues relating to experts in securities cases have arisen over the last year.  In particular, many cases involve the threshold question as to if it is possible for an expert to be qualified or opine on the customs and practices of financial institutions.  There is case law across the United States that seems to indicate an uncertainty as to future court rulings.  However, some courts have indicated that they will require an expert to possess a great deal of experience with these particular issues before qualifying said expert to testify.

As a result, those wishing to propose such an expert should ensure that they have the right qualifications and experience to testify.

Recently, a Texas appellate court upheld a common law prohibition against a former registered rep who had moved firms.

The court indicated that this departing broker had a common law obligation to maintain confidential information from his prior employer.  See Institutional Securities Corporation, et al. v. Vernon J. Hood, III (December 12, 2012), http://judicialview.com/State-Cases/texas/Employment/Institutional-Securities-Corporation-v-Hood/22/568743.  In this case, the broker had downloaded information and also obtained other documents in preparation for sending information to his customers.  The court found that he was not permitted to do such a thing and could not use a broker/client data.  This was interesting because the broker had actually been fired and escorted out of the building.  The broker had previously downloaded this information.

Although the broker did not have a restrictive covenant or non-compete, the court imposed one upon him and indicated that the broker could face disciplinary action from FINRA.  This decision is problematic for those brokers moving from firm to firm.

“Big Boy Letters” are usually used to identify that the buyer in a transaction has made its own independent assessment of certain risks involved and that certain information has not been disclosed to the buyer by the seller.  In particular, this means that a party is not relying upon certain representations or the lack of representations.

The critical step in these letters is considering the application of these non-reliance provisions are received by the courts and the SEC.  In particular, the SEC has taken the position that such a letter will not foreclose an insider trading liability case under a misappropriation theory  However, courts and private litigants could effectively eliminate or at least limit the potential liability from these letters.

Essentially, the use of these letters is somewhat uncertain depending upon the context.  Nonetheless, these letters are certainly not a complete "get out of jail free" card, and will depend upon the facts and circumstances of each situation.

We wanted to let everyone know about recent victory by our colleague, Mitchell Berns.

Fox Rothschild litigators recently prevailed for The Blackstone Group on its contract claim for $3.7 million fees due from Taro Pharmaceutical Industries. Blackstone helped arrange the sale of Taro to Sun Pharmaceutical Industries in 2007, but the sale did not occur until 2010, after the conclusion of Blackstone's engagement. The New York Supreme Court enforced a tail fee provision in Blackstone's engagement letter to sustain its claim for success fees due upon the sale. The award comes to $4.5 million with interest.

Blackstone is a global investment management and financial advisory firm.  Taro engaged Blackstone in late 2006 to help it arrange rescue financing.  Taro, an Israeli pharmaceutical producer, had run into financial difficulties arising from an overstocking of inventories in its wholesale channels.  After exploring financing alternatives, in May 2007 Taro entered into a series of agreements with Sun Pharmaceutical, and Indian generics producer, providing for an immediate cash infusion by Sun, to be followed by Sun’s acquisition of Taro.  Sun invested $59 million in Taro equity shares, and its acquisition of Taro was then to occur either through a merger transaction or, failing that, Sun’s exercise of an option to buy a controlling block of equity held by Taro’s founders.

After Taro received its initial cash infusion from Sun, the proposed merger between Sun and Taro was delayed by Taro shareholder opposition.  When Sun elected to pursue the acquisition by exercising its options to buy the Taro founders’ shares, Taro sued Sun in Israel claiming that Sun had failed to comply with Israeli regulations governing the consummation of an associated tender offer to all Taro shareholders.  In September 2010, the Israeli Supreme Court issued a final ruling permitting Sun’s acquisition to proceed.

Blackstone’s engagement agreement provided that it would earn success fees upon the consummation of transactions associated with Sun’s acquisition of control over Taro.  However, Taro had terminated Blackstone’s engagement in July 2009, over a year prior to the Israeli Supreme Court ruling permitting the acquisition to proceed.   Blackstone’s engagement letter included a “tail fee” clause providing that it would be paid success fees on all related transactions, including those occurring after Blackstone was terminated, so long as the first related transaction occurred within the contract period. 

Taro contested Blackstone’s motion for summary judgment seeking its success fees, arguing that the engagement letter was ambiguous and did not support Blackstone’s claim.  Justice O. Peter Sherwood of the Commercial Division of the Supreme Court, New York County, rejected Taro’s arguments and enforced the tail fee provision, awarding Blackstone the $3.7 million success fees it sought (The Blackstone Group L.P. v. Taro Pharmaceutical Industries Ltd., Index No. 650581/2011, Decision and Order dated December 7, 2012).  With prejudgment interest, the award totals $4.5 million.

Partner Mitchell Berns and associate John Rolecki of Fox Rothschild’s New York office handled the matter for Blackstone.  Taro was represented by Friedman Kaplan Seiler &.Adelman LLP.
Contact:  Mitchell Berns, 212-878-7917, mberns@foxrothschild.com

The short answer to this question is a very large, NO!

All too often in my defense of registered representative and investment advisors do I see a completed account application as the only indicia of the performance of a know your customer analysis.  From my perspective and years of experience, the account application is only the floor, not the ceiling for the know your customer analysis.

Clearly, the account application is a necessary tool in the information gathering process, but checking off boxes does not give you the whole picture.  What I have found most defendable is where the advisor had his or her own checklists to ensure that they adequately know their customer.

For example, many times account applications do not take into account situational issues that may impact an investment strategy.  Does your customer have dependents?  Does your customer have health issues that would require immediate liquidity needs? Does your customer plan to retire in their near or long-term?

Account applications can never answer all of these questions, but my know your customer guidebook may help you with this information gathering process.  It is impossible to truly “know” everything about your customer, but the question in any lawsuit will be did you do enough for that customer and that investment.  A file full of things that reflect a know your customer analysis is much easier to defend than one with only an account application, which was hopefully not completed in blank.

Take your time, and go beyond the account application.  Ask the tough questions.  Push for answers.  Know your customer, and avoid the risk of a customer complaint.

It has been two months since FINRA Rule 2111 has come into effect.  This new rule requires that there must be a reasonable basis to believe that the recommended transaction or investment strategy involving a security is suitable for a customer, where a strategy can involved the recommendation to buy, sell or hold a security.  So what does it mean to make a suitable investment recommendation?

I have effectively argued in arbitrations that a 100% equity growth investment portfolio was suitable for a investor.  Although this may seem a bit out of whack, the panel did not think so; why.

The key for making suitable investment recommendations is to make sure that you first know your customer.  Equally important, you must document the rationale for making such a recommendation.

From my experience, the more documentation in your file to demonstrate your explanation to the customer of the respective risks and benefits of a proposed investment strategy, the more likely that an arbitration panel will agree that you had a reasonable basis for the investment recommendation. 

To protect yourself, never take a shortcut.  Make sure your fully  document you recommendation in your notes, with prospectus or other written materials.  If you  do, you stand a reasonable chance of prevailing if that same customer decides to bring a claim against you.

Over the years and, most certainly, since the passage of the Private Securities Litigation Reform Act, plaintiffs' lawyers have used confidential witnesses in their pleadings. 

Plaintiffs' lawyers, typically, do not name these witnesses in their complaints to avoid motions to dismiss and other legal actions.  However, over the last several years, court decisions have become increasingly critical of this approach, requiring confidential witness disclosure to occur, most notably, in Federal Rule of Civil Procedure 26 initial disclosures.  Not to be outdone, Plaintiffs' lawyers have responded by trying to hide these confidential witnesses among other witnesses named.

Nonetheless, recently, some courts have even required that these so-called confidential witnesses be named at the motion to dismiss stage to assist the court in determining if the defendants motion to dismiss should be granted.  Most notably, the Second Circuit Court of Appeals has approved this process in the Campo v. Sears Holdings Corp., 2010 WL 1292329, No. 09-3589-cv (2d Cir. Apr. 6, 2010).

Additionally, plaintiffs have also run a risk that, when they refuse to name a confidential witness, their action could result in dismissal and/or sanctions.  Some cases have revelaed that confidential witnesses may, ultimately, recant their story as the litigation progresses.  This was vividly seen in the City of Livonia v. Boeing Company case,  http://scholar.google.com/scholar_case?case=7885063100490608775&hl=en&as_sdt=2,39, where the confidential witness recanted, subjecting plaintiffs to a Federal Rule of Civil Procedure 11 sanctions.

Thus, there are dangers in using confidential witnesses in securities litigation, and defendants  should be ready to respond.

We have previously blogged on changes in the arbitration process.  We have seen that commercial arbitration, and, in particular, the securities arbitration process, is undergoing a transformation.

The backdrop for these changes is related to the belief that many consider the increased cost in arbitration to be the of the Americanization of the process.  That means, a higher cost for discovery battles, jurisdictional disputes, as well as litigating evidentiary issues that normally would not be litigated.  Moreover, certain arbitration forums are increasing training for their arbitrators to attempt  to avoid these these issues, and decrease costs.  Further, some arbitration platforms are even implementing something commonly known as a “Rocket Docket,” that is, a process that quickly moves cases along to a conclusion.  Some of the procedures that are being put in place include allowing video-conferencing for witnesses as opposed to actual live testimony and requiring stipulations over certain evidence to avoid long drawn out hearings. 

Some of these reforms seem to have a good basis in reality, however, it will be interesting to see if these changes curtail a litigant’s rights, providing an opportunity to criticize the entire arbitration process.