Notre Dame Deception Roundtable, part 4

Session 4 – Contracts and Securities

Discussion Leaders: Greg Klass, Ann Lipton, Andrea Matwyshyn

 

Matwyshyn: there’s a duty to perform in good faith in the US, but no duty to negotiate in good faith. If you have an integration provision, conversations leading up to the contract will be excluded from contract interpretation. If we let people lie leading up to the contract, what are we showing about our values and also about differences b/t our contract law and EU, where lies in negotiations may be actionable.

 

Klass: integration clause won’t prevent a defense of misrepresentation in negotiations, or the tort of misrepresentation.  Good faith is really interesting, but there’s a separate issue in contract law, the economic loss rule, which will prevent a claim for the tort of deception in the performance. So if you lie about your performance of the contract, only breach damages are available. But a precontractual lie isn’t covered by the economic loss rule.

 

Silbey: Tort cares more about diffuse harms, even if it’s hard to make out a claim, than contract.  Contract is about freedom to contract and freedom from contract, while tort is a different species of social values law cares about.

 

Klass: you want to look at what work the doctrine of pre-contract good faith does in EU.

 

Matwyshyn: people have sued over term sheets successfully in the EU.

 

Klass: before contracting, your duty is not to misrepresent; you don’t have to look out for the welfare of the other party. You can fight for a larger share of the pie as long as you play by the rules.  Related question: can you contract out of fraud liability and say that lying is permitted in your negotiations?  Delaware Ch. Ct. case: the court says you may not do that.  There is an obligation not to lie that’s fundamental; but you can include in your contract a representation of no reliance, effectively precluding any action for misrepresentation.  In M&A, seller is often worried about misrepresentation claims, so they want the buyer to sign an agreement saying it’s not relying on anything outside the agreement. So all you need is the magic words.

 

Lipton: NY has done this w/sophisticated parties.  Mortgage-backed securities/synthetic CDOs contracting w/German bank.  Court said that it was misleading of the P because the P represented that it wasn’t relying on the D’s representations in the contract. 

 

Klass: Maybe one side understands the magic words and the other doesn’t, and instead of saying “there’s no fraud liability” which would be very clear they allow confusion.

 

Lipton: Securities is different b/c of the multiple disclosure obligations.  Deception rules then implement the disclosure obligations; it’s about setting up an information market, and thus it’s not just intentional deception that matters but the quality of information. Capital formation/market structure as well as consumer protection.

 

Klass: Buell comes to it as a federal prosecutor with generic anti-fraud statutes; that’s where he starts, and maybe his approach focusing on deception is more fit to those.

 

Lipton: there is a rather extensive system of claims that don’t require any showing of intent—either strict liability or negligence. Puffery piece by David Hoffman: his framework doesn’t work for securities b/c there’s no intention requirement so his proposal to allow Ds to rebut by showing no intent to defraud is not helpful.

 

Goldman: why the different rules for securities?

 

Lipton: because this is about capital formation.  May have started as consumer protection, but evolved to want a deep and effective secondary market for trading. You therefore need a standardized info package. Lots of products can’t be investigated and are in some ways interchangeable; there are debates about whether/why the market wouldn’t generate the info w/o requirements. Billions of trades a minute.

 

Matwyshyn: it’s all about trust. Risk of investing in low credibility securities and risks of playing poker sometimes aren’t that different in terms of the numbers.  Maybe we are fetishizing this area of the economy in ways we don’t others.

 

McG: because for these other historical reasons and purposes you have such an elaborate set of disclosures, changes the nature of what deception means.  Information you’re owed as a backdrop to define what deception is: there is rough consensus about what has to be disclosed and how.

 

Lipton: there’s now a circuit split on what fraudulent omission is.  The big antifraud statute, 10(b): whether it’s deceptive to fail to disclose required info under 10(b). If you have a background expectation it will be disclosed, 2d circuit says that yes, it’s deceptive; 9^th Circuit says no, there has to be something affirmatively said.  She doesn’t see the 9^th Circuit’s logic. SEC can definitely bring a claim in either case; the case law is muddled by a view about how much we trust private plaintiffs to bring these cases when no one actually read the documents b/c it’s all a fraud on the market theory anyway.

 

McG: gets it back to who are the right parties to sue—it might not be the people who are deceived.  Systemic problems stemming from deceptive omissions.

 

Lipton: fraud on the market is very much an injury to the market, not to heterogenous consumers. We are supposed to use objective reasonable person standard, but in fraud on the market courts look through the lens of sophisticated people and in calls to widows they look through unsophisticated, even though that’s not the formal doctrine.

 

Matwyshyn: classes of trusted intermediaries have special roles and liabilities in this regime.  [And that interacts w/puffery and falsity, b/c things that might be nonfalse if said by others can be false if said by them.]  Frank Pasquale: new tech means we lose some checks on intermediation we used to have, as w/sophisticated algorithms that engage in billions of transactions/minute.  All it takes is one problem and no one is auditing the code.  Historical example: Brokerages lied about completing trades in-house b/c they couldn’t keep up w/the market: ended up w/regulatory intervention, lots of closed brokerages.

 

Eric Goldman: interested in the idea that securities market needs all this regulatory structure to be trustworthy enough to proceed.  What distinguishes this from other markets, like the eBays of the world where reputation is enough to build a trust market?  They’re both pushing stuff.  Type I/Type II errors: people sue b/c stock price went down; he thinks that’s bad. Should be concerned about both types of errors. 

 

Lipton: Congress made it really hard to bring a securities fraud case right now; pleading requirements, discovery bar; Type II errors are really unlikely.

 

Goldman: shows you that a regulatory structure needs constant tweaking to avoid the pendulum swinging too far. What about securities led to us building that oversight?  Case study of too much regulation.

 

Lipton: eBay as a company has the ability to stand behind sellers. NYSE used to have ability to stand behind companies. Regulation means it’s less necessary to be on NYSE b/c I know you have met requirements that the SEC stands behind. If you come from another country w/lower securities laws and you list here, that sends a signal to investors that you’re more credible and you have lower cost of capital.

 

McKenna: it’s also systemic risk. If eBay goes down, it doesn’t take down the entire economy.  That’s why you care about structural features—runaway effects of a crash. Also explains more extensive reporting requirements: thicker info requirements.  If eBay goes away, you just have to buy stuff in stores, but you don’t get a Great Depression (it’s just depressing).

 

Silbey: these disclosures aren’t actually transparent.

 

Lipton: but computers can and do interpret them, and sophisticated people can look at companies and compare them across an industry, which helps in trading.

 

Silbey: aren’t they routinely scrubbed and managed?

 

Matwyshyn: some things you can’t scrub. You have to talk about material litigation, for example. Bird’s eye view into how the company sees itself.

 

Lipton: I was a plaintiff’s lawyer and I’m skeptical but even I think there’s information there.  Commodities disclosures are different.  Pages of boilerplate disclosures of risks. Earthquakes could affect Twitter. You may think this is useless, but it turns out that people do econometric studies and those risk disclosures do affect stock prices. Computers look for tiny changes in language, and differences are caught that way.  You can find accounting fraud by crunching numbers and looking at language choices. When people commit fraud, they use different language.

 

Matwyshyn: companies in same industry were talking about tech in very different ways. 2004: Google didn’t disclose risks of security breaches in the same way Microsoft did.  You can track learning in the industry. 

 

Lipton: standardized set of disclosures allow you to detect patterns, not even as extreme as detecting fraud, through human and computer review.  When companies have bad news, they use bigger and vaguer words. 

 

McKenna: this is very far to the end of the structural harm line. Also there are lots of mediating sophisticated parties, so disclosures can be more useful here than in privacy. Also more standardized, instead of “say whatever you want and you’re going to be held to it.”

 

McG: there is one standardized disclosure in privacy, and it’s financial.  You don’t have to use the standard form, but there’s a safe harbor, so everyone does. Computer scientists at CMU did a computer analysis of them, which is routine in the securities space, and came up w/lots of interesting observations about regional differences, and found some companies breaking the law by their own disclosures, etc.

 

McKenna: if disclosure is the means to regulate, then should we require standardized disclosures?

 

Lipton: that’s good, but also need capacity to actually read them, whether human or computer.

 

Said: so context sensitive: “promotional consideration furnished by” is standardized but doesn’t solve problem (if problem there is). Extent to which digital tools are worsening deception problems b/c of ability to scrape, use hidden info, unsettle expectations; but also digital tools may be part of solution, whether using info commons or to detect fraud.

 

Perzanowski: nothing stops requiring a disclosure to be effective.

 

Lipton: that works unless there’s a lot of heterogeneity—experts in securities help.

 

Klass: misrepresentation in contracts includes nondisclosure, but it’s a vague standard: reasonable/not disclosing violate goods faith. The only way it works is that you get repeat situations: if there’s termites in your house you have to disclose; if you’re an oil company you don’t have to disclose you know there’s oil on the farmer’s land.  His own take: common law of fraud/contract is that we have clear norms about affirmative lies, and law piggybacks on those; that handles new situations. We don’t have strong intuitions on failure to disclose.

 

McKenna: tort is riddled with uncertainties about acts v. omissions writ large.

 

Matwyshyn: real estate contracts are a good example: regulatory interventions to explain what you have to disclose. It’s cooperative set of regimes working together.  Theme of this session: the focus on methods of detecting deception and fraud when it’s happening.  Sec reg might be better at that than some other contexts. 

 

Lipton: clearly there’s a bunch of fraud; sometimes computers are easier to fool than people, as when there are fake merger announcements that computers think are real and people could easily detect as frauds.  However, there’s a lot of money to be made in early detection, so it also happens.

 

Said: In speech arena, we have lots of worry about chilling through misreading/understanding whether speech is false.  We haven’t talked about listening or interpretation here.

 

Klass: pitch for Grice and implicature. A rich theory about how we interpret not just literal but implied meanings, including irony. Cost-benefit analysis may be built in. That’s how a lot of the law of deception piggybacks on extralegal interpretive norms.

 

McKenna: this all sounds like duty to me. Affirmative misrepresentation v. failure to disclose—this is the difference b/t someone who’s begun to act and thus has the duty to do it reasonably well, versus when I never start and have no duty to continue.  Regulation can also create duty.

 

McG: sometimes untidiness in law is based on different interests being served by different silos, and we should be willing to be comfortable w/that.

 

McKenna: but we should be clear about what we mean rather than assuming it has a fixed meaning.

 

Klass: it’s not common purpose or justification, but that there’s a common set of design questions that repeats across different fields.  My way of thinking: most of those are contained in the common law elements.  In this area of law: what’s the deal w/scienter? What’s the deal w/reliance? 

 

Silbey: basic things are missing from TM that could be borrowed.

 

McG: do you want a scary regulator like the SEC?

 

McKenna: think about why features work in some areas and not others.

 

Lipton: law keeps the corporation and the stock certificate relatively stable in what they are, so they’re relatively interchangeable. B/c of relatively homogeneous set of products, it’s easier to regulate them.

 

Matwyshyn: it takes a “river on fire” moment to have a meaningful evolution.  If we look historically at when quality control has meaningfully improved, what would it take to create change in deception regulation?  [FDA: it took a lot of dead kids.]

 

Gadja: news sites shifted from anonymous comments to Facebook in part b/c of all the defamation.

 

Lipton: scandals also produce incremental responses. Bork issue = just video rentals protected.  Harder to get overarching response, in the US.

 

McG: though other countries have done it.

 

Silbey: dilution added to TM act as a response to market forces.

 

McKenna: Even the SCt has no way of thinking about how to reconcile these different fields, as 1A discussion showed.  Alvarez is totally unsatisfying about why SVA is unconstitutional but TM is just fine.  Modern TM law is nothing like history or tradition was, which is why their explanation was wrong.

 

Silbey: Alvarez was not about TM.

 

McKenna: they think TM law is totally fine; they used TM to explain why the SVA was bad.

 

McG: Alvarez pro-US briefs tried to brief TM law as “uh-oh, be careful what you do so as not to destroy it.”  Thus the Court may have been trying to cabin the force of the opinion.

 

McKenna: gives us reason to think harder about the kinds of harms at issue. 

Silbey: in fundamental rights cases, the Court spends lots of time identifying the harms in fundamental rights like marriage cases. They seem unable to do so in these cases however.

 

McKenna: there’s so much assumption about what deception is.

 

Said: what if we looked for tolerated confusion/efficient confusion? 

 

Silbey: they had that in the briefing in Alvarez—a lot of discussion of the benefits of lies.   Flatness of discussion of variety of interests in IP cases, compared to the discussions of competing values in securities law etc.

 

Lipton: that’s a public choice issue—hasn’t been people with lots of money/big megaphone on the other side of IP cases.

conflict mineral disclosure unconstitutional, DC Circuit rules

National Association of Manufacturers v. Securities and Exchange Commission, No. 13-5252 (D.C. Cir. Apr. 14, 2014)

If we needed an example of how the First Amendment can reinstate Lochner, this would be a good one.  Here we have a regulation, whose merits are debatable, which easily survives APA challenges because Congress is allowed to make rules even if the rules are dumb and the SEC just did what Congress told it to do.  But then a substantial chunk of it founders because the output of the regulation is a disclosure.  Argh.
 

In response to horrific human rights violations in the Congo, where war is financed by selling several minerals, Congress enacted a law requiring the SEC to issue regulations requiring firms using “conflict minerals” to investigate and disclose the origin of those minerals.  The required annual report to the SEC needs to disclose whether conflict minerals originated in the Congo or an adjoining country, describe the due diligence measures taken to establish the source and chain of custody of conflict minerals, and list  “the products manufactured or contracted to be manufactured that are not DRC conflict free.” A product is “DRC conflict free” if its necessary conflict minerals did not “directly or indirectly finance or benefit armed groups” in the covered countries.   There’s no exception for de minimis uses, or for issuers who only contract for the manufacture of products made with conflict minerals.
 

The SEC estimated that the rule would be expensive--$3-4 billion to begin with, then roughly $200-600 million annually thereafter.  It was unable to quantify the benefits of reduced violence in the Congo, because it couldn’t assess how effective the rule would be. Instead, the SEC relied on Congress’s judgment that supply-chain transparency would promote peace and stability by reducing the flow of money to armed groups, a judgment that undergirded the SEC’s discretionary choices in favor of greater transparency.
 

The court rejected the APA-based claims.  E.g., the SEC had the authority to create an exception for de minimis uses of conflict minerals, but given that Congress knew that conflict minerals are often used in very small quantities, the SEC was not arbitrary and capricious in determining that such an exception would conflict with Congress’s purpose.
 

The plaintiffs alleged that the SEC failed adequately to analyze the benefits of the final rule by failing to determine whether the rule would achieve its intended purpose.  But the plaintiffs were objecting to Congress’s purpose, not to the SEC’s process:

[W]e find it difficult to see what the Commission could have done better. The Commission determined that Congress intended the rule to achieve “compelling social benefits,” but it was “unable to readily quantify” those benefits because it lacked data about the rule’s effects.

That determination was reasonable. An agency is not required “to measure the immeasurable,” and need not conduct a “rigorous, quantitative economic analysis” unless the statute explicitly directs it to do so. . Here, the rule’s benefits would occur half-a-world away in the midst of an opaque conflict about which little reliable information exists, and concern a subject about which the Commission has no particular expertise. Even if one could estimate how many lives are saved or rapes prevented as a direct result of the final rule, doing so would be pointless because the costs of the rule—measured in dollars—would create an apples-to-bricks comparison.
 

Congress told the SEC to make a rule despite the lack of data.  The SEC could rely on Congress’s determination that the costs were necessary and appropriate in light of the goals. “Congress did conclude, as a general matter, that transparency and disclosure would benefit the Congo. the Commission invoked that general principle to justify each of its discretionary  choices. What the Commission did not do, despite many comments suggesting it, was question the basic premise that a disclosure regime would help promote peace and stability in the Congo.” The SEC was not supposed to second-guess Congress on this point; if it had found that disclosure wouldn’t work, it couldn’t have adopted any rule, and that would’ve been contrary to Congress’s explicit direction.
 

But wait!  There’s also a First Amendment claim based on the requirement that an issuer must describe certain products as not “DRC conflict free” in the report it files with the SEC and on its website.  The majority agreed that this was unconstitutionally compelled speech under Central Hudson.  (The plaintiff didn't challenge other disclosures required by the regulation.  What result if it did?)
 

The SEC argued that rational basis review was appropriate because the disclosure involved purely factual non-ideological information.  But Zauderer is limited to cases in which disclosure requirements are reasonably related to the prevention of deception, and this requirement isn’t.  (But see Am. Meat Inst. v. USDA, No. 13-5281, 2014 WL 1257959, at *4-7 (D.C. Cir. Mar. 28, 2014), vacated and en banc rehearing ordered, Order, No. 13-5281 (D.C. Cir. Apr. 4, 2014) (en banc).)
 

The factual nature of the disclosure is insufficient because speakers also have a right to avoid disclosing facts they don’t want to. Also, it was “far from clear” that “conflict free” was factual and non-ideological, since “[p]roducts and minerals do not fight conflicts.”  “Conflict free” was a “metaphor” that “conveys moral responsibility for the Congo war. It requires an issuer to tell consumers that its products are ethically tainted, even if they only indirectly finance armed groups.”   Issuers might disagree with that assessment of their moral responsibility, and convey that disagreement through silence.  “By compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment.”  (Compare the result in the tobacco RICO case, where statements that the defendants lied—something that is true, but that they don’t really want you to know—were upheld as reasonable corrective measures.  “Controversial” is not a good standard for disclosures, and this is why.)
 

Intervenor Amnesty International argued that SEC v. Wall Street Publishing Institute, Inc., 851 F.2d 365 (D.C. Cir. 1988), applied rational basis review to securities regulation.  That case allowed the SEC to seek an injunction requiring that a magazine disclose the consideration it received in exchange for stock recommendations, but the case didn’t hold that rational basis review governed securities regulation “as such,” but might be “roughly tantamount to the government’s more general power to regulate commercial speech.”  Anyway, that was a classic deception rationale governing inherently misleading speech.

To read Wall Street Publishing broadly would allow Congress to easily regulate otherwise protected speech using the guise of securities laws. Why, for example, could Congress not require issuers to disclose the labor conditions of their factories abroad or the political ideologies of their board members, as part of their annual reports? Those examples, obviously repugnant to the First Amendment, should not face relaxed review just because Congress used the “securities” label.

(WTF? Disclosure of labor conditions, at least, is the exact same thing as this regulation. Repeating it doesn't make it more obvious.)
 

Once rational basis was out of the picture, the regulation flunked even Central Hudson, since “narrower restrictions on expression would serve [the government’s] interest as well.”  Plaintiff suggested that issuers could use their own language to describe their products, or the government could compile its own list of products that it believes are affiliated with the Congo war, based on information the issuers submit to the Commission.  The SEC didn’t show that this would be less effective.  “[I]f issuers can determine the conflict status of their products from due diligence, then surely the Commission can use the same information to make the same determination. And a centralized list compiled by the Commission in one place may even  be  more  convenient  or  trustworthy  to  investors  and consumers.” These “intuitive” alternatives were sufficient to invalidate the rule.
 

The SEC argued that the rule’s impact was minimal because issuers could explain what “conflict free” meant in their own terms, but almost all compelled speech offers the possibility of explanation, and that’s inadequate to cure a First Amendment violation. Thus, the rule (and the statute) was unconstitutional to the extent that it (they) required regulated entities to report to the Commission and to state on their website that any of their products have “not been found to be ‘DRC conflict free.’”

The concurrence would’ve waited for the en banc review of the COOL regulations raising this exact issue under Zauderer, and stayed just that part of the SEC’s rule while allowing the rest to go into effect.

Securities law and advertising law

Ann Lipton (Duke) has a post up on the import of Halliburton II, a securities case about the fraud on the market doctrine, with at least potential relevance to advertising law.   Another of her posts considers the securities law distinctions among facts, opinions, and puffery.   (Cert in the case she discusses was in fact granted.)   Lanham Act cases distinguish between fact and nonfact.  While opinions are actionable under securities law and Lanham Act cases generally put opinions on the nonactionable side of the line, the differences aren’t really as great as they might seem, as Lipton details, because courts call so much in securities an opinion.   Also, the FTC and state consumer protection laws are more willing to recognize liability for "opinions," using reasoning similar to the defamation standard, which also allows liability when an opinion implies the existence of undisclosed defamatory facts.  The classic situation in advertising law is when the speaker claims special expertise in an area and the audience is not sophisticated in that area, and those mostly come up in FTC cases, or in state consumer protection law cases where a pitch is individualized and thus purportedly customized for the individual’s needs.

Guest Post: Ann Lipton on Amgen

I’m happy to bring you a guest post about the Supreme Court’s recent Amgen case, which deals with class action certification along with materiality, which plays a distinctive role in securities litigation but which should still be of interest to advertising litigators given the presumptions of materiality some states allow.

Ann Lipton has been a practicing securities litigator for several years.  Beginning this fall, she will be joining Duke Law School as a Visiting Assistant Professor, where she will teach a class on securities litigation.  In the interests of full disclosure, it should be noted that she assisted with drafting certain amicus briefs in support of the Amgen plaintiffs. Her views are her own. 

In Amgen Inc. v. Conn. Ret. Plans & Trust Funds, 2013 U.S. LEXIS 1862 (Feb. 27, 2013), the Supreme Court held that securities fraud plaintiffs seeking to certify a class using the “fraud on the market” theory need not prove the element of materiality at the class certification stage. Although the case is mainly of significance to securities litigators, the reasoning of the majority and the dissents also carries some lessons for other kinds of class actions. 

Section 10(b) is the basic antifraud provision of the Securities Exchange Act.  To bring a claim under Section 10(b), the plaintiff must show that the defendant made a material false statement, in connection with a securities transaction, with scienter, on which the plaintiff relied, and which caused losses. 

Most Section 10(b) claims concerning open market stock transactions are brought as class actions, typically alleging that the company’s officers portrayed the business in a falsely positive light, and that the stock price plunged – resulting in losses to the class – when the truth was revealed.   

From a Rule 23 perspective, the biggest hurdle to class certification is the element of reliance.  Rule 23(b)(3) requires that in a class action seeking damages, plaintiffs demonstrate that “the questions of law or fact common to class members predominate over any questions affecting only individual members.”  In a Section 10(b) class action, scienter, falsity, and loss causation will be common to every class member; the existence of a purchase or sale, and the amount of any damages due, represent the kinds of individualized issues that can be resolved mechanically through a claims process after liability has been determined, and thus are not said to predominate over common questions.  Materiality, it has long been established, is gauged by whether a “reasonable investor” would find the information significant, in light of the “total mix of information made available,” and thus is also common to all class members.  But reliance is trickier, because not every shareholder will have read and relied upon the same corporate statements when making an investment decision.  And realistically, without a class action remedy, most investors will not be able to recover under Section 10(b) – the typical case is far too expensive to litigate as an individual action. 

So, to facilitate shareholders’ ability to bring claims on a class basis – and take a moment to marvel at the concept – the Supreme Court endorsed the “fraud on the market” doctrine in Basic Inc. v. Levinson, 485 U. S. 224 (1988).  This doctrine is part legal principle, and part economic theory, and the two sometimes sit uneasily together.  In Basic, the Supreme Court concluded – as an empirical matter – that when a stock is heavily traded in an “open and developed market,” its stock price will react to any material information that is publicly released.  Any one trader may miss a particular announcement, or ignore it and rely on other factors when deciding whether to purchase or sell a security, but traders as a whole, who make up the entire universe of buyers and sellers, will collectively absorb material information and factor that in to their purchasing decisions, causing the stock price to go up or down in reaction. 

From this empirical observation, the Court endorsed a legal theory – namely, that the element of reliance is satisfied when an investor purchases a security at an open-market price that has been influenced by a false statement.  In that situation, the Court theorized, the plaintiff “relies” on the market price to reflect the market’s assessment of the security’s value.  Because the market’s assessment is distorted by the false statement, the plaintiff has relied on the false statement to the extent that he or she would not have transacted at that price had the statement not been made. 

The Court then endorsed two legal presumptions that plaintiffs may use when bringing claims under Section 10(b).  First, that a material statement, made publicly, concerning a stock that trades in an open and developed market, will influence the stock’s price.  And second, that anyone who purchases at the market price necessarily relied on that price as a reflection of the stock’s value, or at least relied on the price as a reflection of how the market reacted to (truthful) information about the security. 

Both of these presumptions are rebuttable by the defendants.  The defendant may try to argue that the false statement did not influence stock prices – which might happen, for example, if market makers or large institutional traders were aware of the truth, and they used their power to keep market prices at their unmanipulated level.  Or, the defendant may try to argue that investors – perhaps on a case-by-case basis – did not rely on market prices when making their purchasing decisions, either because they knew the truth, or because they relied on other facts. 

But in most situations, even subject to defendants’ right to rebut, these two presumptions transform reliance from an individualized question into a common one.  In any case where a material misstatement was made publicly and concerned a frequently traded stock, all purchasers may be presumed to have “relied” on the misstatement.  

What Basic left open, though, was exactly what plaintiffs would have to prove at the class certification stage in order to be entitled to the fraud-on-the-market presumption of reliance.  It was eventually settled that plaintiffs would have to prove that the market for the security was “open and developed” – i.e., “efficient,” in economic terms – and that the allegedly false statement was made publicly.  But some courts went further and held that the plaintiff would also have to prove that the false statement was material.  Immaterial statements are not presumed to influence prices; thus, the logic went, materiality is necessary to invoke the presumption of reliance, and without that presumption, individualized issues of reliance will predominate over common questions.  So, for example, if the defendant made an immaterial misstatement, it would not influence stock prices, but some individual investors may have heard it and relied on it, and reliance would not be common across the class.  In such a situation, the argument went, individualized issues of reliance would preclude class certification.   

In Amgen, the Supreme Court entered the fray, and held that materiality need not be considered at the class certification stage.  Justice Ginsburg, writing for a majority that included Chief Justice Roberts, and Justices Breyer, Alito, Sotomayor, and Kagan, rested her logic on three principles.   

First, she stated that when conducting the Rule 23 inquiry, courts may consider “merits” questions only to the extent that they are necessary to determine whether the requirements of Rule 23 are satisfied.  (Which, incidentally, was a significant statement in and of itself, because although that principle is commonly recited among lower courts, it had never been articulated quite so clearly by the Supreme Court). 

Second, she pointed out that materiality itself is gauged by an objective standard, and therefore is common across class members.  

Third – and this was the core of the analysis – Justice Ginsburg concluded that if plaintiffs cannot prove materiality, no individualized reliance issues will arise because plaintiffs will necessarily lose their claims on the merits.  Thus, there is no situation in which the presence, or absence, of materiality is a deciding factor in whether a fraud-on-the-market case splinters into individualized determinations.   

As Justice Ginsburg explained, materiality is both a predicate for the fraud-on-the-market presumption of reliance, and an independent, and necessary, element of a Section 10(b) claim.  Therefore, if the misstatement is material, the fraud-on-the-market presumption applies, and reliance is proved commonly; if the statement is immaterial, all investors lose – commonly.  Even if, theoretically, a few outlier investors might rely on a false, but immaterial, misstatement, but even if they did, they’d lose their case – commonly – because they would fail to satisfy the element of materiality. 

Rule 23 only requires that common questions predominate over individualized ones – not that individualized questions disappear entirely. Because a lack of materiality necessary ends the case for all investors, any individualized questions of reliance – even if they exist – cannot “predominate,” because they will never be tried. 

Justice Ginsburg further reasoned that in this respect, materiality differs from, say, proof of market efficiency, or proof that a statement was made publicly, both of which are also predicates to the fraud-on-the-market presumption of reliance, and which must be proved at the class certification stage.  If the market was inefficient, for example, there might still be substantial numbers of class members who personally read and relied upon the false statement, and thus still have viable Section 10(b) claims.  Plaintiffs would not be entitled to a presumption of reliance across the class, but particular class members might still be able to prove reliance, as well as the other elements of their claims.  In such a situation, individualized reliance issues would predominate over common issues.  Thus, it is necessary at the class certification stage for plaintiffs to prove efficiency, in order to establish that common issues predominate.  But when it comes to materiality, a failure of proof would not result in individualized issues predominating, because no individual class member could proceed. 

Ultimately, then, because the presence or absence of materiality has no bearing on whether individualized issues predominate in a Section 10(b) class action, the Court held that plaintiffs are not required to prove materiality in order to have a class certified under Rule 23(b)(3). 

Justice Thomas, joined by Justice Kennedy, dissented.  In his view, it was improper for the majority to “conflate” the “doctrinally independent (and distinct) elements of materiality and reliance”; instead, each should have been analyzed separately.  He rejected Justice Ginsburg’s view that without materiality, the claims would fail on the merits, because in such a situation, the claims “should never have arrived at the merits at all … [w]ithout materiality, there is no fraud on-the-market presumption, [and] questions of reliance remain individualized.”  Perhaps most significantly, he summarized Rule 23(b)(3) as requiring that plaintiffs show “that the elements of the claim are susceptible to classwide proof,” (emphasis added), and faulted the majority for “ignoring at certification whether reliance is susceptible to Rule 23(b)(3) classwide proof simply because one predicate of reliance—materiality—will be resolved, if at all, much later in the litigation on an independent merits element.”   

Justice Thomas’s approach to Rule 23, then, is apparently quite extreme.  Although the rule itself only requires that common questions “predominate” over individualized ones, he would apparently add the requirement that each element of a claim must be examined separately.  Not only would this significantly raise the bar for plaintiffs seeking class certification in a variety of contexts, but it would also entirely reorient courts’ approaches to class certification.  Right now, the Rule 23 inquiry is a fairly practical one: courts examine how a case will, realistically, be tried, and try to predict whether any individualized issues are so unwieldy that that they will overwhelm the issues that bind the class.  Justice Ginsburg’s pragmatic reasoning fits neatly within this approach: whatever the theoretical distinction between reliance and materiality, as a practical matter, there will be no case in which individualized reliance issues overwhelm common issues when there has been a failure of proof on the element of materiality.  Justice Thomas, however, would apparently take the focus off the practical realities of litigation, and instead focus on theoretical differences among class members.   

Justice Scalia, it should be noted, dissented as well, but he did not agree with Justice Thomas’s reasoning.  Instead, he conceded that if the fraud-on-the-market doctrine were purely a “substantive” method of proving reliance, the majority would be correct.  However, he believed that fraud-on-the-market is a hybrid doctrine that contains both procedural and substantive elements, in that that Basic itself held that materiality must be proved at class certification, regardless of what Rule 23 might otherwise require. 

Although the reasoning of the Amgen opinions seems rather straightforward, there are several additional wrinkles. 

The first is that although Justice Ginsburg’s reasoning is compelling, in fact, it does not entirely hold up on close examination, given the particular facts of the case.   

In an ordinary dispute over materiality, the defendant might argue that a particular statement simply was not very important – like, say, the details of a CEO’s resume, or that an accounting error was too small to matter much to investors.  But in this case, defendant Amgen’s materiality argument was different.  Amgen was pursuing what is known as the truth-on-the-market corollary to the fraud-on-the-market doctrine.  Simply put, this corollary holds that if the truth behind a false statement is sufficiently well-known among traders, a false statement will have no effect on stock prices.  The principle is that if the truth is sufficiently well-known, the false statement – which, standing alone, might have influenced stock prices – becomes immaterial in light of other available information.  

(This corollary is therefore merely a twist on one of the rebuttals to the fraud-the-market presumption noted in Basic, i.e., that stock prices were not influenced because major traders did not believe the lie.)   

In this case, Amgen argued that the “truth” behind any allegedly false statements had been published in the Federal Register and was known to market analysts. 

Justice Ginsburg’s logic regarding the relevance of materiality to class certification does not apply as neatly when truth-on-the-market is on the table.  If, say, the false statement is immaterial in its own right – the CEO lies about the color tie he wore to a business meeting – then any investor who tries to bring a case individually will necessarily lose on the element of materiality.  But if a false statement is, standing alone, material, and only immaterial in light of some other statement made available in some other source, there remains a theoretical possibility that the individual investor – who heard the former statement but not the latter – might still have a claim.  Or, to put it another way, perhaps materiality is not always a common question, in that there may be a “space” between whether a truth is sufficiently well-known among sophisticated traders that it counteracts the effects of a false statement on stock prices, while being sufficiently hidden from ordinary investors such that they might reasonably rely on the false statement, unaware of the truth.   

There is no definitive answer to this question, which is made more complicated by the fact that materiality itself is evaluated based on the “total mix of information made available” – which only begs the question what counts as “information made available” in situations where some information has only been published in sources not usually consulted by ordinary investors (like, say, the Federal Register).  But neither the majority nor the dissents addressed this issue, apparently because of the way Amgen chose to litigate the case.  Rather than emphasize its truth-on-the-market defense specifically, it chose to pursue a general rule that all materiality disputes must be resolved at the class certification phase, leaving no room for arguments about the special qualities of truth-on-the-market. 

The second interesting aspect of Amgen is Justice Ginsburg’s subtle dig at the Supreme Court’s earlier decision in Wal-Mart Stores, Inc. v. Dukes, 131 S. Ct. 2541 (2011).  Dukes considered the requirements for proving commonality under Rule 23(a).  Although the Rule itself requires only that plaintiffs prove the existence of “questions of law or fact common to the class,” the Dukes majority interpreted the rule to require that plaintiffs show that a class action can generate common answers to those common questions.  Justice Ginsburg dissented, arguing, inter alia, that the rule itself is explicitly limited to common questions. 

In Amgen, Justice Ginsburg carried on the fight, repeatedly emphasizing that Rule 23(b)(3)’s requires only a predominance of common “questions” – with the word “questions” italicized several times.  Nowhere did Justice Ginsburg discuss the need for common “answers.”  And, surprisingly, her opinion was joined by two members of the Dukes majority, who were apparently unwilling to fight over the verbiage – Chief Justice Roberts and Justice Alito. 

But these are mere sidebars when compared to the real significance of Amgen, which is what it portends for the fraud-on-the-market doctrine more generally.  As part of its argument, Amgen and its amici challenged the empirical aspects of Basic, insisting that as a factual matter, all material information is not necessarily impounded into the price of a stock.  They contended that more recent research shows that markets can be imperfectly efficient, absorbing some information quickly and other information more slowly, if at all.  Therefore, they argued, the first Basic presumption – namely, that public, material information influences stock prices – needs to be reconsidered.

All of the Justices remarked on the argument and agreed that the Amgen case did not present the proper vehicle to revisit Basic, but four went further and invited such challenges in the future.  Justice Alito wrote a separate concurrence to state that it might be appropriate to reconsider Basic in light of new economic developments; Justice Thomas’s dissent – in a section joined by Justices Scalia and Kennedy – described Basic as “questionable.”   

Were the Court to overrule Basic, it would represent a radical change in securities law and class actions generally.  Section 10(b) actions are among the largest and most common types of class actions today, and such class actions are the primary mechanism by which investors seek and recover damages for securities fraud.  Moreover, in 1995 and again in 1998, Congress revamped the laws governing private securities actions in the Private Securities Litigation Act and Securities Litigation Uniform Standards Act, but made no change to the fraud-on-the-market presumption (despite proposals that it should be legislatively overruled).  Indeed, both statutes explicitly rest on the assumption that plaintiffs will continue to bring their claims as class actions, something that would be if not impossible, then considerably less probable, in the absence of the fraud-on-the-market presumption.  This legislation, however, apparently leaves at least Justice Thomas unmoved; although Justice Ginsburg pointed out in her majority opinion that Congress left Basic intact after passing the PSLRA, Justice Thomas answered in dissent that “The Court retains discretion over the contours of Basic unless and until Congress sees fit to alter them.”

Ponzi scheme leads to securities and consumer protection claims

Belmont v. MB Inv. Partners, Inc., --- F.3d ----, 2013 WL 646344 (3d Cir.)

Mark Bloom, an employee and officer of MB, operated a Ponzi scheme through a hedge fund, North Hills, that he controlled and managed outside the scope of his responsibilities at MB.  (Kind of makes you wonder what other hedgies do with their spare time.)  He was arrested and indicted in 2009, by which time most of the money was gone.  Investors in North Hills sued MB and various MB-related individuals, alleging violations of the Securities and Exchange Act, negligent supervision, violations of SEC Rule 10b-5, violations of the Pennsylvania Unfair Trade Practice and Consumer Protection Law, and breach of fiduciary duty. The district court granted summary judgment to the defendants (after dismissing claims against one) on all claims.  The court of appeals affirmed in part and vacated in part, remanding for a trial on the investors’ Rule 10b-5 and UTPCPL claims against MB (which ceased operations following the discovery of the North Hills fraud and Bloom’s arrest).  Two of the investor-plaintiffs were MB clients/advisees, while two weren’t.

Bloom operated North Hills to fund his own extravagant lifestyle, and also engaged in additional misappropriation/self-dealing activity.  Bloom solicited the plaintiffs while using his MB connections: for example, he met with Belmont to discuss MB’s investment advisory services, gave Belmont his MB business card, described MB’s investment philosophy, then discussed various funds, including North Hills, that he recommended as suitable investments.  Other MB-related people were also allegedly involved in soliciting the investors, though there are factual disputes about what happened. 

MB knew that Bloom was running North Hills while also working as an adviser at MB.  “Although the business address for North Hills was one of Bloom's residences in Manhattan, he made no attempt, while working at MB, to conceal his activities related to North Hills. Investments in North Hills were administered by Bloom and other MB personnel, using MB's offices, computers, filing facilities, and office equipment. MB support staff sometimes carried out tasks related to North Hills.”  As an investment adviser, MB was legally required to supervise its personnel, but it didn’t have adequate compliance procedures in place to prevent fraud and self-dealing.  (MB disputed that, but the SEC issued a deficiency letter detailing compliance failures shortly after Bloom was arrested.)  Bloom was thus able to avoid required disclosures, and MB officers and directors “failed to make basic inquiries about Bloom's operation of North Hills, and did not collect any information on North Hills or monitor sales of investments in North Hills to MB's own customers.”

Bloom pleaded guilty to the counts against him, including charges of diverting at least $20 million from North Hills to his own use, securities fraud, and wire fraud; criminal and civil proceedings against him are still pending.

On appeal, while the court of appeals affirmed summary judgment for the other defendants, it ruled that imputation of Bloom’s conceded violations of Rule 10b-5 might be imputed to MB, and thus summary judgment on that issue was inappropriate.  Similar imputation principles held out the possibility of UTPCPL liability, which creates liability for a person “[e]ngaging in any other fraudulent or deceptive conduct which creates a likelihood of confusion or of misunderstanding.” The standard of liability under this catchall provision is in flux. Some cases require plaintiffs to meet the standards for common law fraud, while others don’t but still require knowledge of falsity/misleadingness.  The court here indicated that a defendant couldn’t be derivatively liable under the UTPCPL for the fraudulent actions of a third party without evidence that the defendant ever knowingly engaged in misrepresentation.  Thus, the claims against an individual defendant failed because he wasn’t alleged to have any knowledge of the North Hills fraud at the time he promoted it.  However, Bloom’s admitted frauds were violations of the UTPCPL, and could potentially be imputed to MB, since the purpose of imputation is “fair risk-allocation, including the affordance of appropriate protection to those who transact business with corporations.” 

There was a genuine issue of material fact on imputation.  “There is some evidence that MB benefitted from Bloom's operation of North Hills, to the extent that access to North Hills was a selling point for MB, and MB was able to solicit North Hills investors for advisory business. There is, however, also evidence that the cross-marketing benefit to MB was limited, given that the two entities had only four clients in common …. Also, MB never collected any fees or received any remuneration on account of any of the Investors' investments in North Hills.”  Whether there was so little benefit to MB that the investors should have known that Bloom’s statements were made without MB’s authority was for the trier of fact to decide.

Standing in securities

NECA-IBEW Health & Welfare Fund v. Goldman Sachs & Co., No. 11-2762-cv 9 (2d Cir. Sept. 6, 2012)

The district court dismissed, for lack of standing, a putative securities class action on behalf of all persons who acquired certain mortgage-backed certificates issued under the same allegedly false and misleading registration statement, but sold in 17 separate offerings by 17 unique prospectus supplements.  The court of appeals reversed: the plaintiff had class standing to assert the claims of purchasers of certificates backed by mortgages originated by the same lenders that originated the mortgages backing plaintiff’s certificates, because such claims implicate “the same set of concerns” as plaintiff’s claims.  As my informant points out, this is a weird line for MBS (given the variety of lenders that could be involved), but perhaps less significant for false advertising plaintiffs.

Click fraud securities case revived

FindWhat Investor Group v. FindWhat.com, -- F.3d --, 2011 WL 4506180 (11th Cir.)

Eric Goldman pointed me to this securities fraud case, of possible interest because it involves advertising-related claims. The investors sued defendant MIVA (aka FindWhat.com) and some principal officers for eleven false or misleading statements to the public, in violation of § 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The statements allegedly artificially inflated the price of MIVA’s stock until the truth came out, at which point the stock dropped and plaintiffs lost money.

The district court rejected all the claims, nine on the pleadings and two on summary judgment on the grounds that plaintiffs failed to show loss causation and damages. Plaintiffs appealed on two of the claims dismissed on the pleadings and on the claims on which summary judgment was granted.

The court of appeals affirmed on the first set and reversed on the second. Basically, earlier false statements weren't actionable, but later ones that perpetuated the falsehood were actionable for sustaining the stock price longer than it would have had the truth come out earlier.

MIVA provides pay-per-click ad services, putting ads on its distribution partners/affiliates’ websites. MIVA shares a portion of its ad revenue with its affiliates. MIVA uses keyword targeting; advertisers bid for a position in search results. MIVA’s revenue is determined by advertisers’ bidding price and the number of clicks MIVA generates. Bidding price itself depends on the conversion rate from clicks to sales.

Because of the pay-for-click arrangement, click fraud (clicking on ads just to get the advertiser to pay) can be very costly. Click fraud can come through automated or human intervention; it results in lower conversion rates because the source of the click is uninterested in purchase.

According to the complaint, in 2003 two of MIVA’s top revenue-generating partners, Saveli and Dmitri, who together accounted for almost 1/3 of MIVA’s revenue from 2003-2005, began using automated click fraud to generate revenue. “According to a former Business Development Manager at MIVA, Saveli and Dmitri were ‘turn and burn guys’ who focused primarily on driving in a lot of traffic, regardless of its quality.” (One thing advertising folks may find notable in securities cases these days is that, because of heightened pleading requirements and judicial hostility to such cases, the average securities fraud pleading is likely to have a lot of detail acquired from independent investigations, usually relying on informants with inside knowledge of the defendant’s operation—by contrast, in an advertising case the plaintiff may have a lot of knowledge of the parties’ products or services, but is less likely to be able to plead about the defendant’s internal operations with specificity.)

The resulting low-quality traffic caused advertisers to lower their bids, decreasing MIVA’s revenue. A former account manager described the result as “serious, serious bid deflation.” Revenue per click dropped from $0.20-$0.21 in early 2003 to $0.12 by June 2005. This had a domino effect, driving away high-quality distribution partners. In a downward spiral, plaintiffs alleged, MIVA increasingly relied on “greedy and unscrupulous distribution partners who were focused on only short-term gain.”

Thus, by summer 2005, MIVA’s “supposedly extensive and diversified partner network had shrunk, with 95 percent of the Company's click revenue coming from its top fifty distribution partners—the top two being Saveli and Dmitri.” The network, according to a former marketing manager, was now best described as a "house of cards ... held together by a thread."

The short-term gains from click fraud allegedly enabled MIVA to report an uninterrupted string of quarter-by-quarter financial gains, meeting or exceeding analyst growth expectations in every single quarter since 2003. “Perhaps demonstrating the Company's obsession with meeting Wall Street's forecasts, these expectations were sometimes met by as little as a penny.” (Maybe I don’t read about them, but are there any nonfraudulent companies that can do this for a multiyear period? Either analysts are just terrible, in which case I don’t get why people rely on them, or their projections exert pressure to commit fraud in a short-term-focused company and the market might want to apply a discount to exceeding expectations at least as much as it punishes falling short of them.) “Between 2003 and 2005, the Defendants issued public statements reporting seemingly unstoppable growth stemming from its primary pay-per-click business.”

Thus, plaintiffs alleged, that despite MIVA’s actual bid deflation, defendants allowed click fraud to continue to meet growth expectations at the expense of the company’s long-term health.

Meanwhile, during 2004 and 2005, regulatory scrutiny of click fraud intensified. “In an effort to lull investors and advertisers into believing that the Company was proactive and aggressive about policing click fraud, Defendant CEO Pisaris-Henderson claimed during a Company conference call on February 23, 2005 that, in the fourth quarter of 2004, the Company had voluntarily removed distribution partners representing $70,000 in revenue per day because ‘our focus is to deliver traffic that converts rather than just clicks alone.’” However, according to the Senior Director of Business Development responsible for the oversight and management of all of MIVA's affiliates, “no traffic was taken off line in the fourth quarter of 2004.” This senior director said that the February announcement clearly referred to Saveli and Dmitri, because that’s what they earned in a day, but they weren’t removed from the network. A former marketing manager said that it was "an open secret within the Company that Dmitri and Saveli were not taken off line in December 2004, and neither was anyone else."

On March 16, 2005, in its Form 10-K annual report to the SEC, defendants repeated their claim that in the "fourth quarter of 2004, we ceased displaying advertisements with distribution partners ... whose traffic did not adequately convert to revenue for our advertisers," and that "the removal of these distribution partners reduced our average click-through revenue by approximately $70,000 per day," in conformity with its "long-stated goal of [providing] high quality traffic to our advertisers.” Miva also stated that "[w]e do not rely on 'spyware' for any purpose and it is not part of our product offerings," that "[w]e have implemented screening policies and procedures to .... detect[ ] fraudulent click-throughs, which are not billed to our advertisers," and that "[w]e have developed automated proprietary screening applications and procedures to minimize the effects of ... fraudulent clicks."

Before the Nasdaq opened on May 5, 2005, MIVA issued a press release announcing disappointing first quarter 2005 results and the resignation of Brenda Agius as CFO. Later that day, defendants CEO Craig Pisaris-Henderson and COO Phillip Thune revealed to the public that click fraud had indeed been responsible for some of the Company's revenues, stating in a conference call with analysts and investors that "a couple" of MIVA's distribution partners had been employing "capabilities ... to get additional traffic that just simply don't adhere to our standards." That day, MIVA's share price plummeted over 21 percent from the previous day, from $6.16 to $4.83, and continued to drop for the next few trading days, closing at $4.46 on May 9, 2005.

The court of appeals first addressed statements made on March 5, 2004 and July 26, 2004. The first was properly dismissed because plaintiffs failed to plead scienter with the requisite specificity and the second because the plaintiffs failed to allege falsity or misleadingness.

To survive a motion to dismiss, a 10b-5 claim must satisfy both Rule 9(b) and the additional pleading requirements of the PSLRA. For claims based on false/misleading statements, “the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed." If scienter is required, "the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind."

As to the insufficient claims: One stemmed from MIVA’s March 5, 2004 10-K, which said, “The FindWhat.com Network is dedicated to delivering high-quality keyword ads as a result of an Internet user's search query. As such, we have written and strictly enforce advertising guidelines to try to ensure high relevancy standards.” It continued, “We employ an integrated system of numerous automated and human processes that continually monitor traffic quality, often eliminating any charges for low quality traffic proactively from the advertisers' accounts. We enforce strict guidelines with our Network partners to ensure the quality of traffic on the system.” It also stated that it “expect[ed]” that its business partners would behave lawfully and ethically.

The district court found that these statements weren’t misleading because MIVA wasn’t warranting that it lacked current questionable associations, and that a “dedication” to high-quality traffic wasn’t inconsistent with the existence of low-quality traffic. Moreover, the Form 10-K was mostly forward-looking statements that were appropriately accompanied by cautionary statements.

The court of appeals disagreed about whether this could be materially misleading. There were statements of present fact about MIVA’s “integrated system ... that continually monitor[s] traffic quality," and claims that "[w]e enforce strict guidelines ... to ensure the quality of traffic," which “unquestionably create the impression that MIVA maintains an active and sophisticated monitoring system for screening fraudulent traffic.” These statements could have misled a reasonable investor. Assuming the truth of the other facts alleged, these statements triggered a duty to disclose the system’s grave defects, and the failure to disclose wasn’t cured by any general cautionary or risk-disclosing language, since MIVA offered only general warnings about risks inherent to its business model, not specifically tailored to risks from click fraud. It would be deceptive to withhold information about actual known breaches of click-fraud monitoring systems already touted in the 10-K.

However, the court of appeals still affirmed because plaintiffs failed to plead scienter adequately. What was required was intent to defraud or severe recklessness, meaning highly unreasonable omissions or misrepresentations involving an extreme departure from the standards of ordinary care that present a danger of misleading others that is either known to the defendant or that is so obvious that the defendant must have known of it. The PSLRA requires that the complaint’s allegations create “a strong inference” of scienter, meaning that the inference must be more than plausible or reasonable. It must be at least as compelling as any alternative inference of nonfraudulent intent. Each act or omission must be evaluated separately and for each defendant, though the court’s inquiry must be holistic (it need not ignore the other acts or omissions when evaluating each one individually).

Essentially, plaintiffs didn't plead enough specifics to generate a strong inference of scienter until mid-2004 at the earliest, when there was a meeting to discuss terminating Saveli and Dmitri. This put the earlier statements off-limits. Defendants’ motives to meet Wall Street revenue expectations were insufficient to establish scienter—mere motive and opportunity is insufficient. (It’s tough out there for a securities plaintiff.)

On to the July 26, 2004 public conference call discussing second-quarter results. Defendant Thune, the COO, said that revenue was increasing by June and that “we believe that every one of our divisions can grow revenue from Q2 to Q3, despite the seasonal softness typical in the summer months, when individual Internet usage usually declines.” The future performance statement was non-actionable, and plaintiffs didn’t allege that revenue was not increasing by June.

Plaintiffs argued that this was misleading because the growth came from click fraud, and that by making affirmative claims MIVA had a duty to disclose other facts necessary to avoid an incomplete and misleading picture. However, a company has a duty to disclose only when the natural and normal implication of its statements would be misleading. Thune’s statement would be misleading only if it conveyed a false impression of the quality of MIVA’s click traffic. But a statement about total revenue, which also included MIVA’s recently acquired companies, conveyed no such message. It’s generally okay to tout past success, even if future prospects are less rosy.

On to the remaining two statements from 2005 (detailed above), the issue was whether plaintiffs’ expert report demonstrated genuine issues of material fact on loss causation and damages. The district court held that there were no triable issues of fact because the expert acknowledged that MIVA’s stock price was inflated by 26.44% before the first actionable misrepresentation and remained inflated after. The district court reasoned that because the stock price didn’t change, the otherwise actionable statements couldn’t have caused the plaintiffs’ losses.

This was error. Investors who purchased at inflated prices after the fraudulent statements were made may have sustained substantial losses they wouldn’t have suffered had the defendants revealed the truth at the start of the class period.

Fraud-on-the-market theory hypothesizes that disclosure of confirmatory information--information already known by the market--will not cause a change in the stock price. But publicly disseminated falsehoods will artificially inflate the stock price as long as they remain uncorrected, tainting the total mix of information. When the misinformation is corrected, the market will dissipate the artificial inflation.

Loss causation can frequently be shown circumstantially, when plaintiffs identify (1) a corrective disclosure, (2) a price drop soon thereafter, and (3) an absence of other possible explanations for the price drop. Plaintiffs’ expert report, which the district court assumed was admissible for purposes of the summary judgment motion, offered evidentiary support for both loss causation and damages. The expert conducted an event study, common in such cases, estimating the damages at $22.24 million.

The district court ruled that the inflation preexisted the actionable fraudulent statements, rendering the expert report irrelevant. The court of appeals held that this was a misapprehension of the nature of market fraud. “Inflation creates an ongoing risk of harm. Every investor who purchases at an inflated price--whether at the beginning, middle, or end of the inflationary period--is at risk of losing the inflationary component of his investment when the truth underlying the misrepresentation comes to light.”

Investors who buy and sell during the inflationary period overpaid, but they can recoup by selling at the same inflated price. But investors who buy at inflated prices and hold will suffer economic loss. “Because thousands of shares of stock are purchased each day, the longer that inflation remains within a stock price, the more shares that are purchased at inflated prices, and the more shares that stand to lose when the inflation subsequently dissipates from the price. Clearly then, a falsehood that endures within the marketplace for a longer period of time, all else being equal, will cause greater harm than one that endures for a shorter period of time.”

In conclusion, the court of appeals declined “to erect a per se rule that, once a market is already misinformed about a particular truth, corporations are free to knowingly and intentionally reinforce material misconceptions by repeating falsehoods with impunity.” So, even if the earlier nonactionable statements started the trouble, as long as the market believed that defendants had click fraud under control, the later false statements could cause continuing harm.