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Subscription price $4325 per year. Published by Computer Law Reporter, Inc., 1611 Connecticut Avenue, N.W., 5th Floor, Washington, D.C. 20009 • 202-462-5755 • Fax 202-328-2430 • Copyright © 2016 Computer Law Reporter, Inc. All Rights Reserved. ISSN 1098-8602 Publications Director: John G. Herring. Production Manager: Kristina M. Reznikov. The views expressed herein do not necessarily represent those of the Editors or the members of the Board of Advisors.

Securities Reform Act Litigation Reporter

(continued on page 4)

A Monthly Reporter Featuring Expert Analysis and Prompt Publication of Oral and Written Decisions

ContentsHighlights

Washington, D.C. January 2016Volume 40, Number 4

Page

Orrick, Herrington & Sutcliffe LLP

EditorsWilliam F. Alderman, Esq.

Daniel J. Dunne, Esq.Jason M. Halper, Esq.

Kenneth Herzinger, Esq.Amy M. Ross, Esq.Michael C. Tu, Esq.

Recent Decisions inDex ................... 9

Recent Decisions .............................. 13

Best of the Blogs ............................ 84

Documents

Opinion, United States v. Litvak

Opinion, Hampton v. Pacific Investment Mgmt. Co., LLC

Opinion, Zweiman v. AXA Equitable Life Insurance Co.

Opinion, KB Partners I, LP v. Pain Therapeutics, Inc.

The most noteworthy decisions this month are the following:

• In United States v. Litvak, No. 14-2902-cr (2d Cir. Dec. 8, 2015), in a trial of a securities broker who allegedly misrepresented his firm’s costs of acquiring the residential mortgage-backed securi-ties he was selling, the Second Circuit vacated the conviction for fraud against the United States. The court determined there was insufficient evidence for a rational jury to conclude that the defendant’s mis-statements were reasonably capable of influencing a decision of the Treasury, since the Treasury was not involved in actual investment decisions of the counterparties to whom the defendant made sales. The counterparties were public-private investment funds, investment vehicles created and overseen by the Treasury Department as part of the Troubled Asset Relief Program.

• In In re Enzymotec Securities Litigation, Civil Action No. 14-5556 (JLL) (MAH) (D.N.J., Dec. 14, 2015), in a case where shareholders brought a securities fraud lawsuit, alleging that corporate officers knew about pending regulatory changes in the company’s primary market which could jeopar-dize corporate financial performance, yet failed to disclose this instability, and also profited from their artificial inflation of the company’s stock prices, the District of New Jersey granted in part and denied in part Defendants’ motion to dismiss.

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3

Securities Reform Act Litigation Reporter1611 Connecticut Avenue, N.W., 5th Floor, Washington, D.C. 20009 • 202-462-5755 • Fax 202-328-2430

____________________________________________________________________________________

eDitoRs

Orrick, Herrington & Sutcliffe LLP

BoaRD of aDvisoRs

William F. Alderman, Esq.Daniel J. Dunne, Esq.

PublisherNeil J. Cohen, Esq.

Managing EditorDain Donelson, Professor, The University of Texas at Austin McCombs School of Business

Glen Banks, Esq.Fulbright & JaworskiNew York, NY

Paul R. Bessette, Esq.King & SpaldingAustin, TX

Martha L. Cochran, Esq.Arnold & PorterWashington, DC

Douglas W. Greene, Esq.Lane Powell PCSeattle, WA

Steven W. Hansen, Esq.Bingham McCutchen LLPBoston, MA

Steven D. Hibbard, Esq.Shearman & Sterling, LLPSan Francisco, CA

Marian P. Rosner, Esq.Wolf & Popper LLP New York, NY

Robert Sidorsky, Esq.Butzel LongNew York, NY

Tower C. Snow, Jr., Esq.Cooley LLPSan Francisco, CA

Lawrence A. Steckman, Esq.Eaton & Van Winkle, LLPNew York, NY

Bruce G. Vanyo, Esq.Katten Muchin Rosenman LLPLos Angeles, CA

Andrew B. Weisman, Esq. WilmerHale Washington, DC

William R. Maguire, Esq.Hughes, Hubbard & ReedNew York, NY

Jonathan W. Miller, Esq.Winston & Strawn LLPNew York, NY

Theodore N. Mirvis, Esq.Wachtell, Lipton, Rosen & KatzNew York, NY

Kenneth M. Moltner, Esq.Bressler Amery & RossNew York, NY

Frank C. Razzano, Esq.Fox Rothschild LLP Washington, DC

Lyle Roberts, Esq.Cooley LLPWashington, DC

Jason M. Halper Esq.Kenneth Herzinger, Esq.

Amy M. Ross, Esq.Michael C. Tu, Esq.

4

• In Loritz v. Exide Technologies, Case No. 13-CIV-02607 (C.D. Cal. Dec. 17, 2015), Judge Stephen V. Wilson of the United States District Court, Central District of California partially granted a second motion for class certification in a securities action against Exide Technologies and the company’s executives and board members. This case is notable be-cause it provides examples of the circumstances in which district courts will permit addi-tional motions for class certifications in securities class actions to remedy defects identified in connection with prior motions. Specifically, the court considered a second motion for class certification only as to two specific deficiencies that the court had previously noted in its order on the first motion for class certification, and not as to every issue on which the plaintiffs lost in connection with the first motion.

• In Lim v. Charles Schwab & Co., Inc., Case Nos. 15 Civ. 02074; 15 Civ. 02945 (N.D. Cal. Dec. 7, 2015), Judge Richard Seeborg of the United States District Court for the Northern District of California dismissed state law claims against defendants Charles Schwab & Co., Inc, and UBS Securities LLC (collectively “Defendants”). The decision is notable because it addresses the applicability of the Securities Litigation Uniform Standards Act (SLUSA) to state law claims concerning a brokerage firm’s obligation to provide best execution when executing its clients’ orders.

• In Zoumboulakis v. McGinn, Case No. 5:13-cv-02379 (N.D. Cal. Dec. 3, 2015), Judge Edward J. Davila of the United States District Court for the Northern District of California granted defendants’ motion to dismiss a shareholder’s derivative action against board members of Verifone Systems, Inc., alleging breach of fiduciary duties and violation of federal securities law. The Court dismissed the second amended complaint on the grounds that plaintiff had failed to adequately allege demand futility. The Court first held that the allegations of demand futility would be judged based upon the composition of the Board of Directors as of the date the second amended complaint was filed, even though four of the nine board members were replaced during the pendency of the action. The Court then found that there was no indication from plaintiff’s second amended complaint that a major-ity of the current Board members were interested and lacked independence because there were insufficient facts plead to show they knew of the alleged misconduct and consciously chose not to act.

• In Colyer v. AcelRx Pharm., Inc., No. 14-CV-04416-LHK (N.D. Cal. Nov. 25, 2015), U.S. District Court Judge Lucy Koh of the Northern District of California dismissed with leave to amend a securities fraud action filed against AcelRx Pharmaceuticals and four of its executives for alleged violations of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The court held that the plaintiffs failed to identify any statement that rose to the level of a material misrepresentation or omission necessary to state a claim

5

under Section 10(b) and Rule 10b-5, and also failed to allege facts giving rise to a strong inference of scienter, or fraudulent intent, as required by the Private Securities Litigation Reform Act of 1995. The case is significant because the holding suggests that public state-ments about a drug and related trials do not become actionable misstatements merely because there has been a delay in the approval process or other action by the FDA.• In Hampton v. Pacific Investment Mgmt. Co., LLC, No. 15-00131 (C.D. Cal. Nov. 2, 2015), State law claims premised on the allegation that an investment fund deviated from its promise that no more than 15% of assets would be invested in risky emerging market se-curities were precluded by SLUSA. Granting the defendants’ motion to dismiss, District Judge Carney held that the state law claims were premised on a misrepresentation, and the misrepresentation was made “in connection with the purchase or sale of a covered secu-rity” within the meaning of SLUSA.

• In Zweiman v. AXA Equitable Life Insurance Co., No. 14-CV-5012 (VSB) (S.D. N.Y. Sept. 30, 2015), in a class action initially filed in state court, a plaintiff’s purported breach of contract claim based on the insurer’s violation of state law in implementing an invest-ment strategy that materially changed the plaintiff’s variable annuity policies, thereby re-ducing their value, was in reality a securities fraud claim. Dismissing the claim as barred by SLUSA, District Judge Broderick held that the plaintiff’s complaint alleged misrepre-sentations or omissions by the insurer in connection with covered securities transactions, and therefore the purported contract claim was preempted by SLUSA.

• In KB Partners I, LP v. Pain Therapeutics, Inc., No. A-11-CA-1034-SS (W.D. Tex. Dec. 1, 2015), an investment firm adequately pleaded securities fraud claims against a drug company and several of its officers, based on the defendants’ intentionally misleading investors regarding the Food and Drug Administration’s approval process for a new drug. Denying the defendants’ motion to dismiss, District Judge Sparks rejected the defendants’ assertion that three alleged omissions were immaterial, ruled that the plaintiff had identi-fied misstatements by the defendants that were actionable, and had adequately pleaded scienter and loss causation.

• In United Energy Trading, LLC v. Pacific Gas & Electric Co., No. 15-cv-02383 (N.D. Cal. Nov. 20, 2015), in a dispute between a natural gas supplier and a major utility that provided billing services to the supplier, the district court could hear the dispute. District Judge Seeborg held that under the primary jurisdiction doctrine, the court did not have to stay the action or dismiss it in favor of pending proceedings before the state public utilities commission. The plaintiff’s RICO claims did not implicate the regulatory authority, and the federal claims were predicated on fraudulent behavior that did not turn of a specific interpretation of rules within the purview of the agency.

6

• In Siga Technologies, Inc. v. Pharmathene, Inc., No. 20, 2015 (Del. Dec. 23, 2015), the Supreme Court of the State of Delaware upheld the Court of Chancery’s finding that SIGA in bad faith breached its contractual obligation to negotiate a license agreement consistent with the parties’ license agreement term sheet (LATS) and remanded the case for reconsid-eration of damages.

• In Prairie Capital III, L.P. v. Double E Holding Corp., C.A. No. 10127-VCL (Del. Ch. Nov. 24, 2015), the purchaser was an acquisition vehicle formed by the “Incline Fund.” The transaction was governed by a Stock Purchase Agreement (SPA). When the Sellers’ Representative sued the Buyer to compel the release of funds from escrow, the Incline Fund intervened, and the Buyer and the Incline Fund asserted counterclaims and cross-claims for fraud, aiding and abetting fraud, and conspiracy to commit fraud. The Buyer and the Incline Fund also asserted two claims for indemnification under the SPA against the Sellers’ Representative.

• In In re El Paso Pipeline Partners, LP Derivative Litig., C.A. No. 7141-VCL (Del. Ch. Dec. 2, 2015),Vice Chancellor Laster advocated for a dual-natured approach and held that a claim survived a merger that terminated the separate legal existence of the entity on whose behalf the derivative action was pursued. In prior litigation, the plaintiff had prevailed in a derivative action against a limited partnership that was subsequently merged out of exis-tence, winning a $171 million award against the general partner for breach of the limited partnership agreement. Following the merger, the former general partner requested dis-missal arguing that the plaintiff lost standing as a result of the merger. The court disagreed and ordered a pro rata recovery of the $171 million award to the former limited partners.

• In Pipal Tech Ventures Private Ltd. v. MoEngage, Inc., No. 103-81-VCG (Del. Ch. Dec. 17, 2015) In an action for theft, conversion and breach of contract in the misappropriation of the plaintiff’s technologies in India by the Delaware defendant’s two Indian principals, the corporate defendant was unable to show that the action should be dismissed on the ba-sis of forum non conveniens. Denying the defendant’s motion, Vice Chancellor Glasscock concluded that the defendant failed to show that fundamental concerns of the administra-tion of justice overwhelmingly supported dismissal of the action in deference to a theoreti-cal action in an Indian court.

• In Wodka v. Causeway Capital Management LLC, Case No. B255454, (Cal. App. 2d Dist. Dec. 14, 2015), the California Court of Appeal, Second Appellate District, upheld dismissal of a shareholder derivative action against Causeway Capital Management LLC (CCM) and various individual defendants. Plaintiff Wodka alleged that by investing in in-ternet gambling businesses, CCM and certain officers and directors breached their fiduciary

7

duties, were negligent and committed waste. Wodka did not make a pre-suit demand on the board, although he previously sued the same defendants in federal court, alleging vio-lations of the Racketeer Influenced and Corrupt Organizations Act (RICO), among other things. The Court of Appeal held that Plaintiff failed to sufficiently allege that demand was excused and the trial court had therefore properly sustained demurrers without leave to amend. This case is notable because the court found that a board’s refusal to toll a statute of limitations or stay proceedings to allow the Plaintiff to make a demand does not make demand futile.

• In DIRECTV, Inc. v. Imburgia, No. 14-462 (U.S. Dec. 14, 2015), the particular topic was classwide arbitration. Three years ago, after California courts refused to enforce provisions in arbitration agreements that barred class arbitration (on the ground that the provisions were unconscionable), a closely divided court in AT&T Mobility v. Concepcion disagreed, holding that the Federal Arbitration Agreement preempted the California doctrine invalidating those waivers.

• In Flannery v. SEC, No. 15-1080 (1st Cir. Dec. 8, 2015), the SEC suffered a stunning loss in the First Circuit in a December 8, 2015 decision ruling that the SEC’s findings of securities law violations by two executives in connection with the operation of a State Street Bank bond fund lacked substantial supporting evidence. The Commission had, by a 3-2 divided vote, overturned a decision by one of its administrative law judges that no violations had occurred, and in doing so wrote a highly controversial opinion in which it staked out aggressive positions on a variety of securities law issues. See SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5; New, Thorough Academic Analysis of In re Flannery Shows Many Flaws in the Far-Reaching SEC Majority Opinion; and SEC not entitled to deference in State Street fraud appeal—law prof.

• In RBC Capital Markets, LLC v. Jervis, No. 140, 2015 (Del. Nov. 30, 2015), the Delaware Supreme Court issued a 107-page opinion affirming the Court of Chancery’s post-trial decisions in In re Rural/Metro Corp. Stockholders Litigation (previously dis-cussed here). In the lower court, Vice Chancellor Laster found a seller’s financial advisor (the “Financial Advisor”) liable in the amount of $76 million for aiding and abetting the Rural/Metro Corporation board’s breaches of fiduciary duty in connection with the com-pany’s sale to private equity firm Warburg Pincus LLC The Court’s decision reaffirms the importance of financial advisor independence and the courts’ exacting scrutiny of M&A advisors’ conflicts of interest.

8

• In In re Riverbed Technology, Inc. Stockholders Litigation, CA No. 10484-VCG (Del. Ch. Dec. 2, 2015), the court weighed the pros and cons of granting any amount of an award to an objector who made important arguments about the problems with “disclosure only” settlements, but in the end did not prevent the class action settlement from being approved.

9

ARBITRATION AGREEMENTS; CLASS ACTIONS; PREEMPTION

DIRECTV, Inc. v. Imburgia, No. 14-462 (U.S. Dec. 14, 2015)

Justices Rebuke California Courts (Again) for Refusal To Enforce Arbitration Agreement .................................................................84

EVIDENCE OF MISREPRESENTATIONS

Flannery v. SEC, No. 15-1080 (1st Cir. Dec. 8, 2015)

First Circuit Rebuffs SEC in Flannery and Hopkins Case and Vacates SEC Order .......87

FRAUD AGAINST UNITED STATES; SECURITIES FRAUD; MATERIALITY; SCIENTER; EX-

PERT TESTIMONY

United States v. Litvak, No. 14-2902-cr (2d Cir. Dec. 8, 2015)

In a Criminal Case, Second Circuit Holds Government Failed To Prove Materiality of Misrepresentations of Bond Trader and Trial Court Erred in Excluding Defendant’s Expert Testimony As to Pricing of Mortgage-Backed Securities; Court Vacates Securities Fraud Conviction and Remands for New Trial ..............................13

SECURITIES FRAUD; MOTION TO DISMISS; PSLRA SAFE HARBOR

In re Enzymotec Securities Litigation, Civil Action No. 14-5556 (JLL) (MAH) (D.N.J., Dec. 14, 2015)

Claims That a Company Marketed Infant Formula Ingredients in China Without Timely Disclosing to Its Shareholders About the Imminent Tightening of the Governing Regulatory Framework Survive a Motion To Dismiss and Proceed to Discovery .............................................................21

Recent Decisions Index

u.s. DistRict couRts

u.s. ciRcuit couRts of appeals

u.s. supReme couRt

10

SECURITIES EXCHANGE ACT; SECURITIES ACT; CLASS ACTIONS; CLASS CERTIFICA-

TION; SECTION 10(B); SECTION 11; CONTROL PERSON LIABILITY; RELIANCE

Loritz v. Exide Technologies, Case No. 13-CIV-02607 (C.D. Cal. Dec. 17, 2015)

Court Grants Second Motion To Certify Class of Investors ........................................28

SLUSA, MISREPRESENTATION; BEST EXECUTION; MOTION TO DISMISS; PLEADING

STANDARDS; BROKERAGE FIRMS; SECURITIES TRANSACTIONS

Lim v. Charles Schwab & Co., Inc., Case Nos. 15 Civ. 02074; 15 Civ. 02945 (N.D. Cal. Dec. 7, 2015)

Court Found SLUSA Precluded State Law Claims Concerning Brokerage Firm’s Failure To Provide Best Execution of Trades ...................................................31

DEMAND FUTILITY; BUSINESS JUDGMENT RULE; SHAREHOLDER DERIVATIVE ACTION

Zoumboulakis v. McGinn, Case No. 5:13-cv-02379 (N.D. Cal. Dec. 3, 2015)

Northern District of California Dismisses Shareholder Derivative Action Against Verifone Systems, Inc. Board Members .............................................33

PSLRA PLEADING STANDARDS; ACTIONABLE OMISSION; SCIENTER

Colyer v. AcelRx Pharm., Inc., No. 14-CV-04416-LHK (N.D. Cal. Nov. 25, 2015)

California District Court Dismisses Securities Action Against Pharma Company for Failure To Adequately Allege an Actionable Omission or Scienter .............................................................................36

SLUSA; MISREPRESENTATIONS; “IN CONNECTION WITH”; DELAWARE CARVE-OUT

Hampton v. Pacific Investment Mgmt. Co., LLC, No. 15-00131 (C.D. Cal. Nov. 2, 2015)

State Law Claims That Fund Deviated From Promised Investment Restriction Were Precluded By SLUSA ....................................................39

CLASS ACTION; SLUSA; VARIABLE ANNUITY CONTRACT; BREACH OF CONTRACT; MIS-

REPRESENTATIONS OR OMISSIONS

Zweiman v. AXA Equitable Life Insurance Co., No. 14-CV-5012 (VSB) (S.D. N.Y. Sept. 30, 2015)

Class Action Asserting Insurer Breached Variable Annuity Contracts By Implementing Investment Strategy Was Barred By SLUSA .......................................43

11

SECURITIES FRAUD; SECTION 10(B); RULE 10B-5; MATERIALITY; SCIENTER; LOSS CAU-

SATION

KB Partners I, LP v. Pain Therapeutics, Inc., No. A-11-CA-1034-SS (W.D. Tex. Dec. 1, 2015)

Securities Fraud Claims Adequately Pleaded Against Drug Maker That Allegedly Mislead Investors About Status of FDA Approval Of New Drug ...............49

RICO; JURISDICTION; ENTERPRISE; PATTERN; RESPONDEAT SUPERIOR

United Energy Trading, LLC v. Pacific Gas & Electric Co., No. 15-cv-02383 (N.D. Cal. Nov. 20, 2015)

Dispute Over Billing Arrangement Between Natural Gas Supplier and Major Utility Could Be Adjudicated By Court ...................................... 55

MERGER; EXPECTATION DAMAGES; TYPE II AGREEMENT

Siga Technologies, Inc. v. Pharmathene, Inc., No. 20, 2015 (Del. Dec. 23, 2015)

Supreme Court of the State of Delaware Upholds Chancery Court’s Award of Expectation Damages in Failed Type II Merger Case, Finding That Where the Injured Party Has Proven the Fact of Damages, Less Certainty Is Required Regarding the Amount of Damages .............................................................................59

PROXIMATE CAUSATION

RBC Capital Markets, LLC v. Jervis, No. 140, 2015 (Del. Nov. 30, 2015)

Gatekeepers No More: Delaware Supreme Court Clarifies Scope of Potential Financial Advisor Liability in M&A Sales Transactions ..............................93

FRAUD; EXCLUSIVE REPRESENTATIONS CLAUSE; SECONDARY LIABLITY FOR FRAUD;

AIDING AND ABETTING; CONSPIRACY; INDEMNIFICATION; MOTION TO DISMISS

Prairie Capital III, L.P. v. Double E Holding Corp., C.A. No. 10127-VCL (Del. Ch. Nov. 24, 2015)

Delaware Chancery Court Dismisses Fraud Claims Based on Extra-Contractual Representations Finding Them Barred by Exclusive Representations Clause, but Declines To Dismiss Fraud Claims Based on Contractual Representations ................65

Delaware Supreme Court

Delaware ChanCery Court

12

MERGERS; DIRECT CLAIMS; DERIVATIVE CLAIMS; DUAL-NATURED CLAIMS; BREACH

OF CONTRACT; STANDING

In re El Paso Pipeline Partners, LP Derivative Litig., C.A. No. 7141-VCL (Del. Ch. Dec. 2, 2015)

Claim With Both Direct and Derivative Aspects Survives Merger .............................73

FORUM NON CONVENIENS; ACTION FOR THEFT, CONVERSION AND BREACH OF CON-

TRACT

Pipal Tech Ventures Private Ltd. v. MoEngage, Inc., No. 103-81-VCG (Del. Ch. Dec. 17, 2015)

Defendant Unable To Show That Action for Alleged Theft and Conversion of Plaintiff’s Technologies By Defendant’s Principals in India Should Be Dismissed on Basis of Forum Non Conveniens .........................................75

OBJECTORS; ATTORNEYS’ FEES

In re Riverbed Technology, Inc. Stockholders Litigation, CA No. 10484-VCG (Del. Ch. Dec. 2, 2015)

Chancery Grants Fees to Class Settlement Objector .................................................101

DERIVATIVE SUITS; DEMAND FUTILITY; PARTICULARITY

Wodka v. Causeway Capital Management LLC, Case No. B255454, (Cal. App. 2d Dist. Dec. 14, 2015)

Demand Not Excused Where Board Refused To Toll a Statute of Limitations or Stay Proceedings To Allow the Plaintiff To Make a Demand .................................80

otheR couRts

13

Recent Decisions

FRAUD AGAINST UNITED STATES; SECURITIES FRAUD; MATERIALITY; SCIENTER;

EXPERT TESTIMONY

United States v. Litvak, No. 14-2902-cr (2d Cir. Dec. 8, 2015)

In a Criminal Case, Second Circuit Holds Government Failed To Prove Materiality of Misrepresentations of Bond Trader and Trial Court Erred in Excluding

Defendant’s Expert Testimony As to Pricing of Mortgage-Backed Securities; Court Vacates Securities Fraud Conviction and Remands for New Trial

Greg Lee

In a trial of a securities broker who allegedly misrepresented his firm’s costs of acquiring the residential mortgage-backed securities he was selling, the Second Circuit vacated the conviction for fraud against the United States. The court determined there was insufficient evidence for a rational jury to conclude that the defendant’s misstatements were reasonably capable of influencing a decision of the Treasury, since the Treasury was not involved in actual investment decisions of the counterparties to whom the defendant made sales. The counterparties were public-private investment funds, investment vehicles created and overseen by the Treasury Department as part of the Troubled Asset Relief Program.

The Court also held that the district court erred in excluding proffered testimony of the defendant’s expert explaining how this specialized market priced such securities. The court explained that the materiality of the defendant’s alleged misstatements was central to the defendant’s case. Because RMB securities lacked an efficient, transparent secondary market through which value could be determined objectively, traders set the value of the securities by engaging in rigorous valuation procedures. They relied on sophisticated computer-pricing models to determine the subjective value of the securities. With the benefit of the excluded testimony, a jury reasonably could have found that misrepresentations by a dealer as to the price paid for certain RMBS would be immaterial to a counterparty that did not rely on a “market” price or the price of prior trades, but instead used its own sophisticated valuation methods and computer model.

The court rejected, however, the defendant’s argument that his misstatements were immaterial as a matter of law. Testimony provided by counterparties that they had relied

14

on the misstatements and had been injured thereby precluded a finding that no reasonable mind could find the misstatements material.

Background

The defendant Jesse C. Litvak was a securities broker and trader at Jefferies & Company. In January 2013, Litvak was indicted on allegations that from 2009 to 2011, he fraudulently misrepresented the prices of certain residential mortgage-backed securities (RMBS) to, among others, counterparties at public-private investment funds.

In March 2014, a jury convicted Litvak on 10 counts of securities fraud, one count of fraud against the United States, and four counts of making false statements. The District of Connecticut subsequently denied Litvak’s motion for judgment of acquittal or new trial and sentenced him to 24 months’ imprisonment, three years’ supervised release, and a $1.75 million fine.

He allegedly made three kinds of fraudulent misrepresentations to several of Jefferies’s counterparties in order to covertly reap excess profit for Jefferies in the course of transacting residential mortgage-backed securities (RMBS). First, he allegedly fraudulently misrepresented the costs to Jefferies of acquiring certain RMBS. Second, he fraudulently misrepresented the price at which Jefferies had negotiated to resell certain RMBS. Third, he fraudulently misrepresented that Jefferies was functioning as an intermediary between the purchasing counterparty and an unnamed third-party seller, when in fact Jefferies owned the RMBS.

The government filed an indictment charging Litvak with eleven counts of securities fraud, one count of fraud against the United States, and four counts of making false statements. A jury convicted Litvak. The district court denied his motion for judgment of acquittal or a new trial, and sentenced him to 24 months’ imprisonment, three years’ supervised release, and a $1.75 million fine.

Fraud Against The United States

Litvak was convicted under 18 U.S.C. § 1001 for making false statements and 18 U.S.C. § 1031 for fraud against the United States. Both sections had a materiality requirement.

In United States v. Coplan, 703 F.3d 46 (2d Cir. 2012), the court determined that Section 1001(a)(2) require that a defendant, knowingly and willfully, make a materially false, fictitious, or fraudulent statement in relation to a matter within the jurisdiction of a department or agency of the United States, knowing it was false, fictitious or fraudulent. The court determined “a statement is material if it has a natural tendency to influence, or be

15

capable of influencing, the decision of the decisionmaking body to which it was addressed ….”

The Second Circuit has not addressed materiality under Section 1031. But the parties agreed that materiality was an element of Section 1031, and that the requirement was coextensive with the materiality element of Section 1001. The parties also agreed that the relevant “decisionmaking body” was the Department of the Treasury.

The government relied primarily on the testimony of David Miller, formerly chief investment officer for the Treasury’s Office of Financial Stability. Miller’s role was to oversee the investment program created as a result of the financial crisis, a program which invested in the PPIFs. While Treasury was responsible for overseeing the PPIFs and selected the PPIF asset managers and prescribed investment rules, investment decisions were made by the fund managers who were given complete discretion over which eligible assets to buy and sell.

Even viewing the evidence in the light most favorable to the government, there was insufficient evidence to conclude that Litvak’s misstatements were reasonably capable of influencing a decision of the Treasury. Despite evidence that the misstatements negatively impacted the Treasury’s investments, there was no evidence that the misstatements were capable of influencing a decision of the Treasury. Miller’s testimony was unequivocal that the PPIFs were deliberately structured in a manner that kept the Treasury away from making buy and sell decisions.

The government argued that a jury reasonably could conclude that the misstatements stymied certain PPIFs from transacting RMBS at the best possible prices, thereby impeding the Treasury’s ability to reap optimal returns on their investments in those funds. But even if a jury could accept the underlying assertion—that the misstatements indirectly frustrated the Treasury’s investment goals—it could not infer solely therefrom that those misstatements were capable of influencing a Treasury decision. For a jury to so conclude, the government must have adduced evidence of an actual Treasury decision that was reasonably capable of being influenced by Litvak’s misstatements. Evidence of such a decision could not be purely theoretical and evidence of such a capability had to exceed mere metaphysical possibility.

The government contended that the information the PPIFs reported to the Treasury was affected by Litvak’s conduct. But even if the PPIFs’ monthly reports to the Treasury accurately reflected slightly higher or lower balances than would have been reported but for Litvak’s misstatements, such evidence was insufficient to permit a jury to find materiality. Indeed, the government failed to identify any evidence tending to show that these minor

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variations in the reports’ aggregate balances had the capability to influence a decision of the Treasury.

Finally, the government suggested that the fact that Treasury referred the matter to a special inspector general showed that it regarded Litvak’s conduct as significant. But every prosecution for making a false statement undoubtedly involved “decisions” by the government. Such “decisions” necessarily were “influenced” by the false statement, but the materiality element would be rendered meaningless if it were sufficient for the government merely to establish the capability of the false statement to influence the decision to investigate or prosecute.

In United States v. Rigas, 490 F.3d 208 (2d Cir. 2007), the court evaluated the sufficiency of evidence in the context of bank fraud. The court explained that “‘relevance’ and ‘materiality’ are not synonymous.” Like the limitations placed on the Treasury’s discretion here, the banks’ discretion also was limited. The court found some misstatements were material where there was evidence that the banks would have decided to charge a different interest rate had the statements been accurate. But other misstatements, like those here, were immaterial even where the government adduced evidence that the banks had received the misstatements and staff had reviewed them, but there was no evidence that the statements were capable of influencing one of the banks’ decisions.

Here, the government established that the misstatements may have been relevant to the Treasury, and even contrary to its interest in maximizing the PPIF returns. But the evidence also showed that the Treasury’s discretion in the matters at issue was greatly constrained by its status as a limited partner in the PPIFs. Similarly to Rigas, the exacting circumscription of the Treasury’s role as decisionmaker highlighted the difficulty of adducing evidence sufficient to identify a decision capable of being influenced.

Securities Fraud—Materiality

Litvak argued that the misrepresentations he made to counterparties during negotiations for the sale of bonds were immaterial as a matter of law because they did not relate to the bonds’ value (as opposed to their price). Although the district court did not squarely address this argument, it held that the evidence sufficiently supported a finding of materiality. The argument was not persuasive on appeal because, given the record, a rational jury could have concluded that the misrepresentations were material.

The record included testimony from several representatives of the counterparties that the misrepresentations were important to them and that they or their employers were injured by the misrepresentations. This testimony precluded a finding that no reasonable mind could find Litvak’s statements material.

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Litvak relied principally on Feinman v. Dean Witter Reynolds, Inc., 84 F.3d 539 (2d Cir. 1996), in which purchasers alleged that the defendant stockbrokers had charged transaction fees that far exceeded the cost of the items or the services for which they ostensibly were charged, as described in the trade confirmations. The purchasers contended the fees were hidden, fixed commissions disguised to circumvent rules prohibiting fixed rates and to prevent customers from negotiating fees. In affirming summary judgment for the defendants, the Second Circuit held that no reasonable investor would have considered it important, in deciding whether to buy or sell, that a transaction fee of a few dollars might exceed a broker’s actual costs.

Feinman was readily distinguishable. First, the brokers thee did not mislead customers as to what portion of the total transaction cost was going toward purchasing securities as opposed to the broker’s costs. Here, the transaction costs were embedded in the price, and the evidence showed that the price was a heavily negotiated term and that the markups Litvak represented himself to be taking were false. Thus, unlike in Feinman, Litvak was untruthful about the portion of each transaction’s total cost that would be used to purchase securities and the portion that would be retained by Jefferies, and in each transaction he falsely understated the latter portion. Also, the amounts Litvak pocketed on behalf of Jefferies were substantially larger than a few dollars.

Moreover, the remedy for the behavior in Feinman—competition among the firms—was not applicable to Litvak’s behavior. Those he dealt with were unaware he was taking a larger cut than he had represented. Without knowledge of his actions, the financial consequences of negotiations collared by false representations were virtually undiscoverable in the opaque RMBS market.

Litvak’s argument also was inconsistent with the Supreme Court’s longstanding principle that Section 10(b) should not be construed technically and restrictively. There was no dispute that Litvak misrepresented facts related to the securities transactions at issue, and that several of his counterparties’ representatives testified that they considered the misrepresentations meaningful and that they or their employees were harmed. In addition, the public interest was implicated by the involvement of the Treasury as a major investor in several of the counterparties. Thus, enforcement of Section 10(b) was consistent with the Supreme Court’s instruction to apply the statute flexibly, and with the statute’s purpose of remedying deceptive and manipulative conduct with the potential to harm the public interest or the interests of investors.

Scienter

Litvak contended that the scienter element of Section 10(b) required proof of “contemplated harm” (or “intent to harm”), that the district court failed to so instruct the

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jury, and that the evidence was insufficient to permit a finding of such intent. The district court properly ruled, however, that “intent to harm” was not an element of securities fraud.

Securities fraud requires proof that the defendant acted with scienter—an intent to deceive, manipulate or defraud. Litvak’s view that this intent should be interpreted in the same manner as “intent to defraud” in the context of mail and wire fraud was contrary to Second Circuit precedent.

In United States v. Vilar, 729 F.3d 62 (2d Cir. 2013), the court rejected the defendant’s argument that the evidence was insufficient to support his conviction for securities fraud because the government failed to prove he intended to steal from the victim. The court ruled that the government only had to show the defendant intended to defraud the victim in connection with his sale of securities.

Exclusion of Expert Testimony

Litvak proffered two experts at trial. One was Ram Willner, a business school professor and former portfolio manager. The district court excluded all of Willner’s proposed testimony. The court exceeded its discretion in excluding Willner’s testimony on the selection and valuation process undertaken by investment managers, and his expert opinion that a sell-side bond trader’s statements, such as Litvak’s, would be widely considered in the industry as biased and often misleading. Excluding such testimony was not harmless, and was grounds alone for vacating Litvak’s convictions for securities fraud and remanding for a new trial.

The government argued that the materiality of Litvak’s liens was for the jury to decide. But that was true only with respect to the portion of the testimony that the alleged misstatements by a sell-side trader would be unworthy of consideration in trading decisions, and were not material to an investment manager’s decision.

The district court erred in excluding the portion of Willner’s testimony on the process by which investment managers valued RMBS and the likely impact on the final purchase price of a broker’s statements during the course of negotiating an RMBS transaction. These portions would have been highly probative of materiality, the central issue in the case. This was particularly true because of the complex pricing of RMBS—it tended to be more subjective, was available only from dealers, and often was based on models as opposed to prices from prior transactions.

The proffered testimony could have educated the jury about this highly specialized field of trading. Because RMBS lacked an efficient, transparent secondary market through which value could be determined objectively, traders set the value of the security by engaging in

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rigorous valuation procedures. Thus, firms trading RMBS relied on sophisticated computer-pricing models to determine the subjective value of the securities.

With such testimony, a jury reasonably could have found that misrepresentations by a dealer as to the price paid for certain RMBS would be immaterial to a counterparty that did not rely on a “market” price or the price of prior trades, but instead used its own sophisticated valuation methods and computer model. The full context and circumstances in which RMBS were traded undoubtedly were relevant to the jury’s determination of materiality.

A contrary conclusion would put Litvak in the untenable position in which he could not introduce testimony that either the specific statements at issue would not be important to a reasonable investor or the types of statements at issue generally were not important to a reasonable investor. He would be left only with the “victims” of his conduct as sources of potential testimony on the issue, an odd limitation.

The error was not harmless. Materiality was central to Litvak’s case and was hotly contested. Litvak’s primary defense was that, despite the victims’ testimony, his statements were not material to a reasonable investor. Without Willner’s testimony on this point, Litvak was left with little opportunity to present his non-materiality defense. While the government produced substantial evidence of materiality, it could not be said that the jury would not have found differently had it been presented with information about the functioning of the specialized RMBS market and the valuation process employed by market participants.

The district court also exceeded its discretion in excluding the portion of Willner’s proposed testimony that minor price variances would not have mattered to sophisticated investors, which also tended to show that Litvak’s statements about the acquisition price would not have been material. Feinman recognized that a misstatement may not be material when it resulted in a mere slight inflation of transaction costs, and district courts in the circuit repeatedly have held in the civil context that the sophistication of the investor was relevant both to the adequacy of the defendant’s disclosure and to the extent of the investor’s reliance on the alleged misrepresentations.

The district court did not exceed its discretion, however, in excluding the portion of Willner’s testimony the fair market value of the securities. The principal issues were not whether the prices were “fair,” but whether a reasonable investor might have found the misstatements important and whether Litvak intended to deceive the purported victims.

Nor was it error to exclude Willner’s testimony concerning the profitability of the trades at issue. Whether a victim later made a profit or loss on the bonds it purchased from

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Litvak had no bearing on whether his misrepresentations were material or whether Litvak intended to deceive the purported victims.

Finally, it was error to exclude the portion of the testimony of Litvak’s other expert witness, Mark Menchel, an attorney who had worked for broker-dealers as well as regulators. The excluded testimony concerned the arm’s-length nature of the relationship between a broker-dealer and a counterparty, which was relevant to show that Litvak was not acting as an agent for the counterparties. Given other testimony at the trial, the excluded testimony would have been relevant to materiality. He also was prepared to testify that, contrary to the government’s characterization in summation that Jefferies’s profits on the trades at issue were “commissions,” Jefferies’s role was that of a principal earning a profit.

Exclusion of Good Faith Evidence

Litvak proffered two categories of “good faith” evidence: (1) evidence that his supervisors had knowledge or approval of his price and inventory misrepresentations; and (2) evidence of Jefferies managers’, including Litvak’s supervisors, knowledge or approval of other employees’ similar conduct. The district court permitted the first category, but excluded the second.

The precise basis for the court’s oral ruling excluding the second category—lack of relevance under Rule 401 or probative value outweighed by other considerations under Rule 403, or both—was not clear from the record. It appeared that the ruling rested solely on relevance grounds.

Litvak argued that the excluded evidence would have been relevant to show his lack of fraudulent intent and good faith. The court had instructed the jury that the government had to prove that he participated in the scheme to defraud knowingly, willfully, and with intent to defraud.

According to the district court, the proffered evidence improperly suggested that everybody did it and therefore it was not illegal. But Litvak’s counsel did not proffer the evidence for that purpose and such an argument in summation could have been proscribed by the court.

As counsel stated at trial, the evidence would provide “a fair basis upon which to infer that when Mr. Litvak did the very same thing, … the supervisors saw and approved of [it] as standard operating procedure.” Such an inference would support Litvak’s attempt to introduce a reasonable doubt as to his intent to defraud—he held an honest belief that his conduct was not improper or unlawful. While the district court was correct that this evidence was less probative of intent than evidence regarding transaction in which he was

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directly involved (the first category), the court exceeded its discretion in concluding the testimony was not relevant under the low threshold of Rule 401.

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SECURITIES FRAUD; MOTION TO DISMISS; PSLRA SAFE HARBOR

In re Enzymotec Securities Litigation, Civil Action No. 14-5556 (JLL) (MAH) (D.N.J., Dec. 14, 2015)

Claims That a Company Marketed Infant Formula Ingredients in China Without Timely Disclosing to Its Shareholders About the Imminent

Tightening of the Governing Regulatory Framework Survive a Motion To Dismiss and Proceed to Discovery

Sharon Siegel

In a case where shareholders brought a securities fraud lawsuit, alleging that corporate officers knew about pending regulatory changes in the company’s primary market which could jeopardize corporate financial performance, yet failed to disclose this instability, and also profited from their artificial inflation of the company’s stock prices, the District of New Jersey granted in part and denied in part Defendants’ motion to dismiss, holding that:

• Plaintiffs adequately alleged materially false and misleading statements about the company’s ability to supply an infant formula ingredient, since at least some of these statements were those of present or historical fact, which are not entitled to immunity under the “safe harbor” of the Private Securities Litigation Reform Act (PSLRA), and even the “present” segment of a mixed present/future statement is not subject to the safe harbor;

• Safe harbor protection is not even available for forward-looking statements about this infant formula ingredient, since Defendants issued generalized warnings, rather than cautioning about particularized risks that had already arisen and their likely effects;

• Statements about krill oil production were afforded safe harbor protection because Defendants provided sufficiently particularized warnings, for example, that the company had only one remaining significant customer for this product, and these warnings contradict Plaintiffs’ allegations that only generalized cautions were issued;

• Allegations about Defendants’ supplying an infant formula ingredient raised mixed questions of law and fact and could plausibly give rise to liability, and Plaintiffs are entitled to offer evidence to support these allegations;

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• Plaintiffs’ allegation that Defendants had a duty to disclose pending Chinese regulations survived the motion to dismiss because Plaintiffs specifically alleged that Defendants had issued only generalized warnings about government regulations when the regulations at issue were already well-known;

• Since Defendants would have to establish a “truth on the market” defense based on allegations in the complaint which are construed in favor of Plaintiffs, it is premature to rule on this motion;

• The allegation that individual officer defendants falsely certified that they maintained sufficient internal controls survived the motion to dismiss because they were pled with particularity;

• Plaintiffs adequately pled scienter because a reasonable person would deem this inference at least as strong as the opposing inference;

• In the context of scienter, a particularly compelling allegation was that defendant officers sold a large volume of shares for significant personal financial gain and that these sales were unusual in scope and timing; furthermore, Plaintiffs tied together the timing of these sales with the core alleged misrepresentations such that the officers knew, or should have known, about the harm threatening the company;

• If a Section 10(b) claims survives a motion to dismiss, so does a “controlled person” claim under Section 20(a); and

• Plaintiffs successfully separated, in their Amended Complaint, the Securities Exchange Act claims from their Securities Act claims such that the latter were subject only to a notice pleading standard which they satisfied.

Background

Enzymotec, a company founded in 1998 and headquartered in Migdal Ha’Emeq, Israel, supplies lipid-based components used worldwide in nutritional and medical food products. InFat, an infant formula ingredient, and krill oil derivatives, which are used in omega-3 fatty acid production, represent the source of most of Enzymotec’s revenues.

China is the biggest market for infant formula that contains InFat, and the largest InFat customer is Biostime, a Hong Kong brand of children’s nutrition and baby care products.

Krill are tiny ocean crustaceans. Enzymotec had contracted with an Indian company to extract oil from these organisms for use in vitamin supplements. On January 13, 2014, Enzymotec announced that it had expanded its Israeli facility and conducted an operating run to process krill itself.

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In May 2013, news began to emerge that China was changing and tightening its regulations governing infant formula production. The new regulations were announced on August 2, 2013.

Biostime, the largest purchaser of InFat, had been involved in a price-fixing scandal, which resulted in a substantial fine imposed by the Chinese government in August 2013. Also, the company had been continuously increasing its inventory at a rate that lagged behind its sales. Both circumstances potentially compromised Biostime’s ability to maintain operations.

Enzymotec’s initial public offering took place in September and October 2013, eight weeks after the new Chinese regulations were promulgated. On Enzymotec’s first day of trading, the shares closed at $18.16. The IPO Prospectus stressed that InFat had been “achieving rapid penetration in the Chinese and other Asian markets” with “significant opportunities in other developing markets” and was expected to attract new customers.

On November 11, 2013, Enzymotec posted record results for the third quarter, with substantial increases in net revenues and net income. The stock closed at $23.29. On December 10, 2013, Enzymotec’s CEO, Ariel Katz, highlighted the company’s “very strong existing business growth” and its ability to expand its customer base. The stock closed at a high of $33.44.

On February 14, 2014, the company reported substantial increases in net revenue and net income for both fourth quarter 2013 and full year 2013. Katz predicted another year of record performance and stated that “we are very optimistic about our long-term growth prospects based on our competitive market position.”

A supplemental public offering occurred on February 27, 2014, at $28 per share, with Katz and CFO Oren Bryan together profiting close to $8 million.

On May 14, 2014, Enzymotec announced increases in net revenue and net income for first quarter 2014, but also disclosed its expectations that financial results for second quarter 2014 to be equal to or less than second quarter 2013. Enzymotec explained that the installation of new manufacturing equipment may require a plant to shut down temporarily, and that changes to Chinese infant formula regulations might require changes to the production chain which, in turn, would require changes to supply arrangements. The company predicted that revenues would shift from second quarter 2014 to the second half of that year. Katz echoed the prediction that impact would be felt in the second quarter and that he was optimistic in his outlook for the second half of 2014 and beyond.

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On August 5, 2014, Enzymotec announced negative financial results for second quarter 2014, with decreases in net revenues and net income. The press release stated that the “overall impact was greater than anticipated and will continue to adversely impact Enzymotec for at least the next two quarters.” Five months after completing the SPO, the company “slashed its net revenue guidance in its key financial metrics by as much as 55%.” The stock closed at $9.11, a 72% decrease from its high on November 11, 2013.

Lead Plaintiff shareholders, David E. Raabe, David R. Raabe, and Yehuda Danon, filed this securities fraud action on September 5, 2014, against Enzymotec, Katz, Bryan, and eleven directors. Plaintiffs alleged that Defendants knew that the pending changes in Chinese infant formula regulations would seriously threaten Enzymotec’s performance, as would the oversaturation of this market; yet the Defendants did not disclose this instability or the company’s inability to sustain its initial rapid growth.

The district court appointed the Enzymotec Investor Group as co-lead plaintiffs, approved counsel, and consolidated related actions. The Class Period is from September 2013 to August 2014. An amended complaint was filed on May 18, 2015, and Defendants moved to dismiss on July 17, 2015.

Applicability of PSLRA Safe Harbor

The court denied Defendants’ motion to dismiss regarding claims about InFat revenues, but granted the motion to dismiss regarding claims for krill oil sales. The court held that Plaintiffs sufficiently alleged materially false and misleading statements about guidance, forecasts, and predictions regarding Enzymotec’s ability to sustain its InFat business. A factfinder could determine that at least some of these statements are those of present or historical fact, and therefore not entitled to protection under the PSLRA’s Safe Harbor provision which immunizes forward-looking statements from liability. For example: Enzymotec is “well-positioned for future growth,” and InFat is “achieving rapid penetration” or “increased market penetration.” These assertions are not entitled to immunity even if they are made “within the context of truly forward-looking statements,” since the “present” segment of a mixed present/future statement is not subject to the safe harbor.

For forward-looking statements about InFat, Defendants were likewise not entitled to Safe Harbor protection since Plaintiffs alleged with adequate particularity that Defendants did not accompany their statements with sufficient cautionary language, as the PSLRA requires for immunity. Even though Defendants warned generally about “significant and increasing government regulations” and identified the Chinese Ministry of Health in the SPO prospectus, the Plaintiffs “specifically allege that these risks had already come to pass

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and that it was therefore unreasonable to make generalized warnings when Defendants knew, or should have known, of the specific regulations and their likely effect.”

However, the court held that Plaintiffs did not state a claim regarding statements about krill oil. Defendants were entitled to safe harbor protection for these statements, since Plaintiffs did not demonstrate that the cautionary language is insufficient. In particular, Enzymotec’s annual report, dated February 13, 2014, specifically disclosed that the company had been subject to “customer concentration” and that the company’s one remaining significant customer accounted for 15% of revenues and $9.2 million of the increase in krill oil sales. These specific statements contradict Plaintiffs’ allegations that Defendants provided only generalized warnings about the krill oil market.

Mixed Questions of Law and Fact

The court held that Defendants’ statements about InFat sales “can plausibly give rise to liability” and that Defendants are accordingly entitled to offer evidence on this point. In drawing this conclusion, the court considered – and viewed in a light most favorable for Plaintiffs -- the allegations that Defendants knowingly or recklessly disregarded the new Chinese regulations for infant formula, as well as the implications of Biostime’s price-fixing scandal, and falsely depicted prospects for Enzymotec’s marketing of InFat. For example, the court pointed to Defendants’ statements such as that they are “see[ing] continuous growth and interest,” that “good acceptance of the products continues,” and that there are “very stable contracts.” While acknowledging Defendants’ argument that Plaintiffs are alleging “fraud-by-hindsight,” the court declined to address this particular theory at this early stage of litigation, especially since inferences work in favor of Plaintiffs on a motion to dismiss.

The court likewise declined to characterize Defendants’ statements as mere puffery. Puffery is a non-specific assertion of corporate boosterism; a statement is found to be puffery only when it is immaterial. Since materiality is a mixed question of law and fact which requires a fact-specific determination, it is not an issue to be decided on a motion to dismiss. At this early stage, the only statements to be dismissed are those where reasonable minds cannot differ on their materiality.

Duty To Disclose Chinese Regulations

The court held that, in light of all inferences in favor of Plaintiffs, Defendants had a duty to disclose the details of the Chinese regulations relating to infant formula. Plaintiffs specifically and adequately make this allegation. As a threshold matter, the question of whether disclosure was required is more appropriate for a factfinder, since the analysis involves whether prior disclosure was sufficient. More particularly, the court noted that

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Defendants warned generally about “significant and increasing government regulations” and specifically mentioned the Chinese Ministry of Health in China in the SPO prospectus. Yet, the court concluded that Plaintiffs “specifically allege that these risks had already come to pass and that it was therefore unreasonable to make generalized warnings when Defendants knew, or should have known, of the specific regulations and their likely effect.” As a result, the duty to disclose allegation survives the motion to dismiss.

Complete Information in the Market

The “truth on the market” defense hinges on the notion that a statement (or omission) is materially misleading if the undisclosed facts have not yet entered the marketplace. But, to do so on a motion to dismiss would require the Defendants to establish this defense based on the allegations in the Amended Complaint. Given inferences made in favor of Plaintiffs at this stage, the court concluded that it is premature to rule on this defense.

Internal Controls

Based on its obligation to make all inferences in favor of Plaintiffs, the court held that Plaintiffs have sufficiently pled that Defendants Katz and Bryan both “falsely certified that Enzymotec maintained effective internal controls over financial reporting and that the Company’s financial statements were accurate and fairly represented the Company’s financial condition.” These certifications were required pursuant to Sarbanes-Oxley. The court emphasized that Plaintiffs specifically alleged that the internal controls were deficient – in direct contrast to the certifications. Furthermore, Plaintiffs specifically alleged that this deficiency enabled Defendants to engage in their fraudulent behavior. The court allowed this internal controls claim to survive the motion to dismiss, noting that no determination is required at this stage on the question of whether the claim will ultimately prevail.

Scienter

The court held that, considering the complaint as a whole, Plaintiffs have sufficiently pled scienter. Said otherwise, the court found that “a reasonable person would deem the inference of scienter at least as strong as any opposing inference.” Since Plaintiffs have adequately alleged falsity with regard to the infant formula situation (discussed above) and scienter, Plaintiffs’ claims pursuant to the Securities Exchange Act Section 10(b) and Rule 10b-5 will proceed.

As an initial matter, Plaintiffs have alleged that “the matter at issue is central to the core business of the Company” and that Defendants spoke about this matter regularly. This allegation is not dispositive, but the court considered it when holistically examining the allegations in the Amended Complaint.

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In reaching its determination, the court found compelling the allegation that Defendants Katz and Bryan, during the course of the SPO, sold a large volume of shares for “significant personal financial gain” and that these sales “were unusual in scope and timing.” In particular, Plaintiffs allege that Katz sold 35% of his total holdings for $6.5 million, and that Bryan sold 42% of his total holdings for $1.45 million. Plaintiffs also specifically alleged that these sales were “suspiciously-timed” because they took place when the stock price was allegedly inflated as a result of Defendants’ misrepresentations about the effect of the Chinese regulations.

Plaintiffs “specifically tie together the timing of these sales with the core of the alleged misrepresentations” such that, when the SPO occurred, Defendants knew, or should have known, about the harm that the pending Chinese regulations would wreak on Enzymotec’s business. Plaintiffs furthermore allege that, six months after the SPO, the Chinese regulations were fully revealed and Enzymotec’s stock price plummeted; thus, at the time of the SPO, the stock price was inflated as a result of Defendants’ misrepresentations. The allegations that go to motive, in the context of the Amended Complaint as a whole, “enhance the inference of scienter.”

Controlled Person Claim Against Officer Defendants

Liability for exercising control over a “controlled person” (including a corporation) under Section 20(a) of the Securities Exchange Act is derivative of an underlying violation of Section 10(b). Since the court held that Plaintiffs have alleged a Section 10(b) violation, it likewise held that they have sufficiently stated a “controlled person” claim under Section 20(a), and the motion to dismiss is denied.

Securities Act Claims

The court held that Plaintiffs adequately pled claims under Sections 11, 12(a)(2), and 15 of the Securities Act under the notice pleading standard. Sections 11 and 12(a)(2) relate to making materially false statements in registration statements and prospectuses, and Section 15 establishes “controlled person” liability.

In the Amended Complaint, Plaintiffs carefully separated the factual allegations supporting the Securities Exchange Act claims from those supporting the Exchange Act claims. The former are pled first, and the latter are prefaced by the following statement: “In this part of the Complaint, Lead Plaintiffs assert a series strict liability and negligence claims based on the Securities Act . . . [and] expressly disclaim any allegations of knowing or reckless misconduct[.]” Thus, Plaintiffs successfully avoided the “heightened pleading” standard for its Exchange Act claims.

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Plaintiffs specifically allege that they bought Enzymotec securities issued in, or traceable to, the offering of Enzymotec securities in the IPO or SPO. The court held that this allegation, accepted as true, is sufficient to establish standing. This is a factual issue that can be resolved through discovery and, if disputed, can be raised in a summary judgment motion. In any event, Plaintiffs have adequately alleged that Enzymotec’s prospectuses contained untrue statements or omissions of material facts.

* * *

SECURITIES EXCHANGE ACT; SECURITIES ACT; CLASS ACTIONS; CLASS CERTIFICATION;

SECTION 10(B); SECTION 11; CONTROL PERSON LIABILITY; RELIANCE

Loritz v. Exide Technologies, Case No. 13-CIV-02607 (C.D. Cal. Dec. 17, 2015)

Court Grants Second Motion To Certify Class of Investors

Orrick, Herrington & Sutcliffe

On December 17, 2015, Judge Stephen V. Wilson of the United States District Court, Central District of California partially granted a second motion for class certification in a securities action against Exide Technologies and the company’s executives and board members. This case is notable because it provides examples of the circumstances in which district courts will permit additional motions for class certifications in securities class actions to remedy defects identified in connection with prior motions. Specifically, the court considered a second motion for class certification only as to two specific deficiencies that the court had previously noted in its order on the first motion for class certification, and not as to every issue on which the plaintiffs lost in connection with the first motion.

Background

Plaintiffs brought the consolidated actions against Defendants, asserting claims under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20 of the Securities Exchange Act of 1934. Plaintiffs alleged that Defendants made misleading statements and omitted material information regarding Exide’s failure to comply with environmental regulations and the company’s financial condition. Plaintiffs sought to represent three classes of purchasers: (1) purchasers of common stock, (2) purchasers of certain senior notes over a two-year period, and (3) purchasers of those same notes who purchased pursuant or traceable to the notes’ initial offering.

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In June 2015, the court certified a liability-only class of Exide investors who purchased common stock during the period June 1, 2011 to May 24, 2013, only as to Plaintiffs’ Section 10(b) claim, and denied, without prejudice, class certification in all other respects. In October 2015, Plaintiffs renewed their motion as to certain claims and classes not certified previously.

Subsequent Motions for Class Certification

The court began its analysis by discussing the appropriate scope of a second motion for class certification. While acknowledging its authority to amend a prior class certification order, the court held that it was not mandated to, nor would it be appropriate to, revisit every issue on a second motion for class certification. The court pointed to Lanovaz v. Twinings N. Am., Inc., Case No. C-12-02646-RMW (N.D. Cal. Dec. 17, 2014) for the limited circumstances where district courts have considered a second motion: cases involving amended complaints with a narrower class definition, or where issues were not addressed in an initial motion for class certification.

The court commented that its June order, which denied without prejudice certain arguments raised in the first motion for class certification, was not intended to allow Plaintiffs to take a “proverbial second bite of the apple,” and raise new arguments on issues previously briefed—and rejected—in Plaintiffs’ initial class certification motion. However, the court noted that its June 2015 order identified two deficiencies in Plaintiffs’ first motion that, pursuant to Lanovaz, could be remedied through new briefing or changes to the class definition: (i) Plaintiffs’ failure to address the certification of their control person claims under Section 15 of the Securities Act and Section 20 of the Exchange Act; and (ii) Plaintiffs’ inability to argue that they were not required to prove reliance for their Section 11 claim unless they limited their class definition to investors who purchased securities within twelve months of the company’s August 12, 2011 registration statement. The court thus proceeded to consider only these issues in Plaintiffs’ second motion.

Certification of Class Relating to Plaintiffs’ Control Person Claims

Plaintiffs contended that because questions concerning a defendant’s “actual power or control” over primary violators are common to all class members, class certification of their Section 15 and Section 20(a) claims was proper. Plaintiffs further argued that the Section 15 and Section 20(a) claims should be certified to the same extent as claims under Section 10(b). Noting that Defendants did not contest Plaintiffs’ characterization of the control person claims, the court found that Plaintiffs sufficiently demonstrated that these claims should be certified. The court held that “to establish controlling person liability, the plaintiff must show that a violation was committed and that the defendant directly

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or indirectly controlled the violator,” and that while the “controlling person” question is intensely factual, it constitutes a common question for all class members. In addition, the court noted that if Plaintiffs are able to prove a primary violation, the controlling person inquiry would not be specific to individual class members, so the class should be certified as to Section 15 and Section 20(a) claims.

Plaintiffs Need Not Prove Reliance To Bring a Section 11 Claim

Plaintiffs also sought the certification of their Section 11 claim on behalf of all investors who purchased the company’s senior notes between August 12, 2011 (the date of the registration statement) and November 9, 2012 (the date on which Exide issued its first earnings statement covering at least a twelve-month period following the registration statement). This was a narrower time period for the Section 11 class from the prior motion and Plaintiffs argued that, by narrowing the time period, they avoided any need to prove reliance and thus eliminated individualized inquiry into that element. Defendants countered that class certification for this claim was not warranted, as Plaintiffs had not established there was an efficient market for the notes and therefore could not establish class-wide reliance.

The court agreed with Plaintiffs, noting that numerous courts have held that plaintiffs who purchased a security within the period between a registration statement and the company’s first subsequent earnings statement covering at least a twelve-month period need not show reliance to bring a Section 11 claim. The court found that Plaintiffs had set forth uncontroverted evidence demonstrating that members of the Securities Act Note Class acquired Exide’s stock prior to the company’s November 12, 2012 earnings statement, which covered the twelve-month period after the effective date of Exide’s registration statement filed with the SEC

The court therefore partially granted Plaintiffs’ motion and certified Plaintiffs’ derivative Section 15 and Section 20 claims, and the Securities Act Note Class’s claims under Section 11. The court denied the remainder of Plaintiffs’ motion without further discussion, as they addressed issues the Court deemed it inappropriate to revisit.

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SLUSA, MISREPRESENTATION; BEST EXECUTION; MOTION TO DISMISS; PLEADING

STANDARDS; BROKERAGE FIRMS; SECURITIES TRANSACTIONS

Lim v. Charles Schwab & Co., Inc., Case Nos. 15 Civ. 02074; 15 Civ. 02945 (N.D. Cal. Dec. 7, 2015)

Court Found SLUSA Precluded State Law Claims Concerning Brokerage Firm’s Failure To Provide Best Execution of Trades

Orrick, Herrington & Sutcliffe

On December 7, 2015, Judge Richard Seeborg of the United States District Court for the Northern District of California dismissed state law claims against defendants Charles Schwab & Co., Inc, and UBS Securities LLC (collectively “Defendants”). The decision is notable because it addresses the applicability of the Securities Litigation Uniform Standards Act (SLUSA) to state law claims concerning a brokerage firm’s obligation to provide best execution when executing its clients’ orders.

Background

Plaintiffs Louis Lim and Francis Fleming, retail clients of Schwab, brought two class actions against Defendants. The claims arise out of a 2004 agreement between Schwab and UBS, in which Schwab contracted to direct at least 95% of its “non-directed” orders—or orders for which its retail clients did not specify a venue in which a trade is to be executed—to UBS. They alleged that Schwab violated its duty of best execution, as its agreement with UBS prevents the firm from considering the factors it must weigh to select the best venue for trade executions, and allows UBS to execute trades on behalf of Schwab’s clients at prices less favorable than the best price available. Plaintiff Fleming alleged that UBS entered into this agreement because it profits from being able to execute trades from Schwab within its alternative trading system (also called a “dark pool”). UBS allegedly allowed preferred customers called high-frequency trading firms (HFTs) to exploit information that orders from discount brokerages such as Schwab provide in the dark pool, allowing the HFTs to move in and out of positions in seconds or less to make better profits. Fleming further contended that Schwab falsely represented in its retail client agreements, public statements, and advertisements that it routes its orders based on a variety of misrepresented factors.

Plaintiffs asserted against Schwab, among other things, state law claims for breach of contract, breach of fiduciary duty, intentional misrepresentation, and negligent misrepresentation. They asserted against UBS claims of unfair competition and aiding and abetting the violations noted above relating to Schwab. They did not allege claims under the Securities Act or the Securities Exchange Act. Nonetheless, Defendants moved to dismiss relying, in part, on the argument that SLUSA precluded Plaintiffs’ claims.

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Plaintiffs’ Standing Under Article III

Schwab argued that Plaintiffs lacked standing under Article III, as they failed to allege a particularized injury in fact. The court rejected this argument, finding that Plaintiffs adequately alleged an injury in fact by averring that the agreement between Schwab and UBS deprived them of the best execution of trades.

SLUSA Factors

Defendants moved to dismiss on the grounds that the SLUSA precluded Plaintiffs’ state law claims. The Court analyzed arguments regarding the two SLUSA factors that were at issue: (1) whether the claims were based on allegations that Schwab made a “misrepresentation or omission or employed any manipulative or deceptive device;” and (2) whether the misrepresentation or omission was made “in connection with” the purchase or sale of a covered security.

(1) Misrepresentation, Omission, or Employment of a Manipulative or Deceptive Device

Schwab argued that the complaints allege fraudulent conduct because they were based on allegations that Schwab falsely claimed to provide its customers the best execution for their trades yet routed customer trades to UBS even though better prices may be available. Schwab argued that since case law indicates that the SEC considers the failure to provide best execution a possible manipulative, deceptive, or fraudulent device, SLUSA precluded the claims. Plaintiffs countered that their complaints did not allege fraud, deception, or the intent to deceive, and misrepresentation did not serve as the factual predicate for their claims.

The court found Defendants’ arguments more compelling, citing Ninth Circuit law holding that SLUSA operates when deceptive statements or conduct form the gravamen of a claim. Freeman Invs., L.P. v. Pac. Life Ins. Co, 704 F.3d 1110 (2013). The court held that the essence of Plaintiffs’ was that Schwab either misrepresented that it would provide its clients best execution, or failed to disclose that it could not provide its clients best execution. In either case, Plaintiffs’ claims arose out of Schwab’s alleged deceptive conduct.

(2) “In Connection with a Securities Transaction”

The parties first disputed the legal standard applicable for determining whether Schwab’s alleged conduct arose “in connection with” a securities transaction. Plaintiffs relied on Chadbourne & Park LLP v. Troice, 134 S. Ct. 1058 (2014) to claim that a misrepresentation or omission is made “in connection with” a securities transaction only if the misrepresentation or omission was material to an individual’s purchase or sale of a covered security. Schwab contended that Chadbourne only clarified the need for a “material connection” between a

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misrepresentation or omission and a securities transaction, but did not disturb the earlier holding in Merrill, Lynch, Pierce, Fenner & Smith v. Dabit, 546 U.S. 71 (2006), that it is enough for a fraud to “coincide” with a securities transaction, regardless of whether the transaction involved the plaintiff. The Court agreed with Schwab’s reliance on Dabit, noting that the Chadbourne Court did not modify Dabit or dispute the construction of the SLUSA, but actually emphasized that its holding was consistent with its holding in Dabit.

Plaintiffs then argued that their complaints did not allege any misrepresentations intrinsically related to traded securities, and Schwab’s conduct did not induce them to purchase, sell, or hold any particular security. Further, Schwab’s conduct would not influence an investor’s decisions related to the purchase or sale of a security. Schwab countered that because the gravamen of Plaintiffs’ claims was that it improperly routed orders to a single venue that purchased and sold securities at a price less than the best price available, its alleged conduct was “in connection” with securities transactions. The court agreed with Schwab, finding that Schwab’s alleged conduct not only coincided with a securities transaction, but was material to the clients’ decision to buy or sell securities.

Based on the above, the court held that all of Plaintiffs’ claims against Schwab were precluded by SLUSA. It further held that SLUSA also precluded all of the claims against UBS for the same reasons. The court also specifically held that the claims against UBS were “in connection with the purchase or sale of securities” because the allegations arose from execution of orders at artificially high or low prices, in the UBS dark pool.

The court granted Defendants’ motion to dismiss in their entirety, although it provided Plaintiffs leave to amend.

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DEMAND FUTILITY; BUSINESS JUDGMENT RULE; SHAREHOLDER DERIVATIVE ACTION

Zoumboulakis v. McGinn, Case No. 5:13-cv-02379 (N.D. Cal. Dec. 3, 2015)

Northern District of California Dismisses Shareholder Derivative Action Against Verifone Systems, Inc. Board Members

Orrick, Herrington & Sutcliffe

On December 3, 2015, Judge Edward J. Davila of the United States District Court for the Northern District of California granted defendants’ motion to dismiss a shareholder’s derivative action against board members of Verifone Systems, Inc., alleging breach of fiduciary duties and violation of federal securities law. The Court dismissed the second amended complaint on the grounds that plaintiff had failed to adequately allege demand

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futility. The Court first held that the allegations of demand futility would be judged based upon the composition of the Board of Directors as of the date the second amended complaint was filed, even though four of the nine board members were replaced during the pendency of the action. The Court then found that there was no indication from plaintiff’s second amended complaint that a majority of the current Board members were interested and lacked independence because there were insufficient facts plead to show they knew of the alleged misconduct and consciously chose not to act.

This case is notable because the Court looked to the composition of the board at the time the amended complaint was filed, not the date the case was first filed, in assessing allegations of demand futility. Under this holding, every time a derivative complaint is dismissed, even if the plaintiff is granted leave to amend, the demand process must begin anew and demand will not be futile unless the board at that time is not sufficiently disinterested or independent.

Background

Plaintiff alleged the following. From 2012 to the beginning of 2013, the Chief Financial Officer pressured employees to inflate revenue and make adjustments to bring revenue in line with guidance. In 2012, the Company issued a press release refuting allegations made by financial analysts that the Company’s accounting practices were not proper. Plaintiff also alleged that internal control deficiencies resulted in improper accounting adjustments earlier, in 2007, which led to an SEC action that enjoined the Company from violating the securities laws and required the Company to maintain a system of internal accounting controls.

With regards to the demand futility allegations, plaintiff alleged that a majority of Verifone’s Board knew of deficiencies in the company’s internal accounting controls, but failed to act to address those deficiencies or disclose the wrongdoing. Specifically, four current Directors were on the Board in 2009 when the Securities and Exchange Commission (SEC) filed suit against the company related to improper adjustments to its financial records. Those four Directors were also allegedly aware of “red flags” such as a 2012 analyst report questioning Verifone’s accounting practices and advising investors to sell their shares in the company, and the Directors should have investigated the Company’s accounting practices, financial results, and internal controls.

Finally, plaintiff alleged that a fifth director, in addition to the four that aware of these red flags, was involved in terminating the company’s Chief Financial Officer (CFO) for cause, yet announcing that the CFO had retired. Plaintiff alleged that two weeks after the new CFO’s tenure began, Verifone disclosed financial results for the first quarter of 2013

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that fell significantly below guidance. Plaintiff alleged that the company failed to announce that the prior CFO had manipulated financial results and that therefore the results released by the new CFO were poorer than expected.

Demand Futility Should Be Assessed Against the Composition of the

Board of Directors at the Time the Second Amended Complaint Was Filed

The parties disputed whether demand futility should be assessed against the Board of Directors as of the date the case was originally filed, or as of the date the second amended complaint was filed. The Court noted that under Delaware law, the existence of a new independent board of directors is relevant to the demand futility inquiry for any claims not already validly in the litigation. The Court found that the composition of the Verifone Board of Directors had changed between