2nd Circuit Gives Guidance to Litigators on Securities Fraud Claims

As the 2nd Circuit explained in JPMorgan, “[t]hese qualitative factors are intended to allow for a finding of materiality if the quantitative size of the misstatement is small, but the effect of the misstatement is large.”

FACTORS AS APPLIED

JPMorgan is only one of a handful of federal court of appeals’ decisions to have expressly applied SAB 99 to test the merits of a securities fraud claim or charge, and it is the 2nd Circuit’s first meaningful and substantive attempt to do so since Ganino first embraced SAB 99 in 2000.[FOOTNOTE 2]

In JPMorgan, the court addressed three SAB 99 factors:

First, the plaintiffs alleged that the misstatement concealed an unlawful transaction. The court concluded that that factor did not apply since the transaction itself was not illegal. Implicit in this conclusion is the distinction between misaccounting for an otherwise legal transaction, on the one hand, and the deliberate misaccounting for a transaction that is inherently illegal independent of the alleged securities fraud (e.g., management stealing from the corporation), on the other.

Second, the plaintiffs alleged that JPMorgan’s misstatements related to a significant aspect of its operations. With respect to this factor, the court held that it “also favors” JPMorgan because JPMorgan’s Enron-related business represented less than 0.1 percent of JPMorgan’s revenues during the relevant years.

Third, the plaintiffs cited the “market reaction” to public disclosures of JPMorgan’s role in Enron’s collapse. In rejecting that argument, the court expressly limited the “usefulness” of SAB 99′s “market reaction” factor to instances where management expects that a known misstatement may result in a significant positive or negative market reaction.

IMPLICATIONS FOR PRACTITIONERS

The 2nd Circuit’s materiality analysis in JPMorgan has several important implications for securities practitioners.

First, the size of the dollar amount involved in a misstatement is not dispositive of the issue of materiality. To be sure, many courts have recognized this in the past. See, for example, Glassman v. Computervision Corp., 90 F.3d 617, 633 (1st Cir. 1996); Parnes v. Gateway 2000 Inc., 122 F.3d 539, 546-47 (8th Cir. 1997); In re Westinghouse Sec. Litig., 90 F.3d 696, 715 (3d Cir. 1996); In re Duke Energy Corp. Secs. Litig., 282 F. Supp. 2d 158, 161-62 (S.D.N.Y. 2003), aff’d, 113 Fed. Appx. 427 (2d Cir. 2004). However, as securities fraud practitioners confront misrepresentations involving larger and larger sums, having a precedent involving a ten-figure misrepresentation, like JPMorgan, could prove pivotal.

Second, after JPMorgan, even when a misrepresentation is clearly quantitatively immaterial, a rigorous, fact-specific analysis of potentially applicable SAB 99 factors is required. The myriad of potential factual scenarios, together with the many undefined concepts built into SAB 99 promise to make qualitative materiality a subject for future litigation. Moreover, given the fact-specific nature of the SAB 99 analysis, we believe there may be situations when the applicability of one qualitative factor may not be sufficient to prove materiality. Thus, before conceding materiality, practitioners confronting a single applicable SAB 99 factor should consider the strength of that factor’s application, and whether it pales in comparison to the quantitative immateriality of the misstatement at issue.

Third, the qualitative materiality analysis should be informed by quantitative considerations. After JPMorgan, determining what constitutes a “significant aspect of operations” requires a quantitative assessment. Presumably the 2nd Circuit would view other SAB 99 factors through a similar quantitative prism.

Fourth, securities fraud defendants seeking to demonstrate immateriality as a matter of law should be heartened by the circuit’s discussion about factors “favor[ing]” defendant JPMorgan. That analysis confirms that SAB 99 factors can also weigh against a finding of materiality.

In some cases, there inevitably will be a “SAB 99 split” (i.e., some SAB 99 factors favor the defendant, while others favor the plaintiff). Courts, therefore, will have to delicately balance whether and under what circumstances certain SAB 99 factors (or collections of factors) should be afforded more weight than others.

Courts also will have to consider the interplay between various SAB 99 factors. For example, the factor regarding “imprecise estimates” may have significant implications on the applicability of other SAB 99 factors, such as whether or not a particular alleged misstatement actually masked a change in earnings or trend.

Fifth, defendants should be aware of JPMorgan‘s reasoning that a misrepresentation may be qualitatively material if management expects that a known misstatement may result in a significant positive or negative market reaction. On its face, this rationale appears to blur the distinction between scienter and materiality, as the entire premise of the “market reaction” SAB 99 factor, after JPMorgan, is management’s knowledge of the misstatement. Commentators previously had raised concerns about SAB 99 for precisely this reason. See, for example, Clarissa Hodges, “The Qualitative Considerations of Materiality: The Emerging Relationship Between Materiality and Scienter,” Bowne Digest for Corp. & Sec. Law. (July-August 2002).

CONCLUSION

Based on our review of the JPMorgan briefs and a transcript of the oral argument, it does not appear the parties addressed this issue.

Historically, courts have been hostile to theories that seek to blur the distinction between scienter and materiality, and typically emphasize that only the materiality of the alleged untrue statement of fact is relevant — not the materiality of the act or transaction that caused the untruth to be published.[FOOTNOTE 3]

In any event, it remains to be seen how practitioners and courts will construe JPMorgan‘s rationale regarding the “market reaction” SAB 99 factor.

Douglas I. Koff is a member of Cadwalader, Wickersham & Taft. Jason Jurgens is special counsel in the firm’s litigation department. Joshua M. Bennett, a litigation associate, assisted in the preparation of this article.

:::::FOOTNOTES:::::

FN1 The decision also contains an important discussion regarding the scienter pleading requirements under the PSLRA that are beyond the scope of this article.

FN2 We are aware of only two other federal court of appeals’ decisions to have expressly applied SAB 99 in addressing qualitative materiality theories. See United States v. Nacchio, 519 F. 3d 1140 (10th Cir. 2008), citing Ganino, 228 F.3d at 162-64 and SAB 99; Romine v. Acxiom Corp., 296 F.3d 701, 706-07, 710-11 (8th Cir. 2002).

FN3 See Greenhouse v. MCG Capital Corp., 392 F.3d 650, 659-600 (4th Cir. 2004); United States v. Reyes, 491 F. Supp. 2d 906, 912 n. 6 (N.D. Cal. 2007); In re Duke Energy Sec. Litig., 282 F. Supp. 2d at 161-62; cf. Stoneridge Investment Partners, LLC v. Scientific-Atlanta Inc., 552 U.S. (2008) (Slip. Op. at 9) (rejecting proposition that “in an efficient market investors rely not only upon the public statements relating to a security but also upon the transactions those statements reflect”); but see Gebhardt v. ConAgra Foods Inc., 335 F.3d 824 (8th Cir. 2003).