SECURITIES

Evidence of a corporation's debts or property.

SEC v. American International Group

After earlier failed negotiations, the Securities and Exchange Commission (SEC) filed fraud charges against New York-based American International Group (AIG) in November 2004 for violating antifraud provisions of the federal securities laws. The SEC also charged AIG with other aiding-and-abetting violations related to the reporting and record-keeping provisions of those laws. SEC v. American International Group, Inc., No. 1:04CV02070 GK (D.D.C.). Corollary and related criminal charges were pending with the U.S. Department of Justice. A similar case was pending against AIG in the U.S. District Court for the Southern District of Indiana, where a grand jury investigation of "non-traditional insurance" or "income-smoothing" products, marketed by AIG and channeled through Brightpoint Inc., ended in an indictment. The grand jury alleged that some of these marketed financial products were directed at creating agreements with businesses that ostensibly would appear to be insurance policies, and would be accounted for as insurance policies, but did not involve any actual risk transfer.

The SEC action primarily concerned conduct arising from AIG's wholly owned subsidiary, AIG Financial Products Corp. (AIG-FP) for developing, marketing, offering to sell, and selling an earnings-management financial product that purportedly enabled PNC Financial Services Group (PNG), a publicly traded company, to remove certain assets from its balance sheet . Through the use of these derivative financial vehicles, PNC reportedly was able to transfer some $762 million in doubtful loans and investments off of its books, and on to AIG's. These tactics enabled PNC to overstate its 2001 earnings and were in serious violation of generally accepted accounting practices (GAAP).

Concurrent with the filing of the charges, the SEC announced a pending settlement of all charges, including criminal charges against AIG, subject to court approval. The settlement called for the payment from AIG of an $80 million penalty, another $46 million into an SEC disgorgement fund, and the appointment of an independent monitor to examine certain AIG transactions going back to the year 2000. Finally, the $126 million settlement package included an agreement clause providing that AIG would establish a Transaction Review Committee to review certain future transactions involving heightened legal, reputational, or regulatory risk. The settlement would close the books on ongoing investigations into AIG's structuring of financial products for Pittsburgh-based PNC. These transactions, which were terminated in early 2003, had been the subject of a prior SEC action against AIG in 2002. As to the 2004 action, the SEC had warned AIG that a civil action was being contemplated, stemming from company statements in three separate press releases dated January 30, 2002, September 21, 2004, and September 29, 2004.

Notwithstanding early settlement, the charges filed by SEC merit further review, in light of several corporate financial scandals haunting the publicly traded market. In its complaint against AIG, the SEC alleged that from at least March 2001 through January 2002, AIG, through its financial products subsidiary (AIGFP), developed a certain product called a Contributed Guaranteed Alternative Investment Trust Security ("C-GAITS"). It then marketed that product to several publicly traded companies and ultimately entered into three C-GAITS transactions with PNC. For its part, AIG received just under $40 million in fees for the three transactions.

In return for the fees, AIG offered to create a special-purpose entity ("SPE") to which the other party to the transaction (in this case, PNC) would transfer troubled or potentially volatile assets. AIG represented to these parties that, under GAAP, the SPE would not show up on the party's financial statements. Thus, the party would be able to avoid charges on its income statement resulting from declines in the value of those assets transferred to the SPE.

The SEC further alleged in its complaint that, while AIG was marketing this product, independent auditors, who had been retained by some prospective clients and counter-parties, had raised questions about whether certain features of the C-GAITS product could cause the product not to satisfy the GAAP requirements for nonconsolidation of SPEs. AIG failed to inform these potential parties of these issues, which came to light when a different potential party used the same independent auditor as the counter-party that had communicated the issue to AIG. AIG nonetheless went forward and entered into the three C-GAITS transactions with PNC, enabling it to remove $762 million in loan and venture-capital assets from its balance sheet.

Finally, the SEC alleged in its complaint that AIG had recklessly made misstatements of material facts, and that it had omitted to state material facts, about whether the C-GAITS product satisfied the GAAP requirements for nonconsolidation of an SPE. In consenting to the issuance of a final judgment based on the settlement, Defendant AIG neither admitted nor denied the allegations. The SEC brought a prior settled proceeding against PNC as well. In Re: The PNC Financial Services Group, Inc., Securities Act Release No. 33-8112, Exchange Act Release No. 34-46225, July 18, 2002. Investigation continued in 2004 as to other potential defendants.

Dura Pharmaceuticals v. Broudo

Issuing a brief, but unanimous, 11-page opinion, the U.S. Supreme Court clearly enunciated the standard of proof needed by investors who sue for fraud under the Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (1995). In Dura Pharmaceuticals v. Broudo, 543 U.S. __, 125 S.Ct. 1627, 161 L.Ed.2d 577 (2005), the high court reversed the ruling of the U.S. Court of Appeals for the Ninth Circuit, which had attached a less stringent meaning to the act's statutory language. The Court instead aligned itself with a majority of the federal appellate courts that had considered the issue, including the U.S. Court of Appeals for the Second Circuit, which had adopted the same approach in dismissing another suit by investors just a few months before the high court's decision. The significance of this closely watched fraud case is to remind potential parties and their legal counsel of the necessity of adequate pleading in a complaint of all necessary elements to establish a viable cause of action .

In causes of action involving publicly traded securities, the actions' basic elements include:

(1) a material misrepresentation (or omission);

(2) scienter ; i.e., a wrongful state of mind;

(3) a connection with the purchase or sale of a security;

(4) reliance on the alleged misrepresentation;

(5) economic loss; and (6) "loss causation" (the causal connection).

On his own behalf, as well as that of a group of shareholders, Michael Broudo filed suit against Dura Pharmaceuticals under the Securities and Exchange Act, 109 Stat. 747, 15 U.S.C. §78u et seq. The class action suit alleged that the company's misleading statements about its antibiotics sales, as well as the prospects for FDA approval of its new spray device for treating asthma, resulted in the plaintiffs' having paid artificially inflated prices for its stock. Later, when the company announced slow drug sales and (eight months later) a failure to obtain FDA approval on the asthma device, there was a significant drop in stock prices. However, the amended complaint filed with the district court only stated the following about economic losses attributable to the alleged misrepresentation about the spray device: "In reliance on the integrity of the market, [the plaintiffs] …paid artificially inflated prices for Dura securities" and the plaintiffs suffered "damage[s] thereby…."

The federal district court dismissed the suit, finding that the plaintiffs had failed to allege a causal connection between the spray device misrepresentation and their economic loss ("loss causation") under the Act's Section 78u-4(b)(4). The court also found that as to the drug sales claim, the plaintiffs had failed to allege the defendants' "scienter" or state of mind; e.g., that the defendants knowingly misrepresented anticipated sales with the intent to induce investment. (These elements parallel those that are necessary to establish a common law tort action for deceit and misrepresentation.)

The Ninth Circuit reversed. It held that plaintiffs could satisfy the loss-causation requirement by simply alleging that the stock prices at the time of purchase were inflated because of the misrepresentation(s). The appellate court added that "the injury occurs at the time of the transaction." Certiorari was granted based on the fact that other circuits differed in their views about loss causation.

In a straightforward and concise manner, Justice Breyer delivered the opinion of the U.S. Supreme Court. The Court held that an inflated purchase price for stock will not, in itself, constitute or proximately cause the requisite economic loss that is necessary to allege and prove "loss causation." The opinion first summarized relevant passages from Section 10(b) of the Securities Exchange Act of 1934 (prohibiting "deceptive device[s]" in connection with the purchase or sale of any security) and correlative Rule 10(b)(5) of the Securities Exchange Commission.

The Court began to dissect the Ninth Circuit's reasoning. First, as a matter of pure logic, noted the Court, no loss is suffered by plaintiffs at the moment when the transaction takes place. This is because the inflated purchase price is offset by ownership of a share that possesses equivalent value at that instant. Second, as a matter of pure logic, the link between an inflated purchase price and any later economic loss is tenuous, because other factors (e.g., changed economic circumstances or investor expectations; or industry-specific or company-specific facts or events) could also trigger a loss in value. Wrote Justice Breyer, Congress's purpose for permitting private suits for securities fraud was "not to provide investors with broad insurance against market losses, but [rather] to protect them against economic losses that misrepresentations actually cause." Accordingly, logic alone would limit references to inflated purchase prices to mere suggestions that "touch upon" a later economic loss.

The Ninth Circuit had concluded that "loss causation is satisfied where the plaintiff shows that the misrepresentation touches upon the reasons for the investment's decline in value." However, Justice Breyer wrote, "To 'touch upon' a loss is not to cause a loss, and it is the latter that the law requires."

Finally, the Court noted that the Ninth Circuit's approach was inconsistent with an important securities law objective. Congress's intent, in creating securities laws, was to permit private actions only where plaintiffs adequately allege and prove the traditional elements of cause and loss. Conversely, the Ninth Circuit's approach would allow recovery in every instance where a misrepresentation leads to an inflated purchase price but does not proximately cause any economic loss.

In summary, the plaintiffs' complaint in the case at hand was legally insufficient with respect to its allegation of "loss causation." While Federal Rules of Civil Procedure Rule 8(a)(2) requires only a "short and plain statement of the claim showing that the pleader is entitled to relief," that "short and plain statement" must allege the requisite elements and give the defendant fair notice of what the plaintiff's claim is and the grounds upon which it rests. Here, the plaintiffs merely alleged that their loss consisted of artificially inflated purchase prices. The complaint nowhere else provided defendant Dura with notice of what the relevant loss might be or what the causal connection might be between the loss and the misrepresentation.

Under the prevailing view, endorsed by the high court, investors who claim that they paid inflated prices for a stock because of fraudulent misrepresentation cannot recover damages unless they can show that any subsequent drop in the stock price was directly tied to the misrepresentation. This can be shown, for example, through the issuance of a subsequent corrective disclosure by the defendant. Without such a showing, plaintiffs fail to carry their burden of proof to establish a causal connection, because many other factors could potentially cause a subsequent drop in share price.

Approximately 190 class-action securities fraud lawsuits are filed each year. Amicus briefs in this case were filed by such entities as AARP, several public pension funds, and the National Association of Shareholder Consumer Attorneys, all in support of the Ninth Circuit's loosened standard, which they argued was necessary to deter recent corporate scandals including that involving Enron. However, the Securities and Exchange Commission supported Dura Pharmaceuticals, telling the Supreme Court that the Ninth Circuit's liberal approach "cannot be reconciled" with the Private Securities Litigation Reform Act.

Sarbanes-Oxley Act Survives Its First Judicial Challenge

In November 2004 the U.S. District Court for the Northern District of Alabama rejected a challenge of the constitutionality of several provisions in the Sarbanes-Oxley Act of 2002. Richard Scrushy, former chief executive officer with HealthSouth Corp., argued that vague terms in the statute rendered it unconstitutional. Lawmakers paid close attention to the decision because it represented the first challenge to the 2002 law that strengthen regulations related to corporate accounting practices.

Scrushy grew up modestly in Alabama and worked his way through Jefferson State Community College. He later attended the University of Alabama, earning a degree in respiratory therapy. He devised a concept for a network of outpatient centers and persuaded several doctors to finance the idea. From this idea, Scrushy formed HealthSouth in 1985. Scrushy built HealthSouth into a Fortune 500 company in just over a decade. He was honored throughout the state of Alabama, including having a campus named in his honor by Jefferson State Community College.

HealthSouth was one of several companies that became embroiled in controversy regarding accounting practices in the new millennium. Government investigators charged Scrushy and other executives with overstating earnings during a period from 1996 through March 2003. According to the government, Scrushy inflated earnings by $2.7 billion during this period in order to convince investors that the company had met Wall Street expectations.

In response to a series of corporate accounting scandals, Congress in 2002 enacted the Sarbanes-Oxley Act, 18 U.S.C. §1350 (Supp. II 2002), which sought to end this corruption. Congress sought to increase the reliability and accuracy of corporate accounting, reporting, and auditing practices with the enactment of the statute. Moreover, the act renders chief executive officers and chief financial officers legally responsible for the validity of their companies' financial statements. When he signed the legislation, President George W. Bush commented, "This law says to every dishonest corporate leader, 'You will be exposed and punished."'

Federal prosecutors indicted Scrushy on 85 counts on October 29, 2003. The prosecution later issued a superceding indictment with 58 counts on September 29, 2004. The indictment claims that Scrushy and other executives devised an elaborate scheme of bogus accounting entries, allowing the company to report fictitious earnings. Fifteen former HealthSouth executives, including several former chief financial officers, reached plea agreements with prosecutors. These executives cooperated with the prosecutors in Scrushy's case. Scrushy, who is the first executive to be charged under Sarbanes-Oxley, pleaded not guilty to the charges.

The charges against Scrushy include three counts of false certification under Section 906 of the Sarbanes-Oxley Act. Under this section, corporate officers must certify that financial statements comply with the requirements of the Securities Exchange Act, 15 U.S.C. §§78 et seq. and that the "information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer." 15 U.S.C. §1350(b). Any corporate officer who certifies a statement that does not comport with these requirements may face a fine of up to $1 million and imprisonment for up to 10 years. 15 U.S.C. §1350(c)(1). Moreover, an officer who "willfully certifies" any statement that does not comply with the section may be fined up to $5 million and imprisoned for up to 20 years. 15 U.S.C. §1350(c)(2).

Scrushy faced charges that he, along with other executives, willfully certified false statements. He claimed that the phrases "fairly presents, in all material respects…" and "willfully certifies" are unconstitutionally vague. U.S. District Judge Karon Bowdre, however, disagreed with Scrushy's arguments. In the opinion, the judge recited numerous instances in which Congress had used similar phrases. For example, the judge pointed out that Congress requires that businesses "fully and fairly present the financial statements" of government pension plans under the Employee Retirement Income Security Act of 1974, 29 U.S.C. §1023(b)(1)(2000).

The final outcome of the case, according to the opinion, should be decided by the jury. "Fairness, materiality, and willfulness are fact intensive questions generally reserved for the jury," Bowdre wrote. "Whether the information contained in the periodic reports certified by Mr. Scrushy fairly presented, in all material respects, the financial condition and results of operations of HealthSouth are questions of fact for the jury and part of the Government's burden of proof in the case." Accordingly, the judge denied the motion. United States v. Scrushy, No. CR-03-BE-0530-S, 2004 WL 2713262 (N.D. Ala. Nov. 23, 2004).

Members of Congress reportedly watched the case with great interest. Among those who commented on the judge's decision was Michael Oxley (R.-Ohio), who had co-sponsored the legislation. According to Oxley, "We weathered the first test when [Scrushy] challenged the constitutionality of the law." He also noted that "it will be interesting" to see the jury's reaction to the statute's requirements.

The Securities and Exchange Commission also brought civil charges against Scrushy, alleging that Scrushy had committed insider trading and had inflated company earnings. After the SEC filed its suit, HealthSouth removed Scrushy from his position as CEO. As part of the criminal prosecution, government officials have additionally sought to force Scrushy to return more than $278 million in assets that he accumulated, including a 92-foot yacht, two airplanes, classic paintings, antique carpets, and a variety of other properties.

In late June 2005, Scrushy as acquitted of all criminal charges by an Alabama jury. In July, Scrushy then asked that civil charges filed by the SEC be dropped due to a lack of evidence. Scrushy stated a desire to return to HealthSouth in some capacity.