Section 10(b) of the Securities Exchange Act prohibits anyone from engaging in manipulative or deceptive activities in connection with a securities transaction. Rule 10b-5, promulgated under Section 10(b), prohibits anyone from “mak[ing] any untrue statement of a material fact” or “omit[ting] to state a material fact necessary in order to make the statements made… not misleading” in connection with securities transactions.
Recently, several Section 10(b) lawsuits have been filed alleging that companies hired stock promoters to pen enthusiastic articles about the companies’ prospects. The lawsuits were apparently inspired by an exposé published at Seeking Alpha regarding stock promoter practices. The CEO of one of the companies involved was ultimately arrested on charges of criminal securities fraud, both for hiring promoters, and for more garden variety manipulative practices.
In all of these cases, the promotional articles did not disclose that they were paid promotions, nor did they accurately disclose their authorship. Instead, they were either published under colorful pseudonyms like “Wonderful Wizard,” and “Equity Options Guru,” or under more mundane fictional attributions, such as “James Ratz.” (A name certainly likely to inspire trust….).
These cases raise a number of interesting technical questions regarding the scope of Section 10(b), not the least of which is, can the plaintiffs get around Janus?
[More under the jump]
Now, here’s my disclaimer: These cases are mostly in their early stages. Discovery has not taken place and in many cases, only the initial complaints have been filed. Thus, I’m going by a really sketchy and unproven account of the facts.
[Sidebar: The PSLRA was supposed to stop the race to the courthouse. It did not; it just changed the nature of the race. These days, cases begin just as quickly as they ever did, with an initial, abbreviated complaint. Later, a new complaint is filed with more detail.]
Anyway, in all of the cases, the companies are alleged to have reviewed and approved the promoters’ articles before they were published. In some cases, the plaintiffs were able to allege with some detail that the companies edited, to a greater or lesser degree, the articles before publication. In other cases, such allegations are lacking (either because there was no such editing, or because the plaintiffs don’t have access to discovery and therefore don’t have evidence yet).
Critically, however, there are no allegations that the articles themselves were false except for their failure to disclose the promotional relationship. That is, they apparently accurately summarized information about the companies, but then added hyperbolic “analysis” that appeared to be independent but was, in fact, bought and paid for. “Falsity” here appears to consist solely of the promoters’ misrepresentation of their true opinions and their identities, and the omission of information regarding compensation.
Now, this might be enough for the promotions to run afoul of Section 17(b) of the Securities Act, 15 U.S.C. § 77q(b), which forbids stock “touting” without disclosure of the payments. But that statute has been held not to provide a private right of action. Thus, for the plaintiffs, it’s pretty much Section 10(b) or bust.
On the surface, these cases seem to resemble the complaints filed in the wake of the internet bubble alleging that certain analysts falsely claimed to be enamoured of various internet stocks in order to win investment banking business. In those cases, as well, the factual information in the reports was true; the only false statement was the misrepresentation regarding the analysts’ true opinion of the stock.
Those cases were mostly dismissed for failure to allege loss causation. The Second Circuit held in Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005) that if the only false statement was the analyst’s opinion, then the plaintiffs would have to show that any losses were also somehow attributable to that lie specifically. But because the companies’ stock prices dropped mostly because they were bad companies – i.e., because of the same risks that were apparent in the truthful factual information accompanying the analyst opinions – the plaintiffs could not make this showing.
The stock promoter cases, however, have avoided this difficulty. In all of them, the stock prices tumbled when the companies’ use of promoters was publicly disclosed. Therefore, loss causation is not an issue.
Materiality, however, does remain an issue, at least theoretically. After all, if truthful information about the company is available, why should any rational investor be influenced by the opinion of some random person on the internet that they’ve never heard of?
Again, the internet bubble provides a parallel. Back in those days, the SEC prosecuted a teenager named Jonathan Lebed for stock manipulation. All he did was go to various internet message boards and post enthusiastically about particular stocks – which apparently resulted in enough of a bump that he was able to turn a quick pump-and-dump profit. Donald Langevoort wrote about the case in his article Taming the Animal Spirits of the Stock Markets; in his view, materiality was a weak point in the SEC’s allegations, because there is no reason why anyone would take the word of an anonymous internet commenter when picking stocks.
Langevoort suggests that people who bought were speculators who were aware of the game, and didn’t actually rely on the false opinions offered – but nonetheless hoped they could also turn a pump-and-dump profit. The Commission ultimately settled the case; thus, the issue of materiality was never tested in court.
Another issue in the stock promotion cases is reliance. All have been brought as class actions using the fraud on the market theory. But they all also involve small cap – indeed, micro cap – stocks. Arguably the only reason the scheme worked was because the stocks were so thinly traded. Thus, if it gets to that point, the plaintiffs will likely have a significant hurdle in establishing market efficiency. It will be interesting to see whether Halliburton II can help them out there: as I previously posted, Halliburton II arguably loosened the requirements for establishing market efficiency.
Which brings us to the elephant in the room: Janus.
In Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), the Supreme Court examined what it means to “make” a false statement for 10b-5 purposes. In that case, the plaintiffs alleged that the prospectuses associated with certain mutual funds were false. The mutual funds themselves had filed and disseminated the prospectuses, but the plaintiffs claimed that the prospectuses had actually been drafted by the mutual fund adviser, organized as a separate entity. The plaintiffs sued the adviser for making false statements in violation of 10b-5. The Court held that only the mutual fund had “made” a statement for 10b-5 purposes, and rejected the claim. As the Court put it:
For purposes of Rule 10b-5, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not “make” a statement in its own right….
[I]n the ordinary case, attribution within a statement or implicit from surrounding circumstances is strong evidence that a statement was made by–and only by–the party to whom it is attributed.
To hold otherwise, the Court said, would undermine Section 20(a) of the Exchange Act, a separate provision that imposes liability on persons who “control” individuals who violate Section 10(b).
Writing in dissent, Justice Breyer objected that, among other things, lower courts had long held that when a company passes false information on to a market analyst, with the expectation that the market analyst will repeat that information publicly, the company is responsible for the market analyst’s statement, even though these statements had not been “made” by the company under Janus’s definition. The majority, in response, suggested – without deciding – that in such cases, the statements made to the analyst could form the basis of a Section 10(b) claim, on the theory that speaking to the analyst was the equivalent of a public statement, on par with speaking to reporters.
Here, though, I don’t think there’s much of an argument that these cases are like the analyst scenario alluded to by the Janus majority. The plaintiffs do not allege that the statements from the companies to the promoters form the basis of their Section 10(b) claims, and it’s hard to see how edits to an article are themselves public statements that can trigger fraud on the market liability.
So the real question is whether the hiring companies exerted the requisite amount of “authority” over the articles to qualify as the “maker” of the statements. Janus offers attribution as a key factor as to whether someone “made” a statement; here, of course, the articles were not attributed to the companies (and, in fact, they were not attributed to real persons at all). However, in practice, courts applying Janus have generally held that attribution is not necessary if control over the statement can be shown in other ways. As a result, since Janus, several courts have held that corporate officers’ review and approval of corporate statements render them “speakers” for Janus purposes. See, e.g., In re Pfizer Inc. Sec. Litig., 936 F. Supp. 2d 252 (S.D.N.Y. 2013). That said, when it comes to the actions of lawyers and accountants, courts have held that review, approval, and even revision do not render someone the “maker” of an unattributed statement. See Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147 (2d Cir. 2007); Pac. Inv. Mgmt. Co. LLC v. Mayer Brown LLP, 603 F.3d 144 (2d Cir. 2010).
What about control over the content of the articles, such as whether and how to communicate them? It appears that the hiring companies had the ability to finally approve whether the article was published, but the how is much less clear – it’s possible that the promoters had discretion regarding general format and placing.
A related possibility is that the promoters acted as agents – in the traditional sense – of the companies. If so, the companies may be liable under a simple theory of vicarious liability, even if the plaintiffs cannot demonstrate the companies’ involvement in the details of the articles. See Elbit Sys. v. Credit Suisse Group, 917 F. Supp. 2d 217 (S.D.N.Y. 2013).
Finally, there’s certainly an argument that even if the companies did not themselves make the misstatements, they acted as controlling persons of the promoters, who certainly did. Therefore, if the promoters are liable under Section 10(b), the companies could be held liable under Section 20(a).
In any event, I think these cases will generate some interesting opinions – I look forward to seeing what happens.