Developments Relating to Regulatory Action Relating to EB-5 Investments

The last few months have seen a number of developments in the securities area relating to the EB-5 program.  Under the EB-5 program, overseas investors can obtain visas to live in the U.S. if they make sufficiently large investments in the U.S. which in turn generate a certain number of jobs in the U.S.  While the program has been in effect for some time, the program has received little scrutiny from regulators on the securities (as opposed to immigration) area.  Presumably, foreign investors select EB-5 compliant investments in substantial part for the immigration benefits -- the investments themselves and their performance might be thought secondary. In recent years, the EB-5 program has grown significantly, and many of the investments made by EB-5 investors over the past several years are now at the stage that those investments should start paying returns.  On the civil side, we have successfully defended companies who raised EB-5 money against litigation brought by EB-5 investors who were disappointed with their investment returns.  In early 2013, the SEC brought its first ever enforcement action relating to EB-5, bringing suit to halt an alleged fraudulent scheme relating to securities sold to allegedly raise money to build a hotel in Chicago.  We have heard that the SEC has issued a number of subpoenas to other companies that have raised capital from EB-5 investors, and we expect that trend to continue.  Even though EB-5 investors may be motivated substantially by immigration benefits, companies that raise money through the EB-5 mechanisms are not excused from compliance with their obligations to comply with U.S. securities laws.

Now, FINRA has weighed in on EB-5.   A broker-dealer requested FINRA guidance as to whether broker-dealers advising foreign investors on EB-5 investments were required to comply with FINRA's suitability rules.  The broker-dealer argued that EB-5 investments are made primarily for immigration benefits, not for investment purposes, and therefore should not be subject to the same scrutiny as other more traditional securities.  FINRA rejected this argument, making clear that the suitability rules apply with equal force to EB-5 investments.  This interpretative guidance from FINRA makes it clear that broker-dealers now also face scrutiny in the EB-6 arena from regulators and may be subject to liability from disgruntled investors if EB-5 investments they recommend do not produce investments returns or turn out to be unduly risky.

We expect the coming months to be quite active on the regulatory and civil litigation fronts with respect to EB-5 investments, as investors are going to be increasingly looking for returns from EB-5 investments made over the last several years and as some of those investments do not perform.

The Second Circuit Strictly Enforces Time Limits for Securities Claims

This week, the Second Circuit issued a very significant ruling regarding the time period during which securities cases must be brought.  In Police and Fire Retirement System of the City of Detroit v. IndyMac MBS, Inc. (http://www.ca2.uscourts.gov/decisions/isysquery/2d3ab723-2344-425c-9bf5-139f44ee9197/1/doc/11-2998_opn.pdf#xml=http://www.ca2.uscourts.gov/decisions/isysquery/2d3ab723-2344-425c-9bf5-139f44ee9197/1/hilite/), the Second Circuit held that so-called American Pipe tolling does not apply to the statute of repose for filing claims under the Securities Act of 1933.  Specifically, the Securities Act requires that civil claims brought thereunder must be filed within one year of plaintiff's discovery of the claim or within three years of the offering at issue, whichever occurs first.  The Second Circuit held that the three year period is a hard limit not subject to a well accepted form of tolling, so-called American Pipe tolling. In American Pipe, the Supreme Court held that statute of limitations for the claims by class members is tolled -- it does not run -- while a class action purporting to advance those claims is pending.  Otherwise, putative class members might be forced to file individual claims while waiting for class certification; otherwise, if class certification were denied, it might by then be too late for individual class members to file individual actions.  The Second Circuit held that the three year repose period under the Securities Act is so strict that this American Pipe tolling rule does not apply to it.

While technical and perhaps esoteric, the no tolling rule as significant implications.  In the IndyMac case itself, plaintiffs failed to include a named plaintiff for each and every one of the over 100 securities offerings at issue.  Accordingly, the claims with respect to offerings for which there was no named class representative were dismissed.  Absent the statute of repose, this problem would be easily remedied; plaintiffs would simply add class representatives for the additional offerings.  But, by the time of the ruling the three year statute of repose had run and the pendency of the class action the Second Circuit held did not extend the time period to file.

More common application of this rule may come in the form of opt outs.  Often, institutional and individual plaintiffs will remain part of a putative class action to see how the class action will proceed and how favorable a settlement might be.  If unsatisfied, the institutions or individuals can "opt out" of the class and file individual actions.  It is now clear that these would-be individual plaintiffs will have to opt out and file an individual action before the three-year statute of repose runs.  Accordingly, this new rule will impact opt out decisions and timing.

The rule will also almost certainly not be limited to Securities Act claims.  The more common securities claims under Section 10(b) of the Securities-Exchange Act and Rule 10b-5 are subject to a functionally identical five year statute of repose.  Therefore, this same rule will apply to Exchange Act claims.

Finally, the rule may also apply to other forms of tolling, possibly even contractual tolling agreements.  This ruling calls all forms of tolling into question with respect to the statutes of repose applicable under the Securities and Exchange Acts.  Plaintiffs will sometimes agree not to name certain defendants in exchange for a tolling agreement in the event that later discovered facts reveal a compelling reason to add that defendant.  Such agreements may be ineffective after the statute of repose date.

In sum, this decision will give defendants opportunities to argue that certain securities cases are time barred.  More importantly, perhaps, it will force plaintiffs to make more rapid decisions on class certification, opting out and other critical decisions in the life of securities actions.

Proof of Materiality Not Required for Certiciation of Securities Class Action

In a highly anticipated ruling, the Supreme Court held in Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds (http://www.supremecourt.gov/opinions/12pdf/11-1085_9o6b.pdf), the Supreme Court held that securities plaintiffs are not required to prove materiality in order to obtain certification of a class seeking to recover under the securities laws.  The plaintiffs in Amgen sought to certify under Rule 23(b)(3) which requires that common questions of fact or law predominate over individual questions.  To do so, plaintiffs invoked the fraud-on-the-market theory to avoid the need to establish reliance on an individual basis.  Courts have long held that in order to obatin certification under this theory, plaintiffs have to establish its prerequisites, such as that the security trades on an efficient market.  Amgen contended that, in order for the theory to apply, the misrepresentation or omission at issue also had to be material -- otherwise the market for the security at issue by definition would be unaffected.  The Supreme Court, however, disagreed.  The Court held that other elements of the theory had to proved at the certification stage because, if those other elements failed, the class would fail but individual plaintiffs could bring individual actions.  The Court reasoned that materiality is different.  Materiality is also a substantive element of a securities claim -- therefore, if materiality fails, all the class' claims fail.  Because all of the class' claims rise or fall together, materiality is appropriately determined at trial. The implication for securities defendants is that they are unable to get a pre-trial opportunity to defeat a securities claim b contesting materiality.  While defendants maintain the opportunity to attack materiality on summary judgment, materiality tends to be a fact question not easily susceptible to summary judgment.  A favorable ruling would have given defendants with strong, but disputed, materiality arguments an opportunity to get a ruling on the merits before trial (and the massive attendent risks that go with it).

The decision also has broader implications for class certification because it gives courts a framework for evaluating how deep into the merits they can go at the certification stage.  Clearly now courts will not address merits issues under which the class will rise or fall together.

Ninth Circuit Clears Up Scienter Analysis

In In re VeriFone Holdings, Inc. Securities Litigation (http://cdn.ca9.uscourts.gov/datastore/opinions/2012/12/21/11-15860.pdf), the Ninth Circuit weighed in on the proper analysis for determining whether a plaintiff in a securities action has properly pled scienter.  After the Private Securities Litigation Reform Act of 1995 (PSLRA), federal courts looked to the specific individual allegations in the complaint to determine whether the plaintiff had pled the requisite strong inference of scienter.  In Tellabs, the Supreme Court clarified the scienter analysis and required that the federal courts take a "holistic" approach -- that is, to determine whether the complaint and all of its allegations as whole create a strong inference of scienter.  Particularly after a subsequent Supreme Court decision in Matrixx Initiatives, at least some federal courts had begun taking the view that only the holistic approach was proper; in other words, courts should not look at the individual allegations one by one to determine whether any individually create a strong inference of scienter.  The Nonth Circuit in VeriFone set this debate to rest in the Ninth Circuit at least, holding that courts should undertake the individual review of allegations for scienter and then step back and look at the complaint as a whole to determine if the standards are met.  The Ninth Circuit referred to this as a two step approach. At first look, it seems that the Ninth Circuit approach is plaintiff friendly.  They have two opportunities to plead scienter:  either through individual allegations so powerful that they create a strong inference of scienter or based upon the allegations of the complaint taken as a whole.  Indeed, a holistic approach only might lead a court to reject even a powerful individual allegation because taken together with all of the rest of the facts before it, there are off-setting facts that suggest an innocent explanation.

But, as a practical matter, the Ninth Circuit approach may not be so plaintiff friendly after all.  The approach allows defendants to focus courts' attention on the individual allegations and pick each apart.  If a defendant can successfully do so, it seems unlikely in most instances that a court is going to find a strong inference of scienter from a bunch of individual allegations that, standing alone, don't amount to enough.  The exercise of going through the first step may advantage defendan

Must Plaintiffs Prove Materiality Before Trial Under the Fraud on the Market Theory?

It is well established that, in order to bring a securities case as a class action, it will almost always be necessary to proceed under the so-call “Fraud-on-the-Market” theory established by the Supreme Court in Basic v. Levinson. Under that theory, the class action mechanism works to adjudicate all affected stockholders’ claims together because the theory posits that any material false public statement inherently affects the market price of the securities at issue – therefore, in order to prove a claim that a stockholder was injured by a false statement, he need not prove that he ever heard, was aware of or relied upon the allegedly false statement. He need only prove he bought the affected security (the price of which was inflated based upon the false statement). In order to invoke the “Fraud on the Market” theory, a representative class plaintiff must establish that defendant made a public statement, that the statement was material and that the securities in question traded on an efficient market. On November 5, 2012, the Supreme Court heard argument in Amgen v. Connecticut Retirement Plans and Trust Funds. The question presented is whether the class representative must prove materiality at the class certification stage. Class plaintiffs must establish efficiency of the market to proceed as a class. However, the federal Circuits are split whether materiality must be proven as well. Because materiality is an element of securities fraud under Rule 10b-5, it must be proven at trial. Accordingly, some Circuits say that requiring proof at class certification is redundant, and, in any event, materiality is necessarily common to all class members and should be no impediment to class certification. Other Circuits have held that materiality is an element of the “Fraud on the Market” theory and thus should be treated like efficiency.

A victory by Amgen requiring materiality to be proved at class certification would be a major win for defendants. At class certification, materiality would be determined by a judge – not the jury. And, it would not be decided under the demanding the demanding summary judgment standard that is unkind to materiality based defenses. Moreover, defendants would not have to wait until trial (and an impending potentially disastrous judgment) to test a materiality defense. In short, if Amgen prevails, look for a much sharper focus by defendants on materiality in securities actions.

While reading into the Justices’ comments from oral argument is always challenging, it sounded like the decision will be split, with perhaps the Chief Justice casting the deciding vote.