Securities — Section 11 — The Affirmative Defense of “Negative Causation” and Overcoming It

Hildes v. Arthur Andersen LLP, 2013 U.S. App. LEXIS 17177 (9th Cir. Aug. 19, 2013):

David Hildes appeals from a district court order denying leave to amend his complaint. Hildes sought to add a claim under Section 11 of the Securities Act of 1933, 15 U.S.C. § 77k, against former outside directors of Peregrine Systems, Inc. ("Peregrine"). The district court concluded that amendment would be futile because the "negative causation" defense barred Hildes' proposed claim. It noted that Hildes entered into a Voting Agreement and Irrevocable Proxy with Peregrine, which required that Hildes' shares in Harbinger Corporation ("Harbinger") be voted in favor of a merger between the two companies. Because that agreement was executed before Peregrine filed an S-4/A registration statement ("Registration Statement") with the SEC that is alleged to contain various omissions and misstatements, the district court concluded that any misrepresentations in the Registration Statement could not have caused Hildes' losses.

We reject this reasoning. Section 11 imposes broad liability without regard to reliance or fraudulent intent for any material misstatements or omissions contained in a registration statement for the first year that the registration statement is available. 15 U.S.C. § 77k(a). Although Hildes agreed to have his Harbinger shares voted in favor of the merger with Peregrine, he did not irrevocably commit to exchange those shares for Peregrine shares prior to the filing of the Registration Statement. Moreover, Hildes alleges that if Peregrine's Registration Statement had contained accurate information, the merger would not have taken place, and Hildes' Voting Agreement and Irrevocable Proxy would have terminated. Accordingly, Hildes sufficiently alleged that the material misstatements caused his losses, and thus amending the complaint would not be futile. Exercising jurisdiction under 28 U.S.C. § 1291, we reverse and remand. ***

Section 11 of the Securities Act of 1933 imposes liability on "every person who signed [a] registration statement" containing "an untrue statement of a material fact or" one that "omitted to state a material fact required . . . to make the statements therein not misleading." 15 U.S.C. § 77k(a). The statute provides that "any person acquiring such security (unless it is proved that at the time of such acquisition he knew of such untruth or omission) may . . . sue . . ." Id. It further provides:

If such person acquired the security after the issuer has made generally available to its security holders an earning statement covering a period of at least twelve months beginning after the effective date of the registration statement, then the right of recovery under this subsection shall be conditioned on proof that such person acquired the security relying upon such untrue statement in the registration statement or relying upon the registration statement and not knowing of such omission, but such reliance may be established without proof of the reading of the registration statement by such person.

Id. The plain text of Section 11 thus imposes a reliance element only as to investors who purchased a security at least twelve months after the registration statement became effective.

The Supreme Court has recognized that Section 11 "places a relatively minimal burden on a plaintiff." Herman & Maclean v. Huddleston, 459 U.S. 375, 382 (1983). "The section was designed to assure compliance with the disclosure provisions of the Act by imposing a stringent standard of liability on the parties who play a direct role in a registered offering." Id. at 381-82 (footnotes omitted). As long as "a plaintiff purchased a security issued pursuant to a registration statement, he need only show a material misstatement or omission to establish his prima facie case." Id. at 382. "Liability against the issuer of a security is virtually absolute, even for innocent misstatements." Id. (footnote omitted).

As numerous courts have held, and the appellees in this case concede, a plaintiff who purchases a security within twelve months of the registration statement need not show reliance to bring a Section 11 claim. See Silverstrand Invs. v. AMAG Pharms., Inc., 707 F.3d 95, 102 (1st Cir. 2013) ("[U]nlike § 10(b) of the Securities and Exchange Act, § 11 does not have a scienter or reliance requirement . . . ."); Hutchison v. Deutsche Bank Sec. Inc., 647 F.3d 479, 484 (2d Cir. 2011) ("[P]laintiffs alleging violations of Section[] 11 . . . need [not] plead scienter, reliance, or loss causation." (internal quotation marks omitted)); In re Constar Int'l Inc. Sec. Litig., 585 F.3d 774, 784 (3d Cir. 2009) ("Since reliance is irrelevant in a § 11 case, a § 11 case will never demand individualized proof as to an investor's reliance or knowledge (except where more than twelve months have passed since the registration statement became effective)."). This court, among several, has also noted that Section 11 lacks a scienter requirement. See Anderson v. Clow (In re Stac Elecs. Sec. Litig.), 89 F.3d 1399, 1404 (9th Cir. 1996) ("No scienter is required for liability under § 11; defendants will be liable for innocent or negligent material misstatements or omissions." (internal quotation marks omitted)); see also Krim v. pcOrder.com, Inc., 402 F.3d 489, 495 (5th Cir. 2005) ("Section 11's liability provisions are expansive--creating virtually absolute liability for corporate issuers for even innocent material misstatements . . . ." (internal quotation marks omitted)); Carlon v. Thaman (In re NationsMart Corp. Sec. Litig.), 130 F.3d 309, 315 (8th Cir. 1997) ("To establish a prima facie § 11 claim, a plaintiff need show only that he bought the security and that there was a material misstatement or omission. Scienter is not required for establishing liability under this section.").

Despite the general rule that a plaintiff need not demonstrate reliance on a misleading registration statement in order to prevail on a Section 11 claim, the district court determined that because Hildes entered into his Voting Agreement and Irrevocable Proxy prior to the issuance of Peregrine's fraudulent Registration Statement, Hildes' claim was barred under the doctrine of "negative causation." The affirmative defense of negative causation prevents recovery for losses that the defendant proves are not attributable to the alleged misrepresentation or omission in the registration statement. See 15 U.S.C. § 77k(e); see also McMahan & Co. v. Wherehouse Entm't, Inc., 65 F.3d 1044, 1048 (2nd Cir. 1995). This court recognized the doctrine in Miller v. Pezzani (In re Worlds of Wonder Sec. Litig.), 35 F.3d 1407 (9th Cir. 1994), under the name "loss causation." Id. at 1421. "The defendant has the burden of proof on this defense," and bears a "heavy burden." Id. at 1422 (internal quotation marks omitted). A defendant must show "that the depreciation in value" of a plaintiff's stock "resulted from factors other than the alleged material misstatement." Id. (alteration and internal quotation marks omitted).

According to the district court, Hildes' losses could not have been caused by the misleading Registration Statement because Hildes made a binding commitment to exchange his Harbinger shares for Peregrine stock when he signed his Voting Agreement and Irrevocable Proxy on April 5, 2000, prior to the date misrepresentations were made in the Registration Statement. We disagree. Although the Voting Agreement and Irrevocable Proxy irrevocably committed Hildes to have his shares voted in favor of the merger, it did not irrevocably commit him to exchange his Harbinger shares for Peregrine shares. Any exchange of shares remained contingent on the consummation of the merger. As Hildes plausibly alleges in his proposed second amended complaint, the merger would not have occurred had the Registration Statement been truthful.

Hildes provides several theories under which the planned merger would have collapsed but for the misrepresentations in the Registration Statement. First, the proposed second amended complaint alleges that the Harbinger board would have declared Peregrine to be in breach of the Merger Agreement for providing materially false and misleading information in the Registration Statement, and terminated the Merger Agreement under Article VII. Had the Merger Agreement been terminated, Hildes' Voting Agreement and Irrevocable Proxy would have expired. Second, the proposed complaint alleges that a majority of Harbinger shares would have voted against the merger had the Registration Statement been truthful. Under this scenario, Hildes' Harbinger shares would not have been exchanged for Peregrine stock. Given the allegation that more than 85% of Harbinger shares were not bound by proxy agreements, coupled with the magnitude of the alleged financial misstatements, these allegations provide a second plausible theory under which the Registration Statement's misrepresentations caused Hildes' loss.

Hildes also identifies several means by which he could have personally avoided the exchange of shares had the Registration Statement disclosed ongoing accounting irregularities by Peregrine. He could have attempted to sell his Harbinger shares to a third party (provided the third party executed a counterpart to the Voting Agreement and Irrevocable Proxy), sought to rescind the Voting Agreement and Irrevocable Proxy based on a claim of fraudulent inducement, or filed a shareholder suit seeking to enjoin the merger.

We conclude that the outside directors have not met their "heavy burden" of "prov[ing], as a matter of law, that the depreciation of the value of [the security] resulted from factors other than the alleged false and misleading statements." Provenz v. Miller, 102 F.3d 1478, 1492 (9th Cir. 1996) (internal quotation marks omitted). Overcoming a negative causation defense requires merely that "the misrepresentation touches upon the reasons for an investment's decline in value." In re Worlds of Wonder, 35 F.3d at 1422 (internal quotation marks omitted). Misrepresentations contained in Peregrine's Registration Statement certainly "touch[ed] upon" the decline in value of Hildes' investments because, he alleges, the merger would have failed but for those misrepresentations. Had the merger not been completed, Hildes would have retained Harbinger stock rather than obtaining shares in Peregrine.

Contrary to the directors' assertions, this is not a case in which "the decision is made and the parties are committed to the transaction" prior to the effective date of a registration statement. APA Excelsior III L.P. v. Premiere Techs., Inc., 476 F.3d 1261, 1267 (11th Cir. 2007). In APA Excelsior, the Eleventh Circuit concluded that a Section 11 claim necessarily fails if a sophisticated investor "participating in an arms-length corporate merger make[s] a legally binding investment commitment months before the filing of a defective registration statement." Id. at 1277. The outside directors place great emphasis on this case, noting the striking resemblance of facts. There, a target corporation's shareholders brought a Section 11 claim against an acquiring corporation and certain directors and officers, alleging misrepresentations in a registration statement. Id. at 1264--65. Prior to the effective date of the registration statement at issue, the target corporation had entered into a stock-for-stock merger agreement, the board had voted to recommend the merger to the shareholders, and plaintiffs had granted irrevocable proxies binding themselves to have their shares voted in favor of the merger. Id. at 1264.

The Eleventh Circuit held that plaintiffs' Section 11 claim failed as a matter of law because "reliance [wa]s rendered impossible by virtue of a pre-registration commitment." Id. at 1272 (footnote omitted). "[B]y virtue of their binding commitment decision," the court determined, plaintiffs "effectively 'purchased' their [acquiring company's] stock months before the registration statement was filed." Id. at 1276. Significantly, because it deemed the issue waived, the court in APA Excelsior declined to consider plaintiffs' argument that they "were not fully committed to the merger before the registration statement because their commitment was revocable." Id. at 1269-70.

In the present case, as noted above, we have concluded that Hildes was not irrevocably bound to exchange his Harbinger shares for Peregrine stock at the time the Registration Statement was filed. Rather, misrepresentations contained in the Registration Statement played a role in the causal chain that resulted in the exchange of stock. We are thus not presented with the issue decided in APA Excelsior. Although that court did not consider whether plaintiffs were committed to exchange stock based on a set of agreements similar to those at issue in this case, it did note that a plaintiff seeking to recover under Section 11 "need only show a material misstatement and/or omission in the registration statement and be able to 'trace' the security he acquired to that defective statement." Id. at 1271 (citations omitted). Hildes' allegations satisfy this traceability requirement.***

In concluding that Hildes entered into a binding commitment to purchase Peregrine stock prior to the Registration Statement's effective date, the district court conflated the issue of loss causation and the question of whether the Registration Statement's misrepresentations caused Hildes to enter into the Voting Agreement and Irrevocable Proxy in the first place. See Akerman v. Oryx Commc'ns, Inc., 609 F. Supp. 363, 369 (S.D.N.Y. 1984) (negative causation defense to Section 11 claim "does not focus on the causal relationship between the misstatement and the original purchase, but rather on the relationship between the misstatement and any subsequent decline in value"), aff'd in part and dismissed in part on other grounds, 810 F.2d 336 (2d Cir. 1987). Hildes' proposed second amended complaint alleges that he purchased Peregrine stock--through the post-Registration Statement exchange of shares--issued and sold pursuant to a misleading registration statement, and that his subsequent losses were caused by the misrepresentations in that registration statement. This is enough to state a Section 11 claim. See Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156, 1161 (9th Cir. 2009) (noting heightened pleading standards of the Private Securities Litigation Reform Act of 1995 do not apply to Section 11 claims and that Fed. R. Civ. P. 9(b) applies only if the complaint sounds in fraud); see also Silverstrand Invs., 707 F.3d at 102 (because Section 11 does not have a reliance requirement, "neither the heightened pleading standard of Fed. R. Civ. P. 9(b) nor of the Private Securities Litigation Reform Act applies unless a § 11 claim sounds in fraud"); Provenz, 102 F.3d at 1492 (although defendants bear a heavy burden of proof in establishing negative causation, a plaintiff can establish loss causation by "simply alleging that the false and misleading statements touch upon the reasons for the investment's decline in value" (alteration and internal quotation marks omitted)).

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