Kathrein on Investor Fraud

Market Manipulation Cases Can Never Be Certified, So Says Ninth Circuit?

In what will hopefully be a short-lived opinion, a panel of the Ninth Circuit issued a per curiam opinion which appears to state that plaintiffs can never certify a class action for market manipulation....only for outright misrepresentations or ommissions---a curious if not frightening holding at a time when Wall Street has proven itself to be ....hmmm...shall we say less than ethical.

The issue: Whether stock purchasers are entitled to utilize a lesser variant of the "fraud on the market" doctrine, called the  "integrity of the market" doctine, to create a rebuttable presumption of reliance, when a stock is maniplutated in a non-verbal way.

In Desai v. Deutsche Bank Securities (9th Cir. - July 29, 2009), a Ninth Circuit panel held that the lower court was correct in refusing to certify a class action based on market manipulation of the stock of GenesisIntermedia, Inc. by various bad actors, including various entities of Deutsche Bank, and one of its Canadian employees. The market manipulation scheme was complex,  the Court accepted that "the scheme had driven GENI's Stock price from $12 per share to over $52 per share." It now trades for pennies. Plaintiffs sued and sought to certify a class of those who purchased the stock during the market manipulation.

Judge Wilson, in the Central District of California, refused to certify the class because each individual member of the class would have to prove its own personal reliance, presumably, the lack of market manipulation, and therefore individual questions of fact predominated. The appellate panel, consisting of Judge John T. Noonan, who wrote the per curiam opinion, and Justices Diermuid F. OScannlain, and Susan P. Graber, agreed.

Justices Noonan and Graber believed that they could reverse the lower court only for a clear abuse of discretion. Plaintiffs had conceded that they needed to prove reliance. ( I'm not sure I would have conceded reliance in a market manipulation case, though I would have conceded lack of knowledge is required). Justice Noonan then drew the battle lines:

Reliance can be presumed in two situations. In omission cases, courts can presume reliance when the information withheld is material pursuant to Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-54 (1972). Reliance can also be presumed in certain circumstances under the so-called “fraud on the market theory.” Basic INc. V Levinson, 485 U.S. 224, 241-49 (1988), Precisely to which cases this presumption applies—that is, to misrepresentation, to omission, to manipulation cases, or to some combination of the three—is an issue the parties contest on appeal. The two presumptions are conceptually distinct.

As explained by the Court, the fraud on the market theory is “based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business.” Basic v. Levinson, 485 U.S. at 241 (internal quotation marks omitted).

So far so good!

But then , Justice Noonan loses his way by picking and choosing verbage from cases that state that the fraud on the market presumtion is available "only" when a plaintiff alleges a material misrepresentation or omission realting to a stock sold in an efficient market. On examination, however, it appear these cases are not market manipulation cases, probably because, up until now, they have been so rare or well hidden.

But plaintiffs had conceded that they could not prove an efficient market. (An efficient market quickly digests new information...from almost any source...causing the stock price to quickly adjusts to incorporate that new information. A thinly traded stock might not absorb the information quickly and therefore any news may not create a price reaction for weeks. In such a case, the disparity between individual investors knowledge becomes an issue. ) Having so conceded, they could not utilize the traditional definition of the fraud on the market presumption.

As for the Affiliated Ute presumption,the lower court rejected the theory that a manipulation was, in essence or fact, an omission. ( A holding with which I strongly disagree).

Applying a "clear abuse of discretion" standard, Judge Noonan agreed. The  Affiliated Ute presumption has only been applied to cases of omission when there exists a duty to speak.  The Court refused to extend the presumption to  manipulative conduct which  "has always been distinct " from omissions., for example, in Rule 10b-5. The Court then claims to "follow" the 10th Circuit in  Joseph v. Wiles, 223 F.3d 1155 (10th Cir. 2000) which is not a market manipulation case. In fact the word "manipulation"only appears once in the lengthy opinion. For those who remember the 1989 Miniscribe class action, Wiles is a related individual case based upon a fraud whereby Miniscribe cooked its books by shipping bricks instead of product to warehouses, thereby overstating revenues and earnings....one of the good ol' frauds).

Regardless, to the extent that an omission might have existed, the plaintiffs failed to allege a duty. And the Court refuses to even attempt to discuss any duty of market participants to the market.

Next plaintiffs argued for a modification of the  fraud on the market theory to fit such a situation, and claimed a rebuttable presumption based upon investors reliance upon the "integrity of the market." The lower court rejected this too.

Judge Noonan first concedes that investors rely on the integrity of the market, citing Basic :

[T]he theory presumes first that “[a]n investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price.” Id. at 247. Second, “[b]ecause most publicly available information is reflected in market price, an investor’s reliance on any public material misrepresentations . . . may be presumed for purposes of a Rule 10b-5 action.” Id.

He notes plaintiffs argument that investors "typically rely on the 'integrity of the market,' that is, that no one has destroyed its efficiency by manipulation [and] when manipulation allegedly destroys the efficiency of the market, and with it the reliability of the market’s price." And he does not disagree. But when asked to find, that as a matter of law, plaintiffs are entitle to such a presumption, Judge Noonan can only summon the argument, "We are chary."

The Court argues, no authority compelled the lower court to adopt this new theory and that the Supreme Court has evidenced a "restrictive view" of private suits, and to not extend 10b-5 beyond its present boundaries, citing Stoneridge, 128 S. Ct. at 773.

The Court unfortunately pulls the Stoneridge quote out of context. In Stoneridge, the issue was framed as creating a private cause of action for aiders and abettors...a cause of action rejected more long ago in Central Bank. Hence the full quote is:

Concerns with the judicial creation of a private cause of action caution against its expansion. The decision to extend the cause of action is for Congress, not for us. Though it remains the law, the §10(b) private right should not be extended beyond its present boundaries. See Virginia Bankshares, supra, at 1102 (“[T]he breadth of the [private right of action] once recognized should not, as a general matter, grow beyond the scope congressionally intended”); see also Central Bank, supra, at 173 (determining that the scope of conduct prohibited is limited by the text of §10(b)).

Plaintiffs were not seeking to extend 10b-5 or create a private cause of action. The law clearly forbids market manipulation and private causes of action have existed under this law for decades.

Justice Noonan, thus, avoids any analytical examination of the requested presumption. Instead he concludes merely "that the district court did not abuse its discretion in refusing to adopt the integrity of the market presumption." In other words...he punts on what the law is or should be.

O'Scannlain, on the other hand, goes after his colleagues for dodging the legal issue, making out a good argument for en banc review:

Unfortunately, however, we are left to conclude abruptly with a declaration of the result, for we cannot agree on the correct approach. I believe that, because the validity of a presumption of reliance in securities class actions is a matter of law and because errors of law are per se abuses of discretion, we must explicitly decide whether Investors are entitled to this novel presumption as a matter of law. I write separately to explain my view.

Even so, O'Scannlain goes on to find the presumption legally unsupportable and logically inadvisable. On the legal side, he can only summon citations to  non-market manipulation cases that have no application to these facts. On the logic side, he actually makes plaintiffs case. He starts by admitting:

Most investors do, I think it fair to say, assume that the markets are not corrupt. Cf. Basic, 485 U.S. at 246-47 (“It has been noted that ‘it is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?’ ” (quoting Schlanger v. Four-Phase Sys. Inc., 555 F. Supp. 535, 538 (S.D.N.Y. 1982))).

But then he concludes, in logic that escapes rigor, that if the presumption were adopted, then no plaintiff would ever have to prove reliance. In so concluding, he simply forgets that plaintffs seek only to apply this presumption  to market manipulation cases....which the Court has just found to be distinct from misrepresentation and omission cases, legally.

Similarly he argues that the theory "would permit a presumption of reliance no matter how unlikely it is that the market price in question would actually reflect the alleged manipulation." Again, how is it that  the presumption of reliance would not still require the plaintiffs to prove that the price during the entire class period was inflated by the manipulation, and by how much? O'Scannlain does not say.

Revealingly, O'Scannlain seems to back track and recognize the problems with his concurring opinion in his concluding. This footnote accurately captures the entire issue...and best statement for l an en banc court to tackle:

I recognize the possibility that certain allegations of manipulative conduct might change the application of the fraud on the market theory. This is because the plaintiff in manipulation cases often alleges that a defendant directly manipulated the price. Certainly, a plaintiff must still show that the market in question could absorb into the price the misinformation communicated by the alleged manipulation. But need a plaintiff show the same type of proof of an efficient market in a manipulation case as is required in a misrepresentation case? Although I note the doctrinal wrinkle, this is a question I would agree we actually do not need to reach, because Investors forsook the fraud on the market theory.

Justice Graber, in her concurring opinion, defends Justice Noonan's contention that the Court need not reach the legal question:

All we have to decide is whether the district court had to recognize that new theory. If so, then the court made a mistake of law (and hence abused its discretion, see Koon v. United States, 518 U.S. 81, 100 (1996) (“A district court by definition abuses its discretion when it makes an error of law.”)).

I agree with O'Scannlain that the Court should have addressed, as a full panel, a broader application of the fraud on the market theory in market manipulation cases. An efficient market should not and, indeed, cannot be a requirement where there are no statements to be absorbed by the market participants in making their decisions. The Court should not have said that a lower Court has no duty to find the right law for the right circumstances, even if it is a new application of a principle. How else does law evolve. It has to start in the lower Courts. Justices Noonan and Graber, shirked their duty.

But in the end, it may not matter that much to the plaintiffs bar. The reason why there is no authority on the subject is, as O'Scannlain states, simply reflects "the relative rarity of" manipulative conduct cases. So the impact will be minimal on securities fraud cases.....except now that the fear of a lawsuit is gone, maybe the fraudsters will start crawling through the cracks.

Shaun Martin's Blog California Appellate Report, has a very good discussion and first analysis of the case at Desai v. Deutsche Bank Securities (9th Cir. - July 29, 2009).

A Fraudster's Mia Culpa: Marc S. Dreier---I Just Wanted Respect

        If you have seen my posts on Madoff, you can tell that I am curious about the criminal mind. With normal securities fraud I have always subscribed to the thought that people simply get caught up in little lies, which get bigger, and then out of control. It mostly happens as a series of events, gets covered up, until bad economic situations cause the fraud to be revealed. But rarely have I seen the two lives these people live as we have seen with such highly regarded individuals as Madoff, and now Marc Drier.

        In a recent letter, Dreier wrote to convince the Judge who is going to sentence him, we see another amazing sad story of refusing to fail at all costs...and perhaps a true lack of self esteem. While Madoff never appeared to lack self-esteem, he did grow up on the wrong side of the tracks...so to speak...for the social circles he wanted to accept him so badly. Dreier just outright confesses to this desire. His letter is reprinted below in its near entirety. If you are unfamiliar with the crime...just read on. Dreier lays it our for you. Read it for what it reveals...and skip the excuses:

Marc S. Dreier

c/o Law Offices of Gerald Shargel

570 Lexington Ave., 45 th Fl.

New York, NY 10022

 

July 7, 2009

 

Dear Judge Rakoff,

 

Please consider this letter in connection with my sentencing on July 13, 2009.

 

I know of course that no words can diminish the harm I have caused to so many people. Those who were victimized by my bogus loans lost millions of dollars. Clients of my law firm lost escrow funds they entrusted to me. The attorneys and staff at my firm who put their faith in me lost their jobs. My friends and colleagues have been tainted by their association with me. And the families of all these people have no doubt shared in the suffering — as has my own family. My children have lost the father they knew, as well as their good name and the  happiness they deserve. I have betrayed the people I care about most, and I suffer every day from the shame and self-loathing and regret with which I will always have to live.

 

My crimes are inexcusable. I expect and deserve a significant prison sentence.

 

Nevertheless, I am writing to give some context to what I did — certainly not to minimize my crimes but to try to explain how a person with my background and advantages came to do the unconscionable. Perhaps in learning how I made these terrible decisions which have ruined my life, others may avoid such mistakes. I have requested that my attorneys file this as an open letter, available in the public record, in the hope that it may do some good as a warning to others not to follow in my path.

 

I was raised in New York by a loving family. in a comfortable home. I always succeeded

in school. I attended Yale College and Harvard Law School. After law school I spent 20 years in several prominent law firms, first as an associate, then as a partner. I performed well, but I was achieving less satisfaction and recognition than I expected. Colleagues of mine and certainly clients of mine were doing much better financially and seemingly enjoying more status. By my mid-forties I felt crushed by a sense of underachievement.

 

So I started my own firm in 1996. My intention was to try to attract lawyers who, like myself, were dissatisfied with large firms and were looking for a more gratifying way to have a sophisticated practice. I had virtually no cash and very few clients. but I was able to grow the firm modestly over the next few years by investing my life in it.

 

I had planned poorly. however, for the expenses. I couldn't get bank loans without better credit or collateral, so I was funding the firm partially with advances from some clients but primarily through "factors" who charged exorbitant fees and interest and were highly intrusive in monitoring the firm's accounts. By 2001 I was deeply in debt.

 

In January 2002, my wife sued for divorce. I had been married for 15 years. We have two children. We entered into a settlement agreement under which I took on financial obligations to her and our children which were actually far more than I could afford. I believed that my fledgling law firm could not survive a contested divorce.

 

All of this left me feeling overwhelmed — by my debt, by a disappointing career, by a failed marriage. And so, incomprehensibly, in 2002 I started stealing. First, I invaded some settlement proceeds due a client. Then I arranged a few bogus investments with some individuals. And soon I stumbled upon the brazen idea of arranging fictitious loans from hedge funds, ostensibly to my principal client (the real estate developer referenced in the Indictment), and diverting the loan proceeds to myself.

 

As I sit here today, I can't remember or imagine why I didn't stop myself. It all seems so obviously deplorable now. I recall only that I was desperate for some measure of the success that I felt had eluded me. I felt that my law firm was my last chance to make a mark for myself, and I was fearful of seeing it fail. I know of course that this amounted to nothing more than self pity, but this was my state of mind when I became a criminal. I gave in to being overwhelmed by the anxieties of life that we are all expected to cope with every day, and most people do, but I just could not manage to do so. I had no one close to me with whom I could talk. I had isolated myself, both personally and professionally. I lost my perspective and my moral grounding, and really, in a sense, I just lost my mind.

 

At the beginning, I spent most of the money on growing the law firm. Much of the money also went to servicing the "debt" itself. But, as time went on, I was more and more self-indulgent.I bought extravagant things — a beach house, an apartment, a boat, expensive art. Obviously, other men suffer through divorce and "mid-life crisis" and manage not to steal. And, other people grow their business without resorting to crime. I just wasn't in control of myself.

 

It is hard to explain how my crimes in 2002 reached the level that they did by 2008. Certainly I never intended when this began to steal on the scale I eventually did. I took the first money thinking that I could and would repay it shortly with revenue derived from the law firm. Soon, however, I exhausted the money, and it was evident not only that I would be unable to repay the initial "loans" but that I would need more. I had stepped in a quicksand of spending. By 2008 I had hired over 250 lawyers and opened additional offices in Los Angeles. Pittsburgh and Connecticut. The expenses were more and more uncontrollable, and the "loans" became more and more expensive. As the credit markets worsened, hedge funds were demanding much higher interest rates and, in many cases. substantial discounts to principal. In some cases, when I desperately needed new money to pay back loans becoming due, I was selling loans for 60-65 cents on the dollar, meaning that I was paying back far more principal than the hedge funds were actually paying me, which obviously was dramatically deepening the hole I was in.

 

In this way, without ever actually planning to. I found myself running a massive Ponzi scheme with no apparent way out. No doubt as is typical in Penn schemes, there was always the unrealistic expectation, or at least the hope, that I could use the "borrowed" money to eventually make it all work out. Obviously, and predictably, I was unable to do so.

 

When I was no longer able to pay off old "loans" to the real estate developer by creating

new ones, I placed a few other fictitious loans, in much the same manner, by using instead as the purported borrower a Toronto pension fund that I had once represented. Finally, when there were no loans I could invent, I began to pull money again from a few of the firm's escrow accounts, knowing of course that it was terribly wrong but still thinking that I could somehow restore the funds in short order. Typically, I did restore this money, but in early December 2008 I was unable to restore about $40 million to one such client account as the due date for its disposition was nearing. As a result, I engaged in the most desperate and irrational act yet - impersonating an attorney from the pension fund in Toronto in order to "close" a loan from a hedge fund which would have given me the funds to return the escrow money. I knew very well that this time I would most likely be caught. I was caught, and that escrow money was not restored.

 

In some sense, being caught was a relief. I had been living a self-inflicted nightmare,

scrambling every day to sustain the charade. I had three "full time" jobs: First, I was managing a large active law firm, with all the daily challenges that come with such responsibility. Second, I was head of the firm's litigation department, with a very heavy active practice and caseload of my own. Finally, I was managing a huge portfolio of fraudulent loans, which required me to constantly prepare and update bogus financial statements and loan documents, field inquiries from lenders and prospective lenders, arrange payments of principal and interest on existing loans, obtain new loans as old ones matured, and do all that was necessary to keep the scam a secret. At the same time, I was trying to spend as much time as possible caring for my son, who lived with me full-time, and my daughter, who lived about half the time with each parent. It was all I could do to get through each day, and each day it got harder. It was a frantic life which I had created for myself, and it left me exhausted and impaired.

 

Your Honor has rightfully observed that as a lawyer I have dishonored the legal profession, and I am very painfully ashamed of that. My whole ambition in life was to be a lawyer who would distinguish himself and honor the profession. Over the course of 33 years of practice, I represented many clients well and devotedly. I made my work as a lawyer the center of my life.

 

Obviously, I then strayed very far from those goals. I lost myself to my ambition and

sacrificed everything else.

Recently, I have had the opportunity to read the letters sent to the Court by the victims of

my offense. I am shamed by these letters. During the time I was committing my fraud. I tried to convince myself that I was hurting only "institutions' . and not "individuals - (as if that were less contemptible), because I was borrowing almost entirely from hedge funds. I knew of course then and I know now that this was all nonsense - my fraud devastated "real people" in a very real way. The letters from these individual victims show their suffering first-hand. I will only add that I believed these individuals would not be harmed. because I always made certain that there were sufficient funds still available to repay them when their money came due. At the time of my arrest, there were in fact sufficient funds in the firm's account (over $10 million) to repay all f these individuals. After my arrest, while I was jailed in Toronto, I instructed the controller of the firm to transfer $10 million to a separate non-law firm account, believing that by doing so I could shield the money owed to these individuals from any competing claims until I returned to New York. As I understand it now, however, several individuals remain unpaid in the wake of the firm's collapse, and these individuals who trusted the firm I controlled have been terribly harmed. I never intended for them to lose their money, but obviously I am responsible for even he unintended consequences of my wrongdoing.

 

Since my arrest, I have done whatever little I can to start to make amends for my crimes.

From the outset I acknowledged my guilt. I never considered putting my victims through the burden of a trial. I have also cooperated fully with the Receiver and Trustees appointed by the ourt. In numerous meetings and discussions I have tried to help them identify and recover funds and other assets to start to compensate those who are owed money.

 

More than that, I can only explain to the people I betrayed how I came to make these mistakes and express my profound remorse. In the brief time I may have to speak at my sentencing, I hope to express my remorse to those I have hurt. Perhaps at least they will feel some degree of my shame, which I will have to live with for the rest of my life.

 

For rne, the punishment that I receive from this Court will only be part of my sentence. I have already been disgraced beyond anything I could ever have imagined. Despite whatever good I once accomplished in my life, and what I had hoped to accomplish, I will always be remembered as a thief. I have lost all my friends. I have lost my law firm, my law license and all that I ever owned. 1 have seen my family suffer the unimaginable. I have lost my past and y future. I have lost everything a man can lose. And now I will lose my freedom as well, and rightly so.

 

All that I have left in my life is the prospect of still sharing in my children's lives, both while I am in prison and, I pray, for some time thereafter. My son is 19; my (laughter is 17. We are very close. I have devastated their lives, and unfortunately nothing I do now can diminish that. I can only try to be there for them to whatever extent I can.

 

I don't know what gives some men the strength of character to lead virtuous lives for all of their lives, and what causes others, such as myself, to lose their way. There is no excuse

whatsoever for what I have done. I have explained it the best I can. 1 will try to learn from this, and hopefully others will as well.

 

Respectfully yours.

Marc S. Dreier

Did Matrixx ( MTXX ) Commit Securities Fraud By Withholding Adverse Reaction Reports From the FDA?

Matrixx Initiatives, Inc. (Nasdaq: MTXX), the makers of Zicam products, looks like it may have come close to violating the securities fraud statutes when it failed to provide the Food and Drug Administration (FDA) with more than 800 reports relating to the loss of sense of smell associated with the Zicam Cold Remedy intranasal products.

According to the FDA, as of Dec. 2007, Matrixx was required to provide reports of adverse reactions to the agency per the Dietary Supplement and Nonprescription Drug Consumer Protection Act, which President Bush signed into law Dec. 22, 2006. The Act requires manufacturers, packers, or distributors whose name appears on a nonprescription drug or dietary supplement product label to notify FDA of any serious adverse event report associated with the product's use within 15 business days of receipt of such information. The industry was given a one-year grace period to begin to comply with the law.

In a warning letter to Matrixx, dated June 16, 2007, the FDA informed Matrixx that it concluded that certain Zicam products may pose serious risks to consumers who use them, and that Matrixx marketing practices violate several laws relating to the products.

The FDA letter also stated that the "agency is aware that Matrixx appears to have more than 800 reports related to loss of sense of smell associated with Zicam Cold Remedy intranasal products" and directed Matrixx "to arrange ubmission of all reports related to loss of sense of smell associated with Zicam Cold Remedy intranasal products" and to "indicate which of these reports have been previously submitted to the FDA."

Upon release of this letter by the FDA, Matrixx stock plummeted from approximately $19 per share to less than $7 per share. From the FDA transcript:

Lisa Stark: Thank you. Actually most of my questions have been
asked. But let me ask you one thing. You mentioned that I think it was
after December 2007 the companies had to provide adverse event reports
to the FDA. They didn't have to do so prior to that. Did this company
since that time provide any adverse event reports to you based visa vie
these products?

Deb Autor(FDA): As Dr. Lee said, the reports that we have are
from consumers and healthcare providers. And in the warning letter we
have asked Matrixx to provide to us the more than 800 reports that we
know that they have relating to the lose of sense of smell associated
with the Zicam Cold Remedy intranasal products.Those have not been
provided to the agency at this time.

Lisa Stark: Should they have been under the current regulations?
Should you have received those reports?

Deb Autor: I can't address that question today.

On July 23, 2009, Matrixx acknowledged the Securities and Exchange Commission (SEC) is launching an informal inquiry. Since December 2007, insiders, including the Executive VP and CFO, the VP of Sales and the VP of Research and Development, have sold more than $2.7 million worth of Matrixx shares.

According to new reports, the COO said Matrixx first learned during the FDA's on-site inspection last month that the federal agency wanted all such "adverse events" reports immediately after consumers filed them with the company. Matrixx claims that, acting on its legal advice, it thought the company merely had to make such reports available to FDA inspectors during on-site visits."We have complaints here, clearly, but we weren't required to send them; at least we didn't believe we were required to
send them," he said.

The Hagens Berman press release regarding their investigation of this matter can be found here.