Plaintiffs, a group of individual investors, alleged that Baron and its clearing broker, Bear, Stearns & Co, Inc. (“Bear Stearns”), falsely represented the market surrounding the securities at issue, and that defendant Isaac R. Dweck (“Dweck”) enabled Baron, through short-term cash infusions and financing, to “park” securities in his accounts, for which he was rewarded with ownership in companies on a preferential basis and returns on the parking arrangements. Plaintiffs also alleged that Dweck’s providing of funds to Baron prolonged Baron’s fraudulent activity. Plaintiffs made no claim for recovery from Dweck for damages caused by the parking of specific securities, but instead sought to impose liability on Dweck for all of Baron’s deceptive activities; in other words, plaintiffs made no attempt to connect particular trades to Dweck’s parking.

The United States District Court for the Southern District of New York held that the plaintiffs’ broad allegations that Dweck was substantially funding and participating in Baron’s fraudulent transactions did not show how plaintiffs relied upon misrepresentations or omissions by Dweck, and therefore, failed to state a claim against Dweck under Section 10(b) and Rule 10b-5. The district court noted that plaintiffs had asserted that Dweck made investments in Baron securities, assisted in the parking transactions and allegedly introduced new co-conspirators to the fraud, and that the plaintiffs claimed generally that the parking transactions and overall fraud caused the price of Baron’s securities to artificially inflate, creating damage to plaintiffs when they purchased the eventually worthless stock. However, the district court held, none of those items satisfied the requirement under Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) (see blog article here), that plaintiffs allege a false material misrepresentation or omission, and reliance thereupon. Accordingly, the district court dismissed the claim for misrepresentations or omissions under Section 10(b) and Rule 10b-5 against Dweck. The district court likewise dismissed plaintiffs claim for market manipulation against Dweck due to a lack of alleged reliance on Dweck’s fraudulent behavior.

The Second Circuit affirmed. As the district court had noted, the absence of allegations of communications between the plaintiffs and Dweck was problematic. The Second Circuit observed that in plaintiffs’ claim against Dweck for all damages caused by Baron, plaintiffs did not made any claim for Dweck’s liability under respondeat superior or another common law theory of vicarious liability. Because aiding and abetting liability is not available in private actions under Section 10(b) and Rule 10b-5, the Court held, Dweck could only be liable as a primary violator. The Second Circuit recognized that under Stoneridge “an allegation of acts facilitating or even indispensable to a fraud is not sufficient to state a claim if those acts were not the particular misrepresentations that deceived the investor.” Plaintiffs were required to allege actions by Dweck that were more than knowing participation in, or facilitation of, Baron’s fraudulent scheme. Looking further to Supreme Court precedent in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011) (see blog article here), the Court held that “only the person who communicates the misrepresentation is liable in private actions under Section 10(b),” even in a market manipulation case.

Here, although plaintiffs alleged that Dweck was part of a group that engaged in phony trading activity, they did not and could not allege “that any plaintiff was told of Dweck’s artificial trading, or purchased securities in specific reliance on such trading.” Rather, Baron and Bear Stearns were the only parties that had directly given the plaintiffs representations about the phony market. Plaintiffs alleged that Dweck had knowledge of some artificial trades, that he participated in them and that he actively facilitated Baron’s fraudulent scheme. But because only Baron or Bear Stearns — but not Dweck — communicated the artificial price information to plaintiffs, and their allegations were insufficient to state a Section 10(b) and Rule 10b-5 claim against Dweck.

The dissent disagreed with the majority’s conclusion that Supreme Court precedent required a direct communication of false information to the plaintiffs in the context of a claim for market manipulation. Further, the dissent argued the majority ignored that Dweck was insider of Baron with primary liability under Section 10(b) for engaging in a manipulative scheme.

The Fezzani majority opinion is significant because it is the first decision from a Court of Appeals to apply the strict limitations on the scope of primary liability set in Stoneridge and Janus to claims involving market manipulation. In light of the dissenting opinion on this important issue, we expect plaintiffs to make a strong request for rehearing en banc and/or petition for certiorari to the Supreme Court.

For further information, please contact John Stigi at (310) 228-3717 or Tyler Baker at (212) 634-3048.

The Securities and Exchange Commission (“SEC”) relies upon the securities exchanges (e.g., the New York Stock Exchange) to enforce Section 15(g). The exchanges are vested with the authority to promulgate their own rules that, once approved by the SEC, have the force of law. The exchanges thus have adopted rules requiring brokerage firms to adopt policies to ensure compliance with the Act.

Each of the brokerage firms in this case adopted policies generally prohibiting their financial advisors from opening self-directed trading accounts outside the firm. The reason given by the firms for doing so is to monitor employee activity to ensure that employees are not engaging in insider trading, and thus ensure compliance with Section 15(g) of the 1934 Act.

Section 450(a) of the California Labor Code provides that no employer “may compel or coerce any employee . . . to patronize his or her employer . . . in the purchase of any thing of value.” The employees here argued that the brokerage firms are violating this provision of California law by forcing them to open self-directed trading accounts inside their firm. According to the employees, they would rather open accounts outside the firm because the trading fees are lower.

The brokerage firms moved to dismiss, arguing that the California statute is preempted by the securities law. The United States District Courts for the Northern and Central Districts of California granted defendants’ motions and dismissed the complaints. The employees appealed.

After consolidating the cases on appeal, the Ninth Circuit affirmed. As an initial matter, the Court rejected the brokerage firms’ argument that when Section 450 is enforced against their policies prohibiting self-directed trading accounts outside their firms, the statute loses its character as a labor law and takes on the nature of a securities regulation. The Court explained that Section 450 regulates the labor market which is an area traditionally of state concern, and therefore, there is a presumption that Congress did not intend to preempt Section 450. However, that was not the end of the Court’s analysis.

The Court next turned to whether Section 450 of the California Labor Code presents an “obstacle” to the accomplishment of a significant objective of the securities laws. The Court concluded that it does. According to the court, Section 15(g) of the 1934 Act calls on the brokerage firms to decide “for themselves how to best monitor their employees’ trading, suggesting that individually tailored policies serve as an important means for achieving the Act’s basic goal of reducing insider trading.” Where federal law grants an actor a choice and the state law would restrict that choice, the state law is preempted if preserving that choice is a significant regulatory objective. Accordingly, the Court held that Section 450 is preempted by the 1934 Act because the state statute would restrict the brokerage firms’ discretion on how to best monitor and prevent insider trading by its employees.

The employees also argued that even if Section 450 of the California Labor Code did impede the firms’ discretion, they could still comply with Section 450 by offering free in-house accounts. The Ninth Circuit did not agree. It held that the plain language of Section 450 forbids mandatory free accounts just as it forbids paid ones. According to the Court, Section 450 not only prohibits forced purchases from the employer, but also prohibits forced purchases from any third party. Thus, free accounts would still violate Section 450 because it would force employees to purchase a thing of value (e.g., a brokerage account) through their employer.

Accordingly, the Court affirmed the dismissals of the lawsuits by the distrct courts, reassuring brokerage firms that may keep and/or implement policies which restrict their employees from opening outside self-directed trading accounts without running afoul of the California Labor Code.

For further information, please contact Jennifer Redmond at (415) 774-2910, John Stigi at (310) 228-3717 or Bram Hanono at (415) 774-3221.

An interesting side note about the three witnesses is that their interviews were not recorded, unlike the other fourteen witnesses in this case. Because of this, any inconsistencies, disclosures of motives for their proffers or other potential impeachment evidence were not “otherwise available” to defense counsel. The SEC also advised the court that the three witnesses might testify at trial.

The lesson of this case is not to underestimate the value to defendants in SEC enforcement proceedings of specific, simply stated interrogatories. The SEC was not ordered to turn over its attorneys’ notes. Instead, it was ordered to answer interrogatories. This case also reminds lawyers not to give up, even when your adversary is far more powerful. In the words of the magistrate judge who handled “every possible objection” that the SEC had asserted to avoid answering, “Sunshine is ordinarily the best medicine for a party that is keeping discoverable information hidden in the dark. But where, as here, one party is repeatedly withholding relevant information, stronger medicine may be required.”

For further information, please contact Bob Rose at (619) 338-6661.

The United States District Court for the Southern District of New York dismissed four of plaintiffs’ seven claims, reasoning that the alleged corporate misconduct was not a violation of international law. In an interlocutory appeal, the Second Circuit dismissed the entire complaint on the ground that customary international law does not provide for or recognize corporate liability for violations of international law.

The Supreme Court, considering the broader question of whether the ATS applies to conduct committed outside the United States, held that the ATS only applies to conduct committed within the United States or on the high seas. Thus where, as in Kiobel, no relevant conduct occurs within the United States, a potential plaintiff cannot bring a claim under the ATS. The Court noted that a claim based upon acts occurring outside the United States may be appropriate under the ATS if the claim touches and concerns the United States with sufficient force to dispute the presumption that U.S. law does not apply internationally. Although the Court did not address the question of corporate liability directly, it did imply that corporations may be subject to claims under the ATS which satisfy the aforementioned requirements, noting that “mere corporate presence” is insufficient to dispute the presumption that the ATS does not apply to foreign-only conduct.

The Supreme Court’s decision in Kiobel decision limits plaintiffs’ ability to bring claims under the ATS for conduct occurring outside of the United States, whether against corporations or individuals. Yet while it is clear that “mere corporate presence” will not suffice, the contours of the limitation are still to be determined.

For further information, please contact John Stigi at (310) 228-3717 or Robin Achen at (213) 617-5579.

Once a board of directors has decided to pursue a process that will result in the sale of the corporation, it is obligated to maximize stockholder value by seeking the highest purchase price reasonably available. See Revlon, Inc. v. MacAndrews & Forbes Holdings, 506 A.2d 173 (Del. 1986). If the target’s certificate of incorporation includes the exculpatory provisions permitted by Section 102(b)(7) of the Delaware General Corporation Law, 8 Del. Code § 102(b)(7), a plaintiff who seeks to challenge the board’s decision must demonstrate that the board acted in “bad faith” in order to succeed on a breach of the duty of care claim. Accordingly, if the corporation has in place a Section 102(b)(7) exculpatory provision, a defendant’s motion to dismiss claims of breach of fiduciary duties in the M&A sales process context will be successful unless the plaintiff pleads facts supporting the conclusion that (1) directors breached their duty of loyalty (i.e., the majority of the board approving the transaction was “interested”) or (2) the directors acted in bad faith.

In re Novell, Inc. Shareholder Litigation, 2013 WL 322560 (Del. Ch. Jan. 3, 2013): Motion to Dismiss Denied

In March 2010, the board of directors of Novell, Inc. (“Novell”) issued a press release announcing that it was rejecting an unsolicited, non-binding offer to purchase the company for $5.75 per share and was retaining a financial advisor to “explore various alternatives to enhance stockholder value.” Over the next few months, fifty potential buyers were contacted, thirty potential buyers signed non-disclosure agreements and nine potential buyers submitted preliminary non-binding proposals. Novell’s board decided to pursue discussions with five of the potential buyers that had submitted non-binding proposals, including Attachmate Corporation (“Attachmate”). Subsequently, Attachmate, who, unlike the majority of bidders, had already been allowed to work with two strategic partners, indicated that it was having difficulties arranging financing and, unlike any other bidder, was allowed to seek additional financing. In August, the two remaining bidders, Attachmate and “Party C,” were asked to submit “best and final offer[s].” Even though Attachmate’s bid was $0.06 lower, it was granted exclusivity. During the exclusivity period, Microsoft offered to purchase certain patents and patent applications from Novell for $450,000,000, and Attachmate, unlike any other bidder, was told of the Microsoft offer and invited to submit a revised bid.

Ultimately, Novell’s board of directors accepted Attachmate’s revised bid, which reflected a purchase price of $6.10 per share. Upon public announcement of the transaction, certain Novell stockholders brought suit in Delaware Chancery Court against Novell’s board alleging, among other things, that the board had breached their fiduciary duties by conducting an “‘improper and opaque’ sales process [that] failed to maximize shareholder value” and had favored Attachmate over other bidders. Although the Court noted that the board was “not absolutely required to treat all bidders equally,” he did not dismiss the case at the pleading stage because the facts pled indicated that the board “treated Party C in a way that was both adverse and materially different from the way they treated Attachmate,” which supported “an inference that the Board’s actions were in bad faith.”

In re BJ’s Wholesale Club, Inc. Shareholders Litigation, 2013 WL 396202 (Del. Ch. Jan. 31, 2013): Motion to Dismiss Granted

In February 2011, the board of directors of BJ’s Warehouse Club, Inc. (“BJ’s”) issued a press release announcing that it had hired a financial advisor to “evaluate potential strategic alternatives.” Shortly thereafter, “Party A,” one of two direct channel competitors, expressed interest in acquiring BJ’s; however, because Party A “had no prior history of acquiring domestic companies” and BJ’s board of directors was “not comfortable sharing material, non-public information with a direct competitor,” Party A was rebuffed. Nonetheless, Party A submitted a conditional proposal to acquire the company in an all-cash transaction at a purchase price in the range of $55 to $60 per share. After two subsequent meetings with Party A, BJ’s board of directors determined that “it would not be in the best interest of [BJ’s] to pursue the expression of interest by Party A.”

Ultimately, BJ’s board of directors accepted a private equity offer that reflected a purchase price of $51.25 per share. Upon public announcement of the transaction, certain BJ’s stockholders filed suit in Delaware Chancery Court against BJ’s board of directors alleging, among other things, that the directors had breached their fiduciary duties by “shunn[ing] Party A . . . despite its superior offer of $55 to $60 per share.” The Court, echoing the concerns of the BJ’s board of directors, dismissed the action because, among other things, “Party A’s proposal was subject to further due diligence and regulatory analysis” and the board “had no reason not to rely on its [financial advisor’s] advice that strategic buyers, including Party A, would not likely be interested or that their interest would not lead to a serious offer.”

The “Crucial Difference”

In the BJ’s decision, Vice Chancellor Noble articulated the “crucial difference” between this case and Novell: the Novell board’s actions “occurred after the board had determined that the bidder was a serious participant,” while “the [BJ’s] board was making an initial assessment, in its business judgment, whether pursuit of Party A’s expression of interest was in the best interest of the Company and whether a transaction with Party A raised serious regulatory issues” (emphasis added). In other words, directors may have some leeway in their treatment of bidders in the initial stages of an M&A sales process; however, once a board of directors has adjudged bidders to be “serious,” it is imperative that the board treat all such bidders equally.

For further information, please contact David Sands at (213) 617-5536 or David Niemeyer at (213) 617-5590.

Allergan and its directors moved in both courts to dismiss the actions for failure to plead demand futility under Delaware Chancery Rule 23.1 and its federal equivalent, Federal Rule of Civil Procedure 23.1. The Chancery Court postponed briefing to allow another Allergan stockholder, also a pension fund, to complete a Section 220 books and records inspection and intervene as a party in the Delaware action. Ultimately, in July 2011, the Delaware and California plaintiffs “filed essentially the same amended complaint in their respective courts,” and Allergan again filed motions to dismiss in each court. Shortly before argument on the motion in Delaware, the California federal court, applying Delaware law, dismissed with prejudice the California action for failure to plead demand futility. The parties in the Delaware action thereafter addressed the preclusive effects of the California judgment in supplemental briefing.

The Chancery Court determined collateral estoppel did not apply. Collateral estoppel requires privity between the current plaintiffs and those in the former action. Because the corporation, Allergan, is the real plaintiff in a derivative suit, numerous jurisdictions, including California, would find the requisite privity between the Delaware and California plaintiffs. But the Chancery Court, purporting to apply Delaware’s demand futility law, determined no privity existed because the California plaintiffs had not yet survived a motion to dismiss for failure to make a demand on the board, and so were not acting for Allergan at the time of dismissal. It further ruled that by failing to first conduct a Section 220 inspection before filing suit, the California plaintiffs acted “to maximize the potential returns of the specialized law firms who filed suit on their behalf” and, by presumption, inadequately represented Allergan. For this reason as well, the Chancery Court held that the California dismissal could have no preclusive effect. It went on to find the Delaware amended complaint stated a claim for relief.

The Delaware Supreme Court reversed. It first found that the Chancery Court failed to afford the California federal court’s decision the “same force and effect as it would be given under the preclusion rules of the state in which the federal court is sitting” — in this case, California. According to the Supreme Court, the Chancery Court “conflated collateral estoppel with demand futility.” The motion to dismiss, however, was “based [solely] on collateral estoppel, [and] was about federalism, comity, and finality.” Thus, the Chancery Court should have applied California law, which deems “differing groups of shareholders who can potentially stand in the corporation’s stead . . . in privity for the purposes of issue preclusion.” Without deciding the issue, the Supreme Court noted that the Courts of Chancery are in fact split on the privity issue.

With respect to the Chancery Court’s ruling on the inadequacy of the California stockholder plaintiffs, the Supreme Court characterized the Chancery Court as having “sua sponte announced and applied an irrebuttable presumption that derivative plaintiffs who file their complaints without seeking books and records, very shortly after the announcement of a ‘corporate trauma,’ are inadequate representatives.” The Supreme Court declared, however, that “[w]e reject the ‘fast filer’ irrebuttable presumption of inadequacy.” Although it acknowledged that “fast filers” may be inadequate, there “is no record support for the trial court’s premise that stockholders who file quickly, without bringing a § 220 books and records action, are a priori acting on behalf of their law firms instead of the corporation.” Without the presumption, it held the Chancery Court had no basis to deem the California plaintiffs inadequate, particularly since the California complaint was so similar to the Delaware complaint, which the Chancery Court found adequately stated a claim for relief. The Supreme Court added that trial court efforts to address the “fast filer” problem “should be directed at the lawyers, not the stockholder plaintiffs or their complaints.”

Pyott strongly reaffirms the use of collateral estoppel by defendants to ensure that dismissals outside Delaware on for failure to plead demand futility have preclusive effect within Delaware. At the same time, by refusing to draw an inadequacy-of-representation inference from “fast filer” conduct alone, Pyott casts doubt on the use of any form of “fast filer” presumption, including the rebuttable presumption the Chancery Court adopted just last year to ensure that its dismissal of a derivative complaint (filed before any books and records inspection) had no preclusive effect on the future litigation efforts of other stockholders whose inspection demands were pending. See South v. Baker, C.A. No. 7294-VCL, 2012 Del. Ch. LEXIS 229 (Del. Ch. Sept. 25, 2012) [blog article here]. In fact, by stating that trial courts should direct their efforts to address “fast filer” behavior at plaintiffs’ counsel, and not plaintiffs (or their complaints), the Delaware Supreme Court is arguably signaling that the fast-filing issue is not a proper collateral estoppel consideration.

For further information, please contact John Stigi at (310) 228-3717 or John Landry at (213) 617-5561.

A reverse triangular merger is an acquisition structure whereby one company, the acquirer, creates a subsidiary to acquire a target company. The subsidiary of the acquirer purchases the target and thereafter merges with and into the target company, with the target company surviving the merger. The result of structure is that the target company continues to exist, but as a wholly-owned subsidiary of the acquirer.

SQL Solutions. In 1986, Oracle Corporation entered into a software licensing and services agreement with a software vendor, D&N Systems Inc. Under the terms of that agreement, D&N received rights that were exclusively for its own use and were not to be assigned or transferred to a third party without Oracle’s prior written consent. In 1990, D&N merged with SybaseSub, Inc., with D&N as the surviving corporation, but changing its name to SQL Solutions, Inc. Oracle alleged that the anti-assignment terms of the licensing and services agreement were breached when the rights granted thereunder to D&N were transferred to SQL. D&N claimed that because there was only a change of ownership followed by a name change, no assignment or transfer of rights occurred.

In concluding that under California law a reverse triangular merger constitutes an assignment by operation of law, the SQL Solutions court held that California courts have consistently recognized that an assignment or transfer of rights does occur merely through a change in the legal form of ownership of a business. The SQL Solutions court found that a transfer of rights is no less a transfer because it occurs by operation of law in a merger.

Meso Scale Diagnostics. In 2007, Roche Diagnostics GmbH acquired BioVeris Corporation through a reverse triangular merger, which resulted in BioVeris becoming a wholly-owned subsidiary of Roche. Following the acquisition, Meso Scale Diagnostics, LLC and Meso Scale Technologies, LLC sued Roche alleging that the acquisition violated the anti-assignment clause of a consent agreement to which they were a party because the reverse triangular merger was an assignment by operation of law and their consent was not obtained. Roche moved for summary judgment and argued that there was no assignment by operation of law or otherwise because BioVeris was the surviving party of the merger, and, therefore, BioVeris did not assign anything to Roche.

In granting Roche’s motion, the Delaware Court of Chancery held that Section 259 of the Delaware General Corporation Law supported Roche’s position that “generally, mergers do not result in an assignment by operation of law of assets that began as property of the surviving entity and continued to be such after the merger.” In doing so, the court explicitly dismissed plaintiffs’ argument that the court should embrace the holding in SQL Solutions that a reverse triangular merger results in an assignment by operation of law. The court stated that if it were to adopt the approach in SQL Solutions, it would conflict with Delaware’s jurisprudence surrounding stock acquisitions. Specifically, the court held that under Delaware law, stock purchase transactions, by themselves, do not result in an assignment by operation of law: Delaware corporations may lawfully acquire the securities of other corporations, and a purchase or change of ownership of such securities is not regarded as assigning or delegating the contractual rights or duties of the corporation whose securities are purchased.

Implications

Foreign Corporations. Section 2115 imposes various requirements of California law on non-California corporations with substantial connections to the state. Specifically, Section 2115 provides that if a corporation is subject to Section 2115, California law trumps the law of the jurisdiction in which such corporation is incorporated with respect to certain matters. The “internal affairs doctrine,” on the other hand, holds that the laws of the state of incorporation should normally govern a corporation’s internal affairs. Internal affairs are described as those “matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders.” Edgar v. MITE Corp., 457 U.S. 624, 645 (1982). Section 2115 and the internal affairs doctrine have created confusion for foreign corporations attempting to comply with conflicting laws of two states. However, the Delaware Supreme Court decision in VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108 (Del. 2005), and the subsequent holding by the California Court of Appeal in Lidow v. Superior Court, 206 Cal. App. 4th 351, 141 Cal. Rptr. 3d 729 (2012), shed some light as to how courts may interpret the holding in Meso Scale Diagnostics as it applies to corporations subject to Section 2115.

VantagePoint. In VantagePoint, the Delaware Supreme Court held that the internal affairs of Delaware corporations are to be decided exclusively in accordance with Delaware law. Specifically, the Court stated that the “internal affairs doctrine is a long-standing choice of law principle which recognizes that only one state should have the authority to regulate a corporation’s internal affairs — the state of incorporation.” The Court also noted that there was a need for certainty and predictability in determining the internal affairs of a corporation and that applying the law of one state over another would result in uncertainty and intolerable confusion. The Court rejected the applicability of Section 2115 and stated that the statute violated the “well-established choice of law rules and the federal constitution mandated that Examen’s internal affairs . . . be adjudicated exclusively in accordance with the law of its state of incorporation.”

Lidow. While the VantagePoint decision provided clarity as to how Delaware courts viewed the conflict between Section 2115 and the internal affairs doctrine, it was not until 2012 in Lidow that the California Court of Appeal suggested that it also agreed with the application of the internal affairs doctrine over Section 2115 in certain contexts. The court in Lidow indicated that the internal affairs doctrine in certain circumstances, such as mergers, consolidations and reorganizations, that involve a corporation’s relationship to its shareholders, trumps the requirements of Section 2115. Specifically, the court noted that the removal of an officer from a corporation for a number of reasons would fall within the internal affairs of corporation, and thus be governed by the laws of the state of incorporation, but the removal of an officer allegedly in retaliation went beyond internal corporate governance and was governed by the law of California, where the alleged wrong occurred.

Impact of Meso Scale Diagnostics. The Meso Scale Diagnostics decision finally clarified that, at least under Delaware law, a reverse triangular merger is not considered an assignment by operation of law. However, the decision did not affect the contrary holding in SQL Solutions. Which decision governs an anti-assignment provision may depend on the purpose of the primary transaction. Under VantagePoint and Lidow, if a reverse triangular merger is conducted for purposes of an internal reorganization, a California court may find that the internal affairs doctrine trumps the requirements of Section 2115. However, if a reverse triangular merger is conducted for purposes that are not integral to the internal affairs of a corporation, a California court may find that the requirements of Section 2115 trump the internal affairs doctrine.

For further information, please contact David Sands at (213) 617-5536 or Amrita Nangiana at (213) 617-5495.

The United States District Court for the Northern District of Illinois dismissed the initial complaint for failure to plead particularized facts giving rise to a strong inference that defendants made the alleged misrepresentations with scienter. The district court, however, granted leave to amend.

In the amended complaint, plaintiffs attempted to bolster their scienter allegations with facts supposedly supplied by a confidential witness. Plaintiffs described him in the amended complaint as a “Boeing Senior Structural Analyst Engineer” who allegedly had worked on wing-stress tests of the 787-8 Dreamliner and who, as part of his job, supposedly had direct access to and first-hand knowledge of the results of the stress tests, as well as internal, contemporaneous communications regarding those tests. On the basis of these new allegations, the district court denied defendants’ motion to dismiss and allowed the case to proceed to discovery.

Defendants promptly took the deposition of the confidential witness, who by this time had been identified. At his deposition, the formerly confidential witness denied virtually everything plaintiffs’ counsel had alleged in the amended complaint. For example, he did not work on the Dreamliner 787-8, but rather a different model, the 787-9; he did not have knowledge of or access to internal Boeing communications regarding tests on the 787-8; and he was not a Boeing employee when the 787-8 tests were conducted, but rather was an outside contractor. When plaintiffs’ counsel conceded that this individual, because of his testimony, would not be a trial witness for plaintiffs, defendants moved for reconsideration of the district court’s denial of their motion to dismiss. The district court reconsidered, and dismissed the complaint, but this time with prejudice. Plaintiffs appealed, challenging the dismissal, while defendants cross-appealed, challenging the failure of the district court to impose sanctions on plaintiffs’ counsel pursuant to Rule 11.

The Seventh Circuit affirmed the dismissal and remanded for a determination of sanctions. Judge Posner first reviewed the language of Section 10(b) and the Reform Act, which he explained altered the landscape of federal securities fraud litigation in four significant ways: (1) for “forward-looking” statements, plaintiff must prove actual knowledge of falsity; (2) the complaint must create a “strong inference” that defendant acted with the requisite state of mind; (3) the heavy pleading burden induces plaintiffs’ lawyers to seek out confidential sources of information about the defendant in advance of filing a complaint; and (4) even if neither side files a Rule 11 motion, the district judge must determine each party’s compliance with the Rule 11 and impose appropriate sanctions for violations.

The Court had little trouble holding that in the absence of the allegations attributed to the confidential witness the complaint failed to provide sufficient particularized facts giving rise to a strong inference that defendants made false statements regarding the first flight of the Dreamliner with scienter.

The Seventh Circuit then analyzed defendants’ cross-appeal for imposition of sanctions. The district court had noted that plaintiffs’ counsel did not speak with the confidential witness until six months after they filed the amended complaint, and that such failure by plaintiffs’ counsel to verify the allegations in their investigator’s notes amounted to a fraud on the court. Judge Posner seemed to agree, noting that the plaintiffs’ law firm was alleged to have made similarly misleading confidential witness allegations in at least three other cases. Judge Posner reiterated that under the Reform Act, defendants need not move for the imposition of sanctions; instead, the statute imposes on the district court the affirmative duty to determine sua sponte whether sanctions are appropriate upon final adjudication of the action. The Court thus remanded to the district court for such determination, making clear his view that sanctions likely were warranted.

This decision illustrates the consequences of careless use of confidential witnesses in securities fraud complaints, and provides a cogent reminder that the Reform Act mandates that the district court consider the imposition of sanctions in every case where the complaint fails to pass muster under its heightened pleading standards.

For further information, please contact John Stigi at (310) 228-3717, Dan Rosenberg at (312) 499-6315 or Valentina Shenderovich at (212) 634-3019.

In a recent panel discussion, one of the speakers was a so-called "ethical hacker" - a hacker-turned-protector of employers' confidential information. As someone at the forefront of cyberattacks, the ethical hacker's opinion was that there are two types of employers: those that know they have been hacked, and those that do not. And with all of the press coverage regarding recent hacks into U.S. confidential security information, it seems our ethical hacker may well be right. Indeed, in March, James Clapper, the director of National Intelligence to the U.S. Senate Intelligence Committee, suggested that cyberattacks now pose the most dangerous immediate threat to the U.S.

What is a Cyberattack?

Cyberattacks generally fall into three categories: infiltrating a secure computer network, Distributed Denial of Service Attacks (DDOS), and planting inaccurate information.

Perhaps the most well-known cyberattack is the traditional infiltration of a company's computer system through Trojan viruses and malware. Generally, the objective is to extract confidential and/or proprietary information from the target company using specially tailored computer programs.

As someone at the forefront of cyberattacks, the ethical hacker's opinion was that there are two types of employers: those that know they have been hacked, and those that do not.

Recently, however, DDOS attacks have become the most common known type of electronic cyberattack. A DDOS attack is coordinated by "botnets," in which a series of "zombie" computers belonging to unknowing users visit a company's website at the same time, overwhelming the server and shutting it down. Such attacks are prevalent amongst "hacktivists," who attempt to shut down bank and financial websites in an act of activism, protest or civil disobedience.

The third type, planting inaccurate information, is exactly as it sounds: attackers covertly insert inaccurate information into a company's computer system. These attacks confuse and mislead users, and can even cause the computer system to fail.

The Human Element

The most prevalent type of "cyberattack," however, remains the "inside job": both willing and unwilling. According to Diligence Information Security, about 70 percent of security breaches are committed by employees. Christ Nuttall, "Hacking Usually an 'Inside Job,'" BBC. Generally, the intruder only needs physical access and a password. An employee attaches a thumb drive or other storage device to an employer's network and downloads sensitive data. Case examples include an employee who used customer credit card information to go on elaborate spending sprees (United States v. John, 597 F.3d 263, (5th Cir. 2010)); a Social Security Administration employee who accessed former girlfriends' addresses to solicit their affections (United States v. Rodriguez, 628 F.3d 1258, (11th Cir. 2010)); and a recruiter in California who downloaded customer lists to start a competing business (United States v. Nosal, 676 F.3d 854 (9th Cir. 2012)).

How is it happening?

Hackers are developing ever more inventive approaches to hacking. For example, in 2006, Secure Network Technologies, a security consulting firm, seeded USB drives throughout an employer's parking lot. The thumb drives were equipped with Trojan malware that, when plugged into a computer, would collect personal information such as passwords and machine-specific information and email these findings back to the Trojan's creator. The test revealed that employees picked up 15 of the 20 USB drives planted, and all 15 were plugged into the employer's computers. Although this was a controlled simulation, this replicated real life attacks, which have included masked gunmen caught on CCTV using spud guns to fire thumb drives over security fences into a technology company's parking lot.

Legal requirements

Although most employers are concerned about data security, many are unaware of the legal requirements. For example, financial institutions covered by the Gramm Leach Bliley Act (financial institutions that collect nonpublic, personal information about individuals who obtain a financial product or service) must establish appropriate standards of administrative, technical and physical safeguards to protect against unauthorized access to records or information which could substantially harm or inconvenience any customer. 15 U.S.C. Section 6801. Similarly, institutions with private health information must comply with HIPAA, which requires employers to create unique user identifications, an emergency access procedure, automatic logoff, and a mechanism for encryption and decryption of electronic protected health information. 45 C.F.R. Section 164.312(a)(2). In addition, HIPAA mandates standards for auditing policies and procedures, encrypting information, and guarding against unauthorized access. 45 C.F.R. Section 164.312.

This means implementing safeguards with respect to collection, storage and usage of information, conducting risk analysis, appointing an employee to manage these safeguards, and training employees on how to recognize and respond to a breach of security. Examples include frequent password changes; encryption of data; tracking network access; restricting employee access to sensitive information; maintaining firewall configuration and blocking access to file-sharing sites; and maintaining a policy that addresses information security. Another overlooked security risk is the use of third -party vendors that do not have secure networks and practices.

Notification duties

Employers also have affirmative duties to disclose information about a security breach to affected persons. Most state data security breach notification laws mirror California Civil Code Section 1798.82 - the first state law of its kind, and generally recognized as the most expansive. Under Section 1798.82, if a business owning or licensing computerized data discovers a breach of security including "personal information," it must notify any California resident whose unencrypted personal information it reasonably believes was acquired by an unauthorized person. Section 1798.82(a). A breach of security is any unauthorized acquisition of computerized data that compromises the security, confidentiality, or integrity of personal information. Section 1798.82(d). "Personal information" is defined as an individual's first name or first initial and last name in combination with any of the following: (1) Social Security number; (2) driver's license number or California Identification Card number; (3) account number, credit or debit card number, in combination with any required security code, access code or password that would permit access to an individual's financial account; (4) medical information; or (5) health insurance information. Section 1798.82(e).

Why is a cybersecurity policy necessary?

Electronic communication and recordkeeping are here to stay. Employers must take electronic measures necessary to protect information. This requires a multi-faceted approach, including firewalls, data encryption and security software.

Cybersecurity policies are more important than ever in the battle to protect sensitive information. Such policies are important first to prevent a breach, and later for maximum legal protection in the event of a breach. The Computer Fraud and Abuse Act (CFAA) provides for criminal and civil penalties against an employee who "knowingly and with the intent to defraud, accesses, and by means of such conduct furthers the intended fraud and obtains anything of value." 18 U.S.C. Section 1030. The CFAA also allows employers to recover damages such as the cost of hiring a computer forensic firm to investigate the employee's activities. Recently, employers have brought CFAA claims against former employees who take confidential information from company computers. U.S. Circuit Courts of Appeal are split as to whether the CFAA applies to an employee who has literal authorized access to documents, but uses that access for an unintended purpose. Several courts have held that the CFAA does apply if an employee violates an employer's computer use or confidentiality policy. (The 1st, 5th, 8th and 11th circuits follow this view. The 9th Circuit does not. Nosal, 676 F.3d 854.)

Employers should implement robust confidential information, electronic communications and usage and access policies. Such policies should prohibit employees from accessing data that is not required as part of their job duties and spell out that violation may lead to termination. Best practice would be to physically limit access so as to prevent the possibility of such violation in the first place. Policies should also discuss the types of threats that businesses are facing and how employees can help to minimize such risks. While written policies are a good starting point, ensuring that they are followed in practice is most important. If implemented correctly, such policies can dramatically help reduce the risks posed by cyberattacks.

For further information, please contact Paul Cowie or Dorna Moini.

The deadline for filing a protective claim for severance benefits paid in 2009 is April 15, 2013.

The United States District Court for the Southern District of New York granted class certification, finding that if plaintiffs’ allegations were true, Bear Stearns owed a fiduciary duty to disclose the scheme to the class. According to the district court, based upon this duty to disclose, plaintiffs alleged a material omission of fact by Bear Stearns sufficient to establish a rebuttable presumption of class-wide investor reliance and satisfy the predominance requirement of Rule 23(b)(3).

On appeal, the Second Circuit explained that for an omission to be actionable under Section 10(b), the defendant must be subject to an underlying duty to disclose. Under Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 153-54 (1972), an omission of a material fact by a defendant with a duty to disclose establishes a rebuttable presumption of class-wide reliance upon the omission by the investors to whom the duty was owed.

The Second Circuit concluded that plaintiffs’ allegations that Bear Stearns participated in Sterling Foster’s fraudulent conduct by continuing to clear transactions despite alleged knowledge of the ongoing scheme and by failing to cancel unpaid trades failed to trigger a duty of disclosure to Sterling Foster’s clients such that the Affiliated Ute presumption of reliance applied. Specifically, the Court contrasted the difference between a primary broker-dealer, like Sterling Foster, and a clearing broker, like Bear Stearns, which is hired to perform nominal back-office services associated with securities trading. The Court recognized that a clearing broker is generally under no fiduciary duty to the clients of the primary broker.

The Second Circuit held that plaintiffs had not adduced any evidence at the class certification stage indicating that Bear Stearns directed or instigated sham or fraudulent trades, or that it otherwise departed from normal clearing functions, such to establish that Bear Stearns owed the investors a duty of disclosure. As such, plaintiffs could not employ a class-wide presumption of investor reliance and the district court erred in certifying a Rule 23(b)(3) class.

By confirming that a clearing broker generally does not owe a duty of disclosure to investors absent extraordinary circumstances (such as where the broker is directly and highly involved in the alleged fraudulent scheme), this decision reinforces the legal protections afforded clearing brokers from liability to investors. It also exemplifies the use of Rule 23 (and related interlocutory appeal procedures) to obtain a dispositive ruling on a common merits issue at the class-certification stage.

For further information, please contact John Stigi at (310) 228-3717, John Landry at (213) 617-5561 or Jonathan Moss at (213) 617-5504.

A review of RULLCA is necessary to determine what existing operating agreement provisions covering these areas, among others, will be impacted and what possible alternatives to RULLCA may need to be considered, including reestablishment of the LLC in a jurisdiction permitting more flexibility in what may be provided in an LLC operating agreement.

As a default statute, RULLCA provides flexibility if LLC members have not expressly agreed in writing on an issue. Under the new Act, an operating agreement may continue to be in written or oral format, but now may be either in a record or implied, or in a combination thereof. Given this flexibility, LLCs should carefully consider how issues affecting the LLC are memorialized and implemented. The benefits of a single written agreement which documents the intents of the members and details of LLC operation should not be dismissed. A single document would be highly desirable in the event of a future dispute, in contrast to an amalgamation of “records” which are claimed to constitute the “operating agreement,” which can be a result under RULLCA. RULLCA also gives priority to an LLC’s operating agreement over its articles of organization in conflicts between the documents as to members, dissociated members, transferees and managers, while the articles of organization prevail with respect to all other persons to the extent that such persons are reasonably relying on the articles of organization. Any inconsistencies between those documents that presently exist should be identified and addressed. As described in detail in the Act, some RULLCA sections can be overridden by an LLC’s operating agreement and legal review can assist in identifying proper compliance and desired variances for existing LLCs.

For both existing and new LLCs, review of agreements and other documents of record to ensure compliance with RULLCA and conformance between LLC documents will be key to compliance with the requirements, and the nuances, of the new Act.

For further information, please contact Bob Copeland (858-720-7407 rcopeland@sheppardmullin.com), or Ryan Connor (858-720-8920 rconnor@sheppardmullin.com).

Because no secondary market for ARS developed, ARS were difficult to liquidate and could not be sold for par value outside of the required auctions. Further, if an auction did not sell out (indicating that there were more people looking to sell than to buy), the auction would “fail” and no ARS could be exchanged — putative sellers would be stuck with their ARS — and the interest rates would default to the maximum rate set out in the offering documents. Because of the dire consequences of a failed auction, the defendant financial institutions would sometimes intervene in the auctions by using proprietary trading accounts to place “support bids” which would result in clearing the auctions despite insufficient external demand.

As the financial market deteriorated throughout 2007 and early 2008, these support bids became increasingly critical to clearing auctions. There were a few isolated failures in 2007, but the ARS market began its implosion on February 12, 2008, when many of the auctions scheduled for that date failed. On February 13, 2008, eighty-seven percent of the auctions failed, and by the next day, the ARS market had essentially shut down. Plaintiffs filed their class action complaints in September of 2008, claiming that defendants had conspired to restrain trade by refusing to issue support bids to protect the auctions they managed.

The United States District Court for the Southern District of New York dismissed the complaint, relying upon the Supreme Court’s decision in Credit Suisse Securities (USA) LLC v. Billing, 551 U.S. 264 (2007) [see blog article here]. The Second Circuit affirmed the dismissal, but did so based on a Twombly analysis, and therefore did not reach the question of whether the Southern District’s Billing analysis was correct.

The Second Circuit explained that the facts pleaded in a complaint must raise a reasonable expectation that discovery will reveal evidence of illegal conduct and that mere legal conclusions couched as factual allegations will get no consideration at all. To state a claim under Section 1 of the Sherman Act, the complaint must allege sufficient facts — as opposed to mere labels or legal conclusions — making the inference that the plaintiff’s injuries were the result of an unlawful conspiracy more plausible than competing inferences, such as that the injuries result from independent, legitimate business decisions by similarly situated actors. The required factual allegations — referred to by Twombly and its progeny as “plus factors” — can include allegations that parallel acts were against defendants’ individual economic self-interests, or that competitors frequently communicated with each other.

In this case, the plaintiffs failed to adequately plead the requisite Twombly plus factors. For example, although plaintiffs pled two interfirm communications, the vast majority of alleged communications were intrafirm. The Court found these predominantly internal communications were insufficient to demonstrate more than a high level of interfirm awareness, which is not in itself unlawful.

Plaintiffs also failed to connect any plus factors to the alleged conspiracy. The Court observed that “the [ARS] market as a whole was essentially holding its breath and waiting for the inevitable death spiral of ARS auctions,” which made “abandoning bad investments [] not just a rational decision, but the only rational business decision.” In other words, the most plausible explanation for defendants’ simultaneous withdrawal of support for ARS auctions was not an antitrust conspiracy, but independent (and widespread) assessments that the ARS market was dying and ARS were a bad investment.

The Second Circuit underscored its unease with permitting large antitrust class actions to proceed absent a well-documented inference of conspiracy, noting: “[i]f we permit antitrust plaintiffs to overcome a motion to dismiss simply by alleging parallel conduct, we risk propelling defendants into expensive antitrust discovery on the basis of acts that could just as easily turn out to have been rational business behavior as they could a proscribed antitrust conspiracy.”

For further information, please contact Rena Andoh at (212) 634-3092. 

The value of plaintiff’s investment decreased substantially between May 2007 and March 2010. Plaintiff sued, alleging that the registration statement and amended prospectus misstated defendants’ underwriting guidelines and failed to disclose defendants’ abandonment of those guidelines, thus violating Sections 11 and 12(a)(2).

The United States District Court for the Southern District of New York dismissed plaintiff’s complaint for failure to state a plausible claim, holding that plaintiff had failed to make allegations “specific to” the loan origination practices. N.J. Carpenters Health Fund v. NovaStar Mortg., Inc., No. 08 Civ. 5310(DAB), 2012 WL 1076143 (S.D.N.Y. Mar. 29, 2012). The district court also held that plaintiff had failed to allege the materiality of any potential misstatements or omissions in light of the risk disclosures that were contained in the prospectus. Plaintiff appealed.

The Second Circuit reversed. The Court acknowledged that the Rule 8(a) notice pleading standards set forth in Twombly and Iqbal apply to claims under Section 11 and 12(a)(2). The Second Circuit explained that courts may “draw a reasonable inference of liability” where the pleaded facts are “suggestive of” a finding of misconduct. The Court held that the existence of competing inferences does not render a plaintiff’s claim unreasonable unless those inferences rise to the level of “obvious alternative explanation[s].” In establishing this standard, the Court cited with approval the decision of the United States Court of Appeals for the First Circuit in Plumbers’ Union Local No. 12 Pension Fund v. Namer Asset Acceptance Corp., 632 F. 3d 762 (1st Cir. 2011), which applied the same standard to a similar case, and noted that the majority of districts within the Second Circuit have allowed similar claims to proceed where plaintiffs pled “fairly specific” accounts of systematic disregard of underwriting guidelines. The Court also contrasted the “plausible inference” pleading standard under Twombly/Iqbal with the “strong inference” pleading standard under the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4(b)(2)(A), and Tellabs Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) [blog article here].

The Court held that plaintiff’s allegations, viewed as a whole, allowed for the reasonable inference that defendants had misstated their underwriting guidelines. Plaintiff provided three factual allegations in support of its claims: (1) that credit rating agencies had downgraded the trust’s rating due to loosening of underwriting practices; (2) that the trust experienced unusually high default rates; and (3) that statements of at least eight former employees contradicted the prospectus’ description of the trust’s underwriting standards. The Court noted that the alleged employee statements constituted a “more substantial source[]” that were not merely consistent with, but suggestive of defendants’ liability. These alleged statements, read in conjunction with plaintiff’s other factual allegations, described plaintiff’s claims with sufficient specificity to state a claim under Sections 11 and 12(a)(2).

Defendants argued that this inference of liability was unreasonable on three grounds. First, defendants argued that the testimony of unnamed employees was both untrustworthy and unrepresentative of company policy. The Court disagreed, noting that plaintiffs may rely on unnamed sources described with “sufficient particularity” to demonstrate the probability of their knowledge. The Court also noted that, as the former employees had allegedly worked at offices spread across the country, their statements could support a reasonable inference that they described company-wide policies. Next, defendants argued the inference of liability was unreasonable because the prospectus had disclosed the risk of higher rates of default and market collapse, and because the reduction in the trust’s rating was due to a deterioration of its credit quality. The Court disagreed again, noting that these facts did not rise to the level of an “obvious alternative explanation” and were consistent with plaintiff’s allegations. Finally, defendants argued that the prospectus did not misstate the loan origination practices because it disclosed that defendants could make “exceptions” to the underwriting guidelines. The Court rejected this argument as well, noting that a disclosure that “exceptions” might be made does not support complete abandonment of the underwriting standards.

Despite the Court’s attempt to reconcile the “plausible inference” pleading standard under Twombly/Iqbal with the “strong inference” pleading standard under Tellabs, some tension remains. While it may appear obvious that a “plausible inference” standard is less onerous than a “strong inference” standard, in practice the two standards arguably are converging. Perhaps when a court applies Twombly/Iqbal to a securities claim also subject to Tellabs it can provide some additional clarification.

For further information, please contact John Stigi at (310) 228-3717 or Robin Achen at (213) 617-5579.

North Hills turned out to be a Ponzi scheme. After it collapsed, Bloom was arrested, charged and pled guilty to all charges levied against him arising from the Ponzi scheme.

After Bloom’s guilty plea, plaintiffs (who had invested in North Hills and lost over $4 million in its collapse) filed suit against MB, certain MB officers and directors and one MB employee, alleging (1) controlling person liability under Section 20(a) of the Exchange Act; (2) negligent supervision; (3) violations Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), and Securities & Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder; (4) violations of the Pennsylvania Unfair Trade Practice and Consumer Protection Law, 73 Pa. Cons. Stat. Ann. § 201-1 et seq.; and (5) breach of fiduciary duty. Plaintiffs alleged that MB’s directors knew Bloom was operating North Hills, but did not know the fund was a Ponzi scheme.

Defendants moved to dismiss. The United States District Court for the Eastern District of Pennsylvania granted the motion in part, dismissing all claims against the MB employee. Following discovery, the remaining defendants filed motions for summary judgment. The district court granted that motion in its entirety. Plaintiffs appealed.

The Third Circuit affirmed nearly all of the district court’s decision, vacating and remanding for trial only the grant of summary judgment for MB Investment on the claims for violation of Section 10(b) and Rule 10b-5. In doing so, the Court made noteworthy rulings relating to Section 20(a) of the Exchange Act and negligent supervision that provide insight into the limits of liability of a corporation’s directors for misconduct of employees.

In their Section 20(a) claim, plaintiffs alleged that MB’s directors were controlling persons jointly and severally liable for the actions of Bloom, a person allegedly under their control. Plaintiffs argued that the directors recklessly failed to monitor Bloom and were therefore culpable participants in his fraud, making them secondarily liable for his actions under Section 20(a). Plaintiffs alleged no acts by the directors in furtherance of the fraud. Instead, they proceeded on a theory of inaction, arguing that because the liability being sought was secondary, they needed only to show recklessness, not knowing misconduct by the directors. According to plaintiffs, the directors’ alleged failure to enforce compliance protocols and investigate red flags relating to Bloom’s activities demonstrated recklessness adequate to make them liable for his misdeeds.

The Third Circuit explained that to prevail on a theory of inaction, plaintiffs must prove that the directors’ inaction was undertaken intentionally to further the fraud and intentionally to prevent its discovery. In other words, the directors must have had knowledge of the fraud in order to intentionally fail to act to prevent it — a fact the plaintiffs conceded was not true when they alleged the directors did not properly monitor Bloom. Further, the Court reiterated the principle that secondary liability requires a more culpable state of mind (intent), not a lesser one (recklessness). The Court concluded that sloppy compliance practices which result in a lack of knowledge of an employee’s harmful activities was insufficient to establish culpable participation for the purposes of Section 20(a) liability.

The Court also held that directors are not liable as employers under a theory of negligent supervision. Plaintiffs alleged that the directors, since they are vested by state corporate law with supervisory responsibilities for the corporation, are subject to liability for negligent supervision of the corporation’s employees. Plaintiffs also argued that Bloom’s misconduct was foreseeable by the directors as a matter of law because the MB directors knew Bloom managed a separate hedge fund, but failed to monitor his operation.

The Court explained that while negligent supervision requires the elements of common law negligence (duty, breach, causation and damages), the tort is specifically predicated on the duties of an employer to responsibly monitor its employees and to refrain from placing an employee in a situation where the employee will harm a third party. The Court observed that the question of whether a director of an employer corporation, rather than or in addition to the employer corporation itself, can be liable for negligent supervision is determined by asking whether a director owes a duty to third parties to supervise a corporation’s employees.

The Third Circuit held that directors do not owe a duty to third parties to supervise employees. The Court noted that while a director’s fiduciary duty of loyalty to act in good faith for the benefit of the corporation has been held to include some duty of oversight, that duty has never been understood to include responsibility for day-to-day supervision of employees. The Court noted that those types of day-to-day supervision duties are the responsibility of officer or employee-supervisors and are expressly not the duty of directors. The Court further concluded that there is no agency relationship between the director and employee. Instead, the corporation itself is the employer of the culpable employee and potentially liable for his or her tortious acts. Therefore, directors are not liable under a theory of negligent supervision.

The rulings issued by the Third Circuit confirm the limits to directors’ exposure for damage caused by actions of unscrupulous employees, and in particular preserve those limits even where arguably poor oversight prevented the directors from discovering the employees’ harmful acts.

For more information, please contact John Stigi at (310) 228-3717.