Securities Law - Proposed Amendments to the Investor Protection Act

The House Financial Services Committee voted strictly along party lines on November 4, 2009 to recommend an amendment to the Investor Protection Act that would double the authorized funding of the SEC and increase its enforcement authority. Further, a fiduciary duty would be imposed on all providers of financial advice, create a whistle-blower “bounty” and protection program and end mandatory arbitration of claims against broker-dealers. If this proposed amendment is adopted it would represent a boom to plaintiffs’ lawyers. This bill will be vigorously opposed by the Republicans in the House and, further, even it passes in one form or another, its passage in the more conservative Senate will be much more difficult.

Edward X. Clinton, Sr.
Copyright 2009

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Attorney Client Privilege - Tenth Circuit Rejects Attorney Work Product Claim

United States v. Textron, Inc. 577 F.3d 21 (August 13, 2009)

A recent case raises an important issue. United States v. Textron, Inc., 577 F.3d, 21 (Aug 13, 2009). In the Textron case, the United States filed a petition to enforce an Internal Revenue Service summons served on Textron, Inc., a public company, in connection with an IRS’s examination to determine tax liability. The United States District Court for the District of Rhode Island denied the petition and the IRS appealed. The question before the 11th Circuit was whether attorney-work product doctrine shields from an IRS summons “tax accrual work papers” prepared by lawyers and others in Textron’s tax department to support its calculation of tax reserves for its
audited corporate financial statements.

As a publicly traded corporation, Textron is required to file financial statements certified by an independent auditor. And, in doing so, it must calculate reserves. The present case began with a 2003 audit. In reviewing Textron’s 2001 returns, IRS determined that a Textron subsidiary had engaged in certain transactions which potentially could be considered abusive tax shelters. Textron had shown the work papers to its accountants, Ernst & Young, but refused to show them to the IRS. The IRS then brought an enforcement action in the Federal District Court of Rhode Island. Textron challenged the summons as lacking a legitimate purpose and it also asserted the attorney-client and taxpayer-practitioner privileges and the qualified privilege available for litigation materials under the work-product doctrine. The IRS contested the privileges claims.

After a hearing, the District Court denied the petition for enforcement on the basis that the papers were protected by the work-product privilege. 507 F.Supp. 2d 138. The District Court stated that the privilege derived from a case Hickman v. Taylor, 329 U.S. 495 (1947) and is now embodied in Rule 26(b)(3) of the Federal Rules of Civil Procedure. The District Court pointed out that there would be no need regarding the adequacy if the reserve amount of Textron had not anticipated a dispute with the IRS that was likely to result in litigation or some other adversarial proceeding.

On appeal to the 11th Circuit, a divided panel upheld the District Court’s decision. A petition for an en banc review was granted. Then the panel decision was vacated and additional briefs were submitted. The En Banc Bank panel pointed out that the U.S. Supreme Court has not ruled on the issue, namely, one in which a document is not in any way prepared for “litigation but relates to a subject that might or might not occasion litigation.” In Hickman v. Taylor, 329 U.S. 510, there was ongoing litigation in which one side filed interrogatories seeking from opposing counsel memorandum recording witness interviews the latter had conducted after receiving notice of possible claims. In Hickman the Court declared that the interrogatories conducted by opposing counsel in preparation for litigation was protected by a qualified privilege.

The En Banc panel concluded that the work-product privilege is aimed at protecting work done for litigation – not in preparing financial statements. Textron’s work papers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they would be carefully prepared in their present form. And, IRS access serves the legitimate and important function of detecting and disallowing abusive tax shelters.
The En Banc Panel vacated the initial decision of the District Court and remanded the case. Thus, the IRS prevailed and will obtain access to the withheld materials.

Two of the five Circuit judges on the en banc panel dissented. The dissent made reference to Rule 26(b)(3) and stated that the text of the Rule does not limit its protection to materials prepared to assist at trial. To the contrary, the text of the Rule clearly sweeps more broadly. It expressly states that work-product privilege applies not only to documents “prepared … for trial” but also to those prepared “in anticipation of litigation.” If the drafters of the Rule intended to limit its protection to documents made to assist in preparation for litigation, this would have been adequately conveyed by the phrase “prepared … for trial.” The fact that documents prepared “in anticipation of litigation” were also included confirms that the drafters considered this to be a different, and broader category. Nothing in the Rule states or suggests that documents prepared “in anticipation of litigation” with the purpose of assisting in the making of a business decision does not fall within its scope.

The dissent made reference to United States v. Adlman, 134 F.3d 1194 (2d Cir. 1998) where Judge Leval stated a “prepared for” requirement is not consistent with the plain language of Federal Rule of Civil Procedure 26, which provides protection for documents “prepared in anticipation of litigation or for trial.” Fed.R.Civ.P.26(b)(3)(A).

In short, the dissent agreed with the District Court and took strong exception to the findings of the majority on the en banc panel.
* * *

The case has created uncertainty. Could its rational be extended beyond work product issues? Perhaps the Supreme Court will accept the Textron case in order to put certainty into the area. It is time for SEC reporting companies and other companies to set up standards for handling work-product materials. It would be prudent to mark documents as “work-product being prepared in anticipation of litigation.” Auditors routinely request comment by corporate counsel on the issues of significant litigation and request a view as to the ultimate conclusion. No responding lawyer wants to disclose information that might enlighten a potential or actual adversary.

Edward X. Clinton, Sr.
Copyright 2009

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Securities Law - The SEC Uses Sarbanes-Oxley To Attack A CEO's Bonus

Apparently the SEC filed its first action under Section 304 of the 2002 Sarbanes-Oxley Act. It appears to represent the start of a more watchful and aggressive approach to regulation by the SEC.

Section 304 provides in part:

If there is material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the CEO and CFO of the issuer shall reimburse the issuer for (1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever occurs first) of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

The Chief Executive Officer of CSK Auto Corp., Maynard L. Jenkins, has been asked to return $4,000,000 he received in bonuses and stock sales while the company was allegedly committing accounting fraud. The action was filed in the United States District Court for Arizona. According to the Complaint, Jenkins, formerly the Chairman and CEO of CSK was engaged in accounting fraud which also involved many of its senior officers for the years 2002, 2003 and 2004.

CSK, a large distributor of automotive parts and accessories, was a retailer which purchased products from vendors that manufactured various parts. A portion of CSK’s income was obtained from allowances it received from its vendors. Vendor allowances are used to provide financial support to market the vendor’s product. Generally, CSK accounted for the allowances by reducing its costs of goods sold. The more vendor allowances earned, the lower the costs and correspondingly greater pre-tax income. There were millions in uncollectible vendor allowances recognized but were actually uncollectible. According to the SEC Complaint, CSK engaged in a scheme to hide the uncollectible receivables. Instead of writing off the uncollectible receivables and taking a reduction in pre-tax income, CSK concealed its uncollectible receivables by applying millions of dollars allowances earned and collected for later program years to prior program years. For this and similar schemes, CSK avoided writing off tens of millions of dollars of uncollectible receivables. As a result of the failure to properly account for the vendor failures, CSK filed its Form 10-K overstating 2003 pre-tax income by about $11,000,000. The SEC charged that CSK knew or was reckless in not knowing that it failed to write off uncollectible allowances. There were similar charges for later years.

As a result of this fraud, the SEC charged that CSK violated the Anti-Fraud Provisions of the Securities Laws, namely Section 17(a) of the Securities Act. Section 10(b) of the Exchange Act and Rule 10(b)-5 thereunder.

The SEC alleges in its complaint that during the 12 month period following the filing of the fraudulent Form 10-K’s, Jenkins received bonuses and other incentive-based and equity-based compensation from CSK. Jenkins never reimbursed CSK for any portion of the bonuses or other incentive-based and equity-based compensations or his stock sales profits.

The SEC seeks a judgment ordering Jenkins to reimburse CSK for any bonuses and other incentive-based and equity-based compensation and the profits of CSK stock sales pursuant to Section 304 of Sarbanes-Oxley. Section 304 of Sarbanes-Oxley does not permit the remedy of attaching salary, so it is possible that in the future corporate officers may want more of their compensation in terms of salary which cannot be affected by Section 304.

Doubtless, the action of the SEC is one further step in the promise by the new Chairman of the SEC, Mary Schapiro, to be more aggressive. The Maddoff Fraud was a serous blow to the agency which has over the years been considered responsive to investor protection. It appears. Schapiro will try to reverse at least some of the SEC’s prestige in failing to detect Maddoff’s massive fraud.

Edward X. Clinton, Sr.
Copyright 2009

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United States v. Ruehle, 09-50161 (9th Cir. 2009)

CONFLICT
THE TREACHEROUS PATH

William Ruehle, the Chief Financial Officer of Broadcom, a California corporation, and Henry Nichols, a co-founder of Broadcom, were indicted by a Federal grand jury for conspiracy, securities fraud, false certification of financial statements, wire fraud and other crimes in the United States District Court for California. These charges arose from the alleged backdating of options granted to officers of Broadcom.
The story started from events commencing in May of 2006 when Irell & Manella, LLP, a prestigious California law firm, with about 220 lawyers, ranked 60th in a nationwide survey by Vault’s 2009 Guide To The Top 100 Law Firms, was retained by the Audit Committee of Broadcom to conduct an internal investigation concerning the backdating of stock options by Broadcom. It was also decided that the Board would not appoint a panel of independent outside directors to oversee the review. At the time Irell was personally representing Ruehle in civil litigation concerning the backdating of stock options by Broadcom. In June 2006, Irell lawyers, at the request of the Audit Committee, met with Ruehle who told them about the option practices of Broadcom. The Irell firm did not state to Ruehle that they were only representing Broadcom. Word of the backdating problem leaked out and civil suits were filed.

Irell lawyers claimed that they gave an oral Upjohn (Miranda) warning to Ruehle prior to or at the meeting. However, Ruehle does not remember receiving such a warning and the notes of the Irell lawyers do not reflect that a warning was given.
Ruehle, at the request of Irell, met with Broadcom executives and board members to discuss Irell’s internal review and it was agreed that the information would be turned over to the outside auditors, Ernst & Young.

Ruehle and Nichols were indicted in a 65 page indictment. Later, Broadcom told Irell to disclose Ruehle’s conversations about backdating options to the auditors of Broadcom, the SEC and the United States Attorney. Irell did not seek or get the advance consent of Ruehle.

The U.S. Attorney now argues that it can use Ruehle’s statements to Irell at Ruehle’s criminal trial. Ruehle objected at that point on the grounds of the attorney-client privilege because Irell was representing Ruehle in connection with certain civil cases involving those same options. In fact, Ruehle had a long relationship with Irell.
Apparently no one asked the Irell lawyers to get Ruehle’s consent to the dual representation, nor did they recommend that Ruehle get separate independent counsel.
Because of Ruehle’s objection, a couple of months later the District Court at the request of the U.S. Attorney, ordered an evidentiary hearing to determine whether, in fact, the attorney-client privilege, asserted by Ruehle at this point, should be recognized. The U.S. attorneys said that they can use the statements to Irell because an Upjohn (“Miranda”) warning was given by Irell to Ruehle. The District Court stated that it doubts that, in fact, an Upjohn warning was given. The Irell attorneys had no notes of such a warning and Ruehle said he did not remember receiving such a warning.

There was then an evidentiary hearing – some of it outside the presence of the U.S. Attorneys. At the conclusion of the hearing, the Court held that Ruehle reasonably believed that Irell was gathering facts for his defense. The Court went on to say that even if there was an oral Upjohn warning, it was not enough, because such a warning should have been in writing and acknowledged by Ruehle. The Court further stated that the subject of the attorney-client privilege and whether an Upjohn warning was given was very important because Ruehle faces a significant prison sentence if convicted in the criminal case. The Court found Irell breached its duties to Ruehle in disclosing information he told them. The District Court in its decision suppressed the statements of Ruehle to the Irell lawyers and referred the Irell Firm to the State Bar Disciplinary authorities.

The government sought, and was granted, an interlocutory appeal to the Ninth Circuit seeking to overturn the decision to suppress the Ruehle disclosures.

At the outset the Ninth Circuit acknowledged the “’treacherous’ path which Corporate Counsel must tread under the attorney-client privilege when conducting an internal investigation to advise a publicly traded company of its financial disclosure obligations.” Broadcom’s outside counsel recommended that Broadcom restate its earnings to account for 2.2 billion in additional stock-based compensation expenses.
The statements of Ruehle were not made in confidence but were for the disclosure to the corporate auditors. Ruehle never attempted to segregate what he considered what was privileged and what was not privileged with regard to the information furnished in his conversations with Irell.

The Ninth Circuit stated that the overwhelming evidence demonstrates that Ruehle’s statements to Irell lawyers were not made in confidence but rather for the purpose of outside disclosure.

The interlocutory appeal of the government was successful. The Order of the District Court suppressing Ruehle’s statements was overturned. The Ninth Circuit stated that the reference to the Bar authorities was not before it on appeal and therefore it did not enter into that area of whether that referral was appropriate. The case represents a series of questionable acts.

Why did an experienced corporate officer, Ruehle, proceed without clear written assurances from Broadcom, his employer, and Irell, his lawyer, in the option backdating cases that disclosures he might make were subject to the attorney-client privilege? Or, why did Ruehle not ask for separate counsel? Ruehle’s lapse is difficult to understand. The Indemnification By-laws of Broadcom undoubtedly provided that Ruehle could have retained separate counsel at least initially at the expense of Broadcom.

Why did Irell proceed with a dual representation without written acknowledgement by Broadcom and Ruehle that it was representing both, that a conflict might well develop and that such a conflict might involve Broadcom blaming Ruehle of the wrongful backdating. However, even if Irell had such acknowledgment, would its disclosures have breached Irell’s duty of loyalty to Ruehle? A lawyer cannot furnish adverse information about a client.

Why didn’t the General Counsel of Broadcom intervene and insist on a full disclosure of the conflict in the interests of his corporate employer, Broadcom?
Should Ruehle be found guilty following a trial, it seems to be a prime case for review by the United States Supreme Court.

Edward X. Clinton, Sr.
Copyright 2009

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Securities Law - Posner - Easterbrook Debate

A recent decision of the Seventh Circuit represents an interesting conflict between Judges Posner and Easterbrook. In Jones et al v. Harris Associates L.P., 527 F.3d 629 (May, 2008), the Plaintiffs appealed a decision of Judge Kocoras of the District Court for the Northern District of Illinois. Plaintiffs’ shareholders of Oakmark, an open-ended mutual fund managed by Harris Associates, claimed that management fees charged to Oakmark were excessive in violation of Section 32(b) of the Investment Company Act of 1940. There were several other issues but the most important issue was – were the management fees paid by the Oakmark Fund excessive? The District Court granted Summary Judgment in favor of Defendant. The Seventh Circuit affirmed. The Seventh Circuit Panel consisted of Chief Judge Frank Easterbrook and Judges Kanne and Evans.

Plaintiff sought and was granted certiorari by the U. S. Supreme Court.
The District Court followed Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (1982) and ruled that Harris Associates must prevail because its fees are in line with Gartenberg. Gartenberg sets forth two versions of a test to determine whether fees charged a mutual fund violate Section 36(b) of the Investment Company Act of 1940: (1) whether the fee schedule represents a charge that was within the range of what would have been negotiated at arm’s-length in the light of all the surrounding circumstances, and (2) to be guilty of a violation of § 36(b) the advisor must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining. Gartenberg was considered the settled law for 25 years.

The Oakmark Fund paid Harris 1% percent on the first two billion of assets and a declining percentage thereafter. Plaintiffs argued that Gartenberg should not be followed because, among other things, the fees were set incestuously. Defendant Harris Associates organized Oakmark and controls it. Plaintiffs pointed out that Harris Associates has institutional clients that pay less in fees. For such clients, the first $15 million under management is paid 0.35% of the amount over $500 million with intermediate breakpoints. Plaintiffs argued that a fiduciary may charge its controlled clients no more than its independent clients.

The Seventh Circuit in Jones v. Harris Associates, 527 F.3d 629 (7th Cir. 2008) on May 19, 2008, in an opinion by Judge Easterbrook stated that the 7th Circuit now disapproves the Gartenberg approach and, among other things, stated that a fiduciary duty differs from rate regulation.

According to Judge Easterbrook, a fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The Trustees of a mutual fund, rather than a judge or jury, determine how much advisory services are worth. The opinion went on to state that a lawyer cannot deceive his client or take strategic advantage of the dependence that develops once representation begins. Hard bargaining and seemingly steep rates are lawful.

The opinion also stated that Federal Securities laws, of which the Investment Company Act is one component, work largely by requiring disclosure and then allowing price to be set by competition in which investors make their own choices. Plaintiffs do not contend that Harris Associates pulled the wool over the eyes of disinterested trustees or otherwise hindered their ability to negotiate a favorable price for advisory services. The fees are not hidden from investors - and the Oakmark funds net return has attracted new investment rather than driving investors away. According to Judge Easterbrook, Section 36(b) does not make the federal judiciary a rate regulator, similar to the Federal Energy Regulatory Commission. Judgment of the district court granting summary judgment in favor of Harris Associates was affirmed.
There was a Petition For Rehearing. The panel voted unanimously to deny the Petition For Rehearing. A judge called for a vote on the suggestion for rehearing en banc. The majority did not favor such rehearing and it was denied. Judge Posner with Judges Rovner, Wood, Williams and Tinder dissented from the denial of rehearing en banc.

The dissent by Judge Possner (__ F.3d __, 2008 WL 3177282 (7th Cir. 2008) states that the case merits the attention of the full Court. The original panel rejected the approach taken by the Second Circuit in Gartenberg v. Merrill-Lynch Asset Management, Inc., 694 F.2d 923 (1982) in deciding whether a mutual fund adviser has breached his fiduciary duty to the fund. Gartenberg permits the Court to consider as a factor in determining if a breach occurred, whether the fee is “so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” The dissent quotes the Oakmark Prospectus and states “Subject to the overall authority of the board of trustees, [Harris Associates] furnishes continuous investment supervision and management to the Funds and also furnishes office space, equipment and management personnel.” The Oakmark Fund, “Prospectus,” Jan. 28, 2008, p. 36. Recall Professor Kuhnen’s observation that “when directors and the management are more connected, advisers capture more rents and are monitored by the board less intensely.”

According to the dissent, the panel opinion states that advisors cannot profit if high fees drive investors to invest elsewhere. The dissent questions whether in fact high fees do drive investors away. The dissent states: “The chief reason for substantial advisory fee level differences between equity pension fund portfolio managers and equity mutual fund portfolio managers is that advisory fees in the pension field are subject to a marketplace where arm’s-length bargaining occurs. As a rule [mutual] fund shareholders neither benefit from arm’s-length bargaining nor from prices that approximate those that arm’s-length bargaining would yield were it the norm.” John P. Freeman & Stewart L. Brown, “Mutual Fund Advisory Fees: The Cost Of Conflicts Of Interest,” 26 J. Corp. L. 609, 634 (2001).

Judge Posner in the dissent also points out that the Jones case is the only appellant opinion disagreeing with Gartenberg and references approximately 20 cases following Gartenberg. Judge Posner stated that in rejecting Gartenberg, the Court relied on economic analysis which should be re-examined on the basis of growing indications that executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation, quoting various sources and authors, including Warren Buffet, Chairman of Berkshire Hathaway. “Letter to the Shareholders of Berkshire Hathaway, Inc.,” Feb. 27, 2004, p. 8.

Judge Posner points out that the advisers charges the captives funds more than twice what it charges independent funds and that the opinion by the panel creates a circuit split, although the panel did not acknowledge such or circulate its opinion to the full court in advance of publication as required when a panel creates a circuit split.
The principles and reasoning in Gartenberg seem to this writer to be more reasonable. Gartenberg was followed for about 25 years. Most practitioners view Judges Posner and Easterbrook to be the intellectual heavy weights of the Seventh Circuit. Judge Posner points out, it is not as if plaintiffs were routinely succeeding under Gartenberg. They were not. However, there were some settlements which resulted in a roll back of rates. In the writer’s opinion, if Judge Easterbrook’s view of fiduciary duty is extended to other factual situations, it could cause the doctrine to be seriously undermined. His analysis is very narrow. He states in his opinion: “A Trustee owes an obligation of candor in negotiation, and honesty in performance, but may negotiate in his own interest and accept what the settlor or governance institution agrees to pay.” Jones et al., 527 F.3d. 632 (7th Cir., 2008)

However, a Trustee is responsible for the interests of others. According to Black’s Law Dictionary: “Fiduciary Duty – A duty of utmost good faith, trust, confidence, and candor owed by a fiduciary (such as a lawyer or corporate officer) to the beneficiary (such as a lawyer’s client or a shareholder); a duty to act with the highest degree of honesty and loyalty toward another person and in the best interests of the other person (such as the duty that one partners owes to another).” Black’s Law Dictionary (8th ed. 2004).

Also, trustees are not in fact independent though the fund meets the rule that 60% are considered to be “independent” by the Investment Company Act. They are selected by the adviser which controls the fund. They are in effect paid by the adviser.
Judge Easterbrook makes reference to lawyers and states: “Lawyers have fiduciary duties to their clients but are free to negotiate for high hourly wages or compensation from any judgment. Jones, 527 F.3d 629, 632 (7th Cir., 2008). See, e.g., In re Synthroid Marketing Litigation, 325 F.3d 974 (7th Cir. 2003), In re Continental Illinois Securities Litigation, 962 F.2d 566 (7th Cir. 1992).

Is the reference to lawyers and legal fees correct? Is a lawyer negotiating a fee a fiduciary? A lawyer becomes a fiduciary only when an attorney-client relationship has been established. “[T]he attorney-client relationship constitutes a fiduciary relationship”. In re Winthrop, 219 Ill 2d at 543). A lawyer negotiating with a prospective client seeks an attorney-client fiduciary relationship. After a fee is settled, the lawyer then has the burden of protecting the client’s interests to the maximum extent possible. Judge Easterbrook says the federal judiciary is not a rate regulator after the fashion of the Federal Energy Regulatory Commission (FERC). FERC is the U.S. agency with jurisdiction over interstate electricity sales, wholesale electric rates, hydroelectric licensing, natural gas pricing, and oil pipeline rates. It seems a stretch to compare a fiduciary’s duty to setting electricity rates.

A fiduciary owes an obligation to those he has agreed to protect. For example, a fiduciary or trustee for minor children must extend his efforts first for the benefit of the children. He or she may seek fees, but his or her interests are secondary. Rate regulation has nothing to do with a fiduciary responsibility.

Plaintiff does not expect rate regulation but rather asks the question did the adviser breach its fiduciary responsibility? If it did, the summary judgment in favor of the defendant would be reversed. On remand, the parties at the district court would seek a rate that was not “excessive.” A settlement would be likely.

The Supreme Court will hear arguments in the coming weeks.

The briefs have been filed in the appeal by Oakmark of Jones v. Harris Associates, L.P., 527 F.3d 629 to the U.S. Supreme Court and can be viewed at 2007 WL 1833245 (C.A. 7).

Note: the Supreme Court unanimously reversed the Seventh Circuit in this case. See Jones et al. v. Harris Associates, L.P., 08-586 (March 30, 2010). The unanimous opinion was written by Justice Alito.

Edward X. Clinton, Sr.
Copyright 2009

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Stoneridge Investment Partners v. Scientific Atlanta, Inc. 552 U.S. 148 (2008)

Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008)

This article, by Edward X. Clinton, Sr., appeared in the Chicago Daily Law Bulletin In September 2007.

"The U.S. Supreme Court will hear argument on October 9, 2007 on whether to limit the scope of SEC Rule 10b-5 or expand the reach of the Rule.

It is the most important case in Securities Regulation in years and goes to the core of President Bush’s conservative base. The President personally intervened and overruled the Republican controlled SEC. Doubtless, the President was asked by a business supporter to intervene.

The case is controversial as the plaintiffs seek to impose liability not on Scientific-Atlanta, which allegedly made the false statements, but on its customers and suppliers who allegedly agreed to contracts which concealed fraudulent activity from investors in Scientific Atlanta.

The case is Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al., No. 06-43. The case involves a claim of securities fraud by Scientific American, Inc. and Motorola, Inc. The facts as alleged in the complaint are as follows:

Respondents supplied digital set-top boxes to Charter Communications, one of the largest cable-television operators. In 2000, Charter learned that it was unlikely to meet its annual target for operating cash flow and decided to ask respondents to enter into “wash” transactions, whereby Charter would pay respondents additional amounts for the set-top boxes and respondents would use those amounts to “purchase” advertising on Charter’s cable channels. In effect, those transactions would entitle respondents to receive free advertising.

In order for Charter to improve its cash flow as a result of those transactions, it needed to capitalize the payments to respondents (on the theory that they were for the purchase of equipment) while treating the return of payments from respondents as revenue (on the theory that they were for the purchase of advertising). Before entering into the transactions, Charter discussed them with Arthur Andersen, its outside accountant. Andersen advised Charter that it could not recognize the advertising payments as revenue if they were integrally related to the payments to respondents, but that it could do so if the two sets of payments were unrelated to each other, negotiated at least one month apart, and made at fair market value. Charter informed Andersen that it would satisfy those conditions. In September 2000, Charter and each respondent entered into separate agreements for the price increase in the set-top boxes and for the advertising; the agreements concerning the set-top boxes, however, were backdated to August 2000.

A proposed second amended complaint contains more detailed allegations. It alleges that Charter instructed Scientific-Atlanta to notify Charter that it was raising the price of set-top boxes that Charter had already agreed to purchase, and further instructed Scientific-Atlanta to cite higher manufacturing costs as the reason for the increase. Scientific-Atlanta followed Charter’s instructions, even though it knew that the stated reason for the increase was false. The parties later entered into an agreement under which Charter would pay an extra $20 for each set-top box it had already agreed to purchase (totaling $6.73 million in excess payments). The parties simultaneously entered into a separate agreement in which Scientific-Atlanta agreed to purchase $6.73 million in advertising from Charter (at rates four to five times higher than those paid by other advertisers).

The proposed complaint also alleged that Charter entered into an agreement with Motorola to purchase 540,000 set-top boxes by December 31, 2000, even though Charter had no present need for the Motorola boxes (and thus no intention of buying them). The agreement contained a provision requiring Charter to pay Motorola $20 per box in liquidated damages (totaling $10.8 million) if it did not purchase the boxes by the specified date. The parties entered into a separate agreement in which Motorola agreed to purchase $10.8 million in advertising from Charter (again at rates four to five times higher than those paid by other advertisers).

The proposed second amended complaint alleges that respondents knew that Charter intended to use the transactions artificially to inflate its operating cash flow.

Charter subsequently informed Andersen that the agreements had been negotiated a month apart from each other, and Andersen duly advised Charter that it could recognize the advertising payments as revenue. Charter did so in its financial statements for the fourth quarter of 2000, thereby increasing its operating cash flow by at least $17 million. But for its accounting of the transactions with respondents, Charter would not have met analysts’ projections for its operating cash flow. Charter continued to report an increase in cash flow throughout 2001 and the first quarter of 2002. On April 1, 2003, however, Charter issued a restatement of its financial reports in which it reduced its operating cash flow for 2000 by $195 million and its operating cash flow for 2001 by $292 million.

Respondents filed motions to dismiss, contending, that the complaint failed to allege actionable misstatements or omissions by respondents, and also failed to allege that petitioner had relied on respondents’ alleged deceptions. The district court granted the motions. The court held that “the claims amount to claims for aiding and abetting liability under § 10(b) and Rule 10b-5,” and were therefore barred by Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), which held that a private party may not pursue a Section 10(b) action on a theory of aiding and abetting liability. The district court reasoned that petitioner does not assert that respondents made any statement, omission or action at issue or that petitioner relied on any statement, omission or action made by either of them. Instead, the court noted, “petitioner contends that respondents are liable to Charter’s investors on the basis that they engaged in a business transaction that Charter purportedly improperly accounted for.”

The court of appeals affirmed and noted that, in Central Bank, the Supreme Court held that “Rule 10b-5 does not reach those who only aid or abet a violation of § 10(b).”

The court of appeals rejected petitioner’s contention that it had “properly alleged a primary violation of the securities laws within the meaning of Central Bank because respondents violated Rule 10b-5(a) and (c),” which prohibit “employing a device, scheme, or artifice to defraud” or “engaging in an act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.”

The court of appeals determined that petitioner’s complaint failed to state a claim. The court reasoned that “the focus of [petitioner’s] § 10(b) and Rule 10b-5 claims was deception” by Charter, and that “neither Motorola nor Scientific-Atlanta was alleged to have engaged in any * * * deceptive act.” In addition, the court held that respondents “did not issue any misstatement relied upon by the investing public, nor were they under a duty to Charter investors and analysts to disclose information useful in evaluating Charter’s true financial condition.” The court thus concluded that the district court properly dismissed the claims, barred by Central Bank, that respondents knowingly aided and abetted the Charter defendants in deceiving the investor class.

The court of appeals stated that is was aware of no case imposing § 10(b) or Rule 10b-5 liability on a business that entered into an arm’s length non-securities transaction with an entity that then used the transaction to publish false and misleading statements to its investors and analysts. Imposing liability in those circumstances, the court concluded, “would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings,” and “decisions of this type should be made by Congress.”

The Supreme Court accepted certiorari with the Chief Justice and Justice Breyer not participating. At least 30 amicus briefs have been filed by a wide array of persons and entities, including: North American Securities Administrators Association, Inc.; AARP; Ohio, Texas, and 30 other States and Commonwealths; Former SEC Commissioners and Officials and Law and Finance Professors; Defense Research Institute; American Bankers Association; Chamber of Commerce of the United States of America; John Conyers, Jr., Chairman of the House of Representatives Committee on the Judiciary, and Barney Frank, Chairman of the House Committee on Financial Services.

The Securities and Exchange Commission, by a vote of 3 to 2, asked the Solicitor General to submit an amicus brief on behalf of Petitioner (in other words, to support reversal). According to the amicus brief of representatives Conyers and Frank, President Bush personally intervened and instructed Paul D. Clement, the Solicitor General, to file an amicus brief supporting affirmation, which he did. You have the unusual conflict of a Republican SEC voting to ask the Solicitor General to seek reversal and the President asking the Solicitor General to submit a brief in favor of affirming. Of course, the Solicitor General followed the President’s direction.

The amicus brief of the Solicitor General argues that the district court’s dismissal of petitioner’s complaint was correct was because petitioner did not sufficiently plead reliance on respondents’ deceptive conduct. Petitioner does not allege that it was even aware of the transactions that respondents executed with Charter; at most, petitioner relied on Charter’s misstatements in purchasing Charter stock. Petitioner does not dispute that Charter independently decided to make the misrepresentations in its financial statements, and does not contend that respondents drafted or otherwise created those misstatements.

The brief also argued that allowing liability for a primary violation under the circumstances would constitute a sweeping expansion of the judicially inferred private right of action in Section 10(b) and Rule 10b-5, potentially exposing customers, vendors, and other actors far removed from the market to billions of dollars in liability when issuers of securities make misstatements to the market.

The amicus brief of Messrs. Conyers and Frank argued that the interpretation of Section 10(b) and Rule 10b-5 adopted by the Court of Appeals and urged by Respondents ultimately rests on policy considerations at odds with the statutory text that should more appropriately be addressed to Congress than to the Supreme Court. The brief stated that the conduct at issue is prohibited by the plain language of Section 10(b) of the Exchange Act and its companion regulation, Rule 10b-5, and urges that any change to the substantive law should be made by legislative action and not by the courts.

The amicus brief also stated that the Supreme Court has stated repeatedly that Section 10(b) should be construed “ ‘not technically and restrictively, but flexibly to effectuate its remedial purposes.’” SEC v. Zandford, 535 U.S. 813, 819 (2002) (quoting Affiliated Ute Citizens v. United States, 406 U.S. 128, 151 (1972), quoting SEC v. Capital Gains Research Bureau, 375 U.S. 180, 195 (1963)); accord Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 12-13 (1971); see also Santa Fe Indus. v. Green, 430 U.S. 462, 477 (1977) (“No doubt Congress meant to prohibit the full range of ingenious devices that might be used to manipulate securities prices.”).

The brief also stated that the Supreme Court previously has stated that “§ 10(b) and Rule 10b-5 prohibit all fraudulent schemes in connection with the purchase or sale of securities, whether the artifices employed involve a garden type variety of fraud, or present a unique form of deception. Novel or atypical methods should not provide immunity from the securities laws.” Bankers Life, 404 U.S. at 11 n.7 (quoting A.T. Brod & Co. v. Perlow, 375 F.2d 393, 397 (2nd Cir. 1967)); also see Ernst & Ernst v. Hochfelder, 425 U.S. 185, 203 (1976) (stating that Section 10(b) is “a ‘catchall’ clause to enable the Commission ‘to deal with new manipulative (or cunning) devices.’”).

Taking into account the current make-up of the U.S. Supreme Court, the odds are in favor of affirmation."

P.S. As I predicted the U.S. Supreme Court did in fact affirm.

THE SUPREME COURT OPINION

The opinion can be found at 128 S.Ct. 761 552 U.S. 148. Writing for the majority, Justice Kennedy wrote: In this suit investors alleged losses after purchasing common stock. They sought to impose liability on entities who, acting both as customers and suppliers, agreed to arrangements that allowed the investors’ company to mislead its auditor and issue a misleading financial statement affecting the stock price. We conclude the implied right of action does not reach the customer/supplier com-panies because the investors did not rely upon their statements or representations. We affirm the judgment of the Court of Appeals."

The majority opinion further reasons as follows: "Respondents had no duty to disclose; and their deceptive acts were not communicated to the public. No member of the investing public had knowledge, either actual or presumed, of respondents’ deceptive acts during the relevant times. Petitioner, as a result, cannot show reliance upon any of respondents’ actions except in an indirect chain that we find too remote for liability."

THE DISSENT

Justice Stevens, joined by Justice Ginsburg and Justice Souter, dissented.

The Dissent argued that the majority opinion had construed the concept of "reliance" far too narrowly.

Justice Stevens wrote: "The sham transactions described in the complaint in this case had the same effect on Charter’s profit and loss statement as a false entry directly on its books that included $17 million of gross revenues that had not been received. And respondents are alleged to have known that the outcome of their fraudulent transactions would be communicated to investors. The Court’s view of reliance is unduly stringent and unmoored from authority."

The Dissent further argued that, without the fraudulent acts of the respondents, Charter would not have been able to defraud investors.

"Charter Communications, Inc., inflated its revenues by $17 million in order to cover up a $15 to $20 million expected cash flow shortfall. It could not have done so absent the knowingly fraudulent actions of Scientific-Atlanta, Inc., and Motorola, Inc. Investors relied on Charter’s revenue statements in deciding whether to invest in Charter and in doing so relied on respondents’ fraud, which was itself a “deceptive device” prohibited by §10(b) of the Securities Exchange Act of 1934. 15 U. S. C. §78j(b)."

The SEC, which voted 3 to 2 in support of the view announced in the Dissent, no doubt viewed the sham transactions and the alleged conspiracy as a serious threat to investors and the markets.


Edward X. Clinton, Sr.
Copyright 2009

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Discovering the Work Of Your Opponent's Consulting Expert

I. INTRODUCTION

Parties often hire consulting experts to assist them in preparing their testifying experts for trial. Under Rule 26(b)(4)(B) ("R.26") of the Federal Rules of Civil Procedure, it is difficult, but not impossible, to gain access to the work of a consulting expert. This article will explain when the rule applies and how it is possible in certain circumstances to discover the opinion of a consulting expert.

Rule 26(b)(4) Trial Preparation: Experts.

(A) Expert Who May Testify. A party may depose any person who has been identified as an expert whose opinions may be presented at trial. If Rule 26(a)(2)(B) requires a report from the expert, the deposition may be conducted only after the report is provided.

(B) Expert Employed Only for Trial Preparation. Ordinarily, a party may not, by interrogatories or deposition, discover facts known or opinions held by an expert who has been retained or specially employed by another party in anticipation of litigation or to prepare for trial and who is not expected to be called as a witness at trial. But a party may do so only:

(i) as provided in Rule 35(b); or

(ii) on showing exceptional circumstances under which it is impracticable for the party to obtain facts or opinions on the same subject by other means.

The rule is designed to prevent one party from taking advantage of the other party's investigative work. The Advisory Committee made clear that the protections provided by the rule are not based upon the attorney work product privilege. See Notes of the Advisory Committee ('70)("Notes").

Rule 35(b) provides a very narrow exception for the notes, opinions and conclusions of examining physicians. Castillo v. Western Beef, Inc. (E.D. NY December 21, 2005) (Garaufis, J.) (unpublished opinion).

II. DOES THE RULE APPLY?

The first question is whether a potential witness is covered by the rule. According to the rule a consulting expert must be "retained or specifically employed... in anticipation of litigation or preparation for trial and who is not expected to be called as a witness at trial." R.26. The Committee also commented that the rule "precludes discovery against experts who were informally consulted in preparation for trial, but not retained or specifically employed." See Advisory Committee Notes. See also USM v. American, 631 F.2d 420 (6th Cir.'80) (defendant could not discover letter written by expert informally consulted but not retained by plaintiff); Ager v. Jane, 622 F.2d 496 (10th Cir.'80). [The rule may not apply to witnesses consulted by non-parties. Awkwright v. National, 148 F.R.D. 552 (S.D.W.Va.'93) (rule does not protect work done by expert witnesses who consulted with a third party).]

Medical examiners and treating physicians do not apply as consulting experts. In Harasimowicz v. McAllister, 78 F.R.D.319 (E.D.Pa.'78), a civil rights action, plaintiff sought to take the deposition of the medical examiner for Philadelphia who had done an autopsy on the decedent. The medical examiner's work was not protected by the rule because he was not an expert. The autopsy was a routine job duty of the medical examiner. Thus, he did "not obtain or develop the information in anticipation of litigation or trial." Id. at 320. See also Congrove v. St. Louis-San, 77 F.R.D.503 (W.D.Mo.'78) (treating physician subject to ordinary discovery).

Where a party claims that its employee is a consulting expert, courts have required the party to show that at the time the materials were prepared there was "more than a remote possibility of litigation." Fox v. Cal. Sierra, 120 F.R.D.520 (N.D.Cal.'88). The rule does not apply to ordinary employees. In re Sinking of Barge, 92 F.R.D.486 (S.D.Tex.'81). Where work was done to assist litigation and for ordinary business purposes, "the privilege is available only if the primary motivating purpose behind the creation of [the materials] was to assist in pending or impending litigation." U.S. v. Gulf Oil, 760 F.2d 292 (Temp.Emer.Ct.App.'85); McEwen v. Digitran, 155 F.R.D.678 (D.C.Utah'94) (no protection where accountant's reports were prepared primarily for the preparation of the company's financial statements).

A fact witness who is later retained as an expert or who is later asked to give opinion testimony is not immune from discovery. The Notes caution:

the [Rule] does not address itself to the expert whose information was not acquired in preparation for trial but rather because he was an actor or viewer with respect to transactions or occurrences that are part of the subject matter of the lawsuit. Such an expert should be treated as an ordinary witness.

This is an important caveat. Without this exception, some litigants might attempt to shield fact witnesses from discovery.

This comment applies where a person witnesses an event and is later retained as an expert. Because the person is a fact witness, his personal knowledge is subject to discovery just as any other witness's factual knowledge would be. As one court explained, "the relevant distinction is not between fact and opinion testimony but between those witnesses whose information was obtained in the normal course of business and those who were hired to make an evaluation in connection with expected litigation." Chiquita v. M/V Bolero, 1994 U.S.Dist.Lexis 5820 (S.D.N.Y.'94).

An example of a fact witness turned expert occurred in Silman v. Aetna, 990 F.2d 1063 ('93). In Silman, a fire destroyed plaintiffs' painting business but the defendant insurer denied coverage and asserted that the plaintiffs had set the fire. Plaintiff prevailed at trial. On the appeal the insurer argued that the court erred in allowing plaintiff to offer testimony concerning the cause of the fire from the local fire chief. The fire chief had arrived on the scene twenty minutes after the fire started. Id. at 1068. At trial, defendant objected to the testimony on the ground that plaintiffs had not disclosed the fire chief as an expert witness in their discovery responses and that R.26 should therefore bar his testimony. Although the court agreed that the fire chief had given expert testimony at trial, the court held that his testimony was properly admitted because he had observed the fire. Moreover, he was not a consulting expert because both parties had copies of his statements and had equal access to him before trial. Id. The court's opinion makes clear that either party could have taken the deposition of the fire chief and asked him what he believed caused the fire.

Where a potential witness has first-hand factual information and also acted as a consulting experts one court restricted discovery to factual knowledge and barred inquiry into consulting work. In Adams v. Shell, 134 F.R.D.148 (E.D.La.'90), defendant retained several employees to work with its attorneys in defending litigation arising from an explosion at one of its refineries. Because the employees had factual knowledge concerning the refinery's activities, they could be deposed about facts known and opinions held prior to their retention as consulting expert. The rule, however, shields both facts and opinions known by a consulting expert. See Grindell v. American, 108 F.R.D.94 (W.D.N.Y.'85) (work done by consulting expert retained to assist with litigation and to evaluate automobile for possible improvement was protected; court refused to allow a limited deposition into actual knowledge of the witness). Adams can be viewed as an effort to find a compromise solution to discovery from a consulting expert who also has factual knowledge.

III. WHAT IS REQUIRED FOR A SHOWING OF EXCEPTIONAL CIRCUMSTANCES?

Even if the rule applies, it is possible to discover the work product and opinions of a consulting expert upon a showing of "exceptional circumstances." A party attempting to make such a showing bears a "heavy" burden. See Hartford Fire v. Pure Air, 154 F.R.D.202 (N.D.Ind.'93). Exceptional circumstances are present where the other party lacks the ability to discover equivalent information by other means. Id. at 208. The mere fact that information known by a consulting expert would be helpful to the moving party's expert is, of course, insufficient to show exceptional circumstances. Santos v. Rando, 171 F.R.D.19 (D.RI.'93). Exceptional circumstances are present where one party's experts cannot duplicate a test or an observation by a consulting expert. For example, in Sanborn v. Kaiser, 45 F.R.D.465 (E.D.Ky.'68), plaintiff claimed that defendant's aluminum sewer pipe was defective. Plaintiff's experts were present and took photographs when the pipe was removed and replaced. Plaintiff, however, denied access to defendant's experts. Defendant was entitled to plaintiff's consulting experts' reports and photographs because the information could not be obtained by defendant's experts. See also Delcastor v. Vail, 108 F.R.D.405 (D.Colo.'85) (compelling deposition of consulting expert who investigated a mud slide in part because conditions at the site had changed).

A party may also obtain access to a consultant's work where a testifying expert relies on it in forming his opinion. Heitmann v. Concrete Pipe, 98 F.R.D.740 (E.D.Mo.'83) (testifying expert relied on consulting expert's report); Delcastor at 408 (testifying expert relied on the report of the consulting expert who had the first opportunity to observe conditions after a mudslide). However, if the testifying expert does not consider the work of the consulting expert it is protected. In Dominguez v. Syntex, 149 F.R.D.158 (S.D.Ind.'93), consulting experts examined plaintiff and prepared records. Where plaintiff's testifying expert stated that he read the records but did not consider them in forming his opinion, the court denied defendant's motion to compel production of the records. Id. at 161 (court also noted that defendant could obtain the substantial equivalent by doing its own examination).

IV. WAIVER

Is it possible to waive the protections of R.26? One court has rejected the possibility of waiver because the rule is not based on the attorney work product privilege. Vanguard v. Banks, 1995 U.S.Dist.Lexis 2016*6 (E.D.Pa.'95) (no waiver where report inadvertently turned over to third parties). However, in U.S. v. 22.80 Acres, 107 F.R.D.20 (N.D.Ca.'85), a gov't employee prepared an appraisal report concerning a parcel of real estate in a land acquisition action. Because two gov't employees used the report to refresh their recollection in preparation for their depositions, the court held, pursuant to Fed.R.Evid. R.612(2), that the gov't waived any work product privilege. Id. at 25. It is possible to waive almost any legal right, including the attorney-client privilege, so it follows logically that the protections of Rule 26 can be waived by the careless.

V. CASES WHERE THE EXPERT IS REDESIGNATED

Sometimes in baseball one manager selects a batter to pinch hit, only to learn that the other team is changing the pitcher. In Baseball, the manager is allowed to select another hitter. In litigation, this can be very problematic where a party designates a testifying expert and then revokes the designation and decides that the former testifying expert is really a consulting expert. A party would only do this where the party discovered some huge problem with the testifying expert’s testimony or methodology.

In Netjumper Software, LLC v. Google, Inc., 19-138,04-70366-CV (Keehan, J.) the District Court permitted Plaintiff to redesignate a testifying expert as a consulting expert because the expert had not yet been deposed. See also Ross v. Burlington Northern Railroad Co., 136 F.R.D. 638 (N.D. Ill. 1991) (re-classification of expert as non-testifying where the expert was not deposed). These cases show that it may be possible to avoid disaster where a testifying expert develops an opinion that is inconsistent with the theory of the case of the party that disclosed him. But see Bradley v. Cooper Tire, (D. New Hampshire; January 11, 2007) (Muirhead, J.) (motion to quash denied where the expert produced a report).

VI. RECENT DEVELOPMENTS

Since this note was first published in 1996, there have been several decisions of interest.

In Spearman Industries, Inc. v. St. Paul Fire and Marine Insurance Company, 128 F.Supp. 2d 1148 (N.D. Ill. 2001) (Alesia, J.), the district court considered whether certain testimony by an appraiser was covered by the Rule, and therefore inadmissible. The lawsuit was a coverage case in which the plaintiff insured claimed that its roof was damaged by a winter storm. Defendant contended that the roof was damaged by ordinary wear and tear and thus not covered. There was no dispute that the appraiser had appraised the damage to the roof. The Court found that the appraiser was a non-testifying expert “consulted in anticipation of litigation or preparation for trial.” Defendant was unable to show “exceptional circumstances.” The Court wrote: “Defendant had ample opportunity to conduct whatever investigation it desired, and the site was inspected by [two consultants hired by defendant]. Thus, the court granted Plaintiff’s Motion in Limine to exclude the work and opinions of its consulting expert. The court noted that “any opinions or records developed or acquired by [the appraiser] prior to consultation by plaintiff fall outside the protection of Rule 26(b)(4)(B).

In Portis v. City of Chicago, 02 C 3139 (August 24, 2005) (Nolan, J.), the plaintiffs hired a computer consultant to develop a database supporting their 42 U.S.C. Section 1983 claims. Magistrate Nolan found that because the computer database was an important piece of evidence in the case and because the consultant was “undisputably the person most knowledgeable about the database and its creation, what information went into the database, how the data was input, what procedures were followed to ensure accuracy,” the City could take his deposition. The Court limited the deposition to the creation of the database and the accuracy of the methodology.


V. CONCLUSION

Rule 26 shields most work done by consulting experts. To obtain the protection of the rule a litigant must show that the potential witness was, in fact, a consulting expert. If that showing is made, it is only possible to discover the consultant's opinion upon a showing of "exceptional circumstances." Exceptional circumstances can be shown where the work or analysis done by the consulting expert cannot be repeated by another expert because conditions have changed or where there are no other experts in the field. This is a very heavy burden to meet and those attempting too meet this burden will rarely succeed.


Edward X. Clinton, Jr.
Copyright 2009

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