May 21, 2008

Stoneridge in Action

Now that the Supreme Court has weighed in against the notion of “scheme” liability in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008), the federal courts have begun applying the Stoneridge holding to securities fraud claims against various types of third parties. (In Stoneridge, the Court held that “the private right of action [under Section 10(b) and Rule 10b-5] does not reach the customer/supplier companies because the investors did not rely upon their statements or representations.”)

In Pugh v. Tribune Co., (7th Cir.; April 2, 2008), the first appellate court to apply Stoneridge rejected the notion of finding “scheme liability” in a situation where a company employee was allegedly involved in a scheme to defraud that ultimately led to a securities fraud. Employees of Tribune and its subsidiaries had participated in a scheme to falsely inflate circulation figures for two Tribune publications in order to increase the amounts charged for advertising. Once the fraud was uncovered, Tribune took a $90 million charge to earnings and several employees pled guilty to fraud charges. The plaintiffs sued Tribune Co. and several individual defendants under Exchange Act Sections 10(b) and 20(a) for losses caused by the inflated revenue generated through the fraudulent circulation number scheme. The District Court dismissed the claims with prejudice.

The Seventh Circuit affirmed, most notably applying Stoneridge to plaintiff’s claims against Louis Sito – the Tribune employee allegedly behind the circulation scheme – and finding that he was not liable for securities fraud based on a theory that it was “foreseeable” that that the circulation fraud would lead to an overstatement of the company’s revenues. The court indicated that Sito “had participated in a fraudulent scheme but had no role in preparing or disseminating Tribune’s financial statements or press releases.” The court concluded that the Supreme Court’s holding “indicates that an indirect chain to the contents of false public statements is too remote to establish primary liability.”

In another recent case, In re DVI Inc. Securities Litigation (E.D. Pa.; April 29, 2008), the District Court in the Eastern District of Pennsylvania applied Stoneridge in addressing class certification for claims against a law firm. The plaintiffs had alleged that the firm (Clifford Chance) “initiated and masterminded” a “workaround” that allowed DVI to fraudulently misrepresent the adequacy of the company’s internal controls. The court noted that the misleading 10-Q in which the internal controls disclosure was included “was issued solely by DVI and contains no indication that any statement therein is attributable to Clifford Chance.” Because investors did not rely upon the allegedly deceptive conduct of Clifford Chance and the conduct was not “publicly disclosed such that it affected the market for DVI’s securities,” the court found that the plaintiffs were not entitled to the fraud on the market presumption in establishing reliance on a class-wide basis with respect to the activities of the firm.

These cases may indicate that the lower courts will apply the Supreme Court’s Stoneridge holding relatively broadly – including (somewhat surprisingly) to situations where there is some affiliation between the defendant and the issuer, such as an employee.

Convertible Securities: New Accounting for Cash-Settled Instruments

This WSJ article from last Friday noted that convertible securities are very cheap right now, given the widespread exit from the market earlier this year by those hedge funds pursuing a convertible arbitrage strategy. Financial firms in need of cash have been going to the market with convertible deals, given the attractiveness of convertibles over selling common stock at depressed levels or issuing long-term debt. The article notes that recent issuances have offered relative high yields and some attractive add-ons, such as compensation for changes in dividends or takeovers that come at lower prices.

Companies considering a convertible debt issuance or that have convertibles already on their books should take look at the new FASB Staff Position (FSP) No. APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement).” This new position will be effective for fiscal years (and interim periods) beginning after December 15, 2008, and is to be applied retrospectively to all past periods presented – even in those situations where the convertible instrument has matured, converted or has otherwise been extinguished as of the effective date of the FSP.

The FSP will likely have a big impact on the financial statements of companies that have issued the relatively popular flavor of convertible debt securities that, upon conversion, may be settled by the company fully or partially in cash. While today most types of convertible debt instruments are treated as debt securities for accounting purposes, under the new FSP companies will need to allocate between the liability and equity components of the instrument. Splitting up the debt and equity components will inevitably result in a debt discount, which will need to be amortized to interest expense over the expected life of the debt. As a result of the FSP, companies that have issued cash-settled convertible securities will see an increase in interest expense associated with those instruments (and a resulting reduction in earnings and earnings per share), with a decrease in the net carrying amount of debt on the balance sheet along with an increase in the amount of equity.

The Firm, but Fair, Hand

First there was Adam Smith’s “Invisible Hand,” then there was “Slowhand” (aka Eric Clapton), and now apparently we have the “Firm, but Fair, Hand.” I ran across this advertisement on the editorial page of my local newspaper. I can’t recall ever seeing this kind of “campaign-style” ad from an interest group defending the record of the SEC and its Chairman, but then again there have been a lot of things over the past few years that I don’t recall seeing before…

– Dave Lynn