Boletim Sobre Litigância em Seguros

Newsletter
Issue No. 11
Second Quarter 2005
Securities Litigation and Professional Liability Practice

A Note from the European Co-Chair
In recent years, European legislatures have strengthened shareholders rights, and many additional regulatory measures are under way. As a consequence, we anticipate the corresponding substantial increase in corporate governance litigation, securities litigation and professional liability cases to continue all over Europe. Particularly in securities litigation, clients operating in the United States and Europe can expect to face not only U.S.-based class actions but also parallel proceedings in Europe.
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Inside This Issue:

A Note from the European Co-Chair The Introduction of a Class Action Light in Germany SEC and PCAOB Provide Needed Guidance on New Internal Control Requirements Supreme Court in Dura Pharmaceuticals Unanimously Endorses Loss Causation Requirement in Fraud-on-the-Market Cases Recent Victories Circuit and State Round-Up The Selective Waiver Doctrine and the McKesson Cases Out in Front 12 The Scope of SLUSAs Covered Class Action Requirement Contact Information
Latham & Watkins has established leading securities litigation and professional liability practices in Paris, London and Frankfurt during the last two years. To reflect the continuing growth of our international practice and the globalization of our clients litigation needs, this newsletter aims to keep you informed about all major European legislative actions and legal decisions relating to securities law, in addition to keeping you apprised of the United States securities law developments.
Bernd-Wilhelm Schmitz
The Introduction of a Class Action Light in Germany

By Bernd-Wilhelm Schmitz and Mathias Fischer Class actions have been common to civil procedure in the United States for quite some time. Other legal systems, like those of the United Kingdom, France and Sweden, have also established rules allowing a group of plaintiffs to litigate similar claims in one action. German civil procedure, on the other hand, knows only a very limited scope of possibilities for plaintiffs to bring their claims under one action. The most popular way for multiple plaintiffs to file their claims against a defendant in one action is to consolidate them.
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SEC and PCAOB Provide Needed Guidance on New Internal Control Requirements
By Robert J. Malionek In May 2005, the U.S. General Accountability Office (GAO) issued a report on its Financial Audit of the Securities and Exchange Commissions (SEC) financial statements for fiscal year 2004.1 While finding that the SECs financial statements were fairly presented in all material respects, the GAO also found that the SEC did not maintain effective internal control over financial reporting as of the end of the SECs fiscal year, which was September 30, 2004. While noting that the SEC is currently working to improve controls,
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Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. Copyright 2005 Latham & Watkins. All Rights Reserved.
Supreme Court in Dura Pharmaceuticals Unanimously Endorses Loss Causation Requirement in Fraud-on-the-Market Cases
By Pamela S. Palmer, Jeff G. Hammel and J. Christian Word In a landmark decision, the United States Supreme Court has reversed the Ninth Circuit in a fraud-on-the-market securities class action. Unlike almost all other federal courts, the Ninth Circuit which encompasses nine western states including California had adopted a price inflation theory of loss causation. This theory, had it been allowed to stand, would have allowed investors to sue a company merely by claiming that they paid too much for the companys stock because of a defendants alleged misrepresentations. A unanimous Supreme Court in Dura Pharmaceuticals, Inc. v. Broudo, 125 S. Ct. 1627, 2005 WL 885109 (April 19, 2005), however, rejected the theory with eight words: In our view, the Ninth Circuit is wrong. Although no lower courts have interpreted Dura in published decisions as of this writing, there is no doubt as to the significance of this opinion in securities litigation for years to come. In 1988, the Supreme Court enabled so-called stock drop class actions by allowing plaintiffs to plead the first component of causation transaction causation or reliance based on a fraud-on-the-market theory. In Basic v. Levinson, 485 U.S. 224 (1988), the court held that all investors who trade stock in an efficient market such as the New York Stock Exchange or the NASDAQ inherently rely on the integrity of the market price because that price should rapidly reflect all available material information. Accordingly, class action plaintiffs may plead transaction causation by alleging that a defendants material misrepresentation was a fraudon-the-market that artificially inflated the stock price on which investors relied. The efficient market theory also comes into play in the second component of causation: loss causation. The so-called truth-on-the-market theory is that, in an efficient market, an artificially inflated stock price remains inflated until the truth comes out. As the Supreme Court in Dura explained, this means that investors do not suffer an economic loss caused by the alleged misrepresentations until their falsity is disclosed and absorbed by the efficient market causing the stock price to drop (deflate). It logically follows that any adverse price movement prior to a corrective disclosure is caused by events other than the alleged misrepresentation because the negative truth is not yet known and, therefore, not reflected in the stock price. Thus, investors who buy after the misrepresentation but sell before the truth comes out have not been injured. Herein lay the problem with the Ninth Circuits Dura decision: It permitted plaintiffs to maintain a securities fraud suit while pleading only that the stock
Pamela S. Palmer
What is Loss Causation and Does it Matter?

Jeff G. Hammel
J. Christian Word
The Private Securities Litigation Reform Act of 1995 (PSLRA) codified a longstanding judicial interpretation of Rule 10b-5 requiring plaintiffs to prove that their investment losses were caused by the defendants misrepresentations. This causation requirement has two components: (i) transaction causation (that the plaintiff relied on the defendants alleged misrepresentations in making the investment decision), and (ii) loss causation (that the alleged misrepresentation caused the plaintiffs investment loss). These requirements are designed to insure that defendants are only held liable for investment losses actually resulting from their misrepresentations and not for stock price declines attributable to other factors, such as adverse changes in market conditions or other negative business developments.
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Securities Litigation and Professional Liability Practice, Second Quarter 2005
Recent Victories
Alaska Electrical Pension Fund v. Adecco S.A.
Latham recently won a significant victory in a published decision dismissing a securities fraud action against Adecco S.A., a Swiss staffing company, and several of its officers and directors. In Alaska Electrical Pension Fund v. Adecco S.A., 371 F. Supp. 2d 1203 (2005), the U.S. District Court for the Southern District of California dismissed a securities fraud complaint, holding that the plaintiffs allegations of accounting improprieties were insufficient to state a claim, based in large part on the complaints failure to identify its confidential sources adequately. In January 2004, Adecco announced that the audit of its consolidated financial statements for fiscal year 2003 would be delayed because of its auditors identification of weaknesses in internal controls in the companys North American operations. After the resulting drop in Adeccos stock price the plaintiffs filed suit, asserting claims under Sections 10(b) and 20(a) and Rule 10b-5 and alleging that Adecco would ultimately be restating its financial statements. However, upon the conclusion of an extensive investigation in June 2004, Adeccos auditors provided a clean opinion on Adeccos financial statements without the need for a restatement. Rather than drop the suit, the plaintiffs filed an amended complaint, alleging that Adeccos takeover of a U.S. company in March 2000 resulted in millions of dollars in uncollectible receivables in its North American operations and therefore resulted in misrepresented financial statements. The defendants moved to dismiss the complaint arguing, inter alia, that the plaintiffs allegations of accounting violations were insufficient to establish that Adeccos financial statements were false and failed to raise a strong inference of scienter. Confidential Sources of Allegations. The court analyzed the complaints failure to provide details regarding its confidential sources alleged, applying the standards set out in two recent Ninth Circuit decisions, Nursing Home Pension Fund, Local 144 v. Oracle Corp., 380 F.3d 1226 (9th Cir. 2004), and In re Daou Sys., Inc. Sec. Litig., 397 F.3d 704, 710 (9th Cir. 2004). In Daou, the Ninth Circuit looked to the standard adopted by the Second Circuit and borrowed additional criteria from the First Circuit to require that a complaints sources be described with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged, and by engaging in an assessment of the reliability of the witnesses. Although the complaint in Adecco did not provide any details regarding the confidential witnesses referenced, the plaintiffs argued that the Ninth Circuits decision in Daou excused them from providing specificity about the sources of the allegations so long as other facts in the complaint provided an adequate basis for believing defendants statements were false. Holding that the absence of any description of the confidential witnesses upon which the Complaint relies requires dismissal, the court rejected the plaintiffs interpretation, explaining that while Daou did not necessarily require that sources be identified by name, it did require a meaningful description of confidential witnesses in addition to, not as a substitute for, corroborating facts. Sufficiency of Accounting Fraud Allegations. The court then held that the plaintiffs generalized allegations that the defendants understated and hid uncollectible accounts in its financial statements were insufficient to satisfy the requirements for pleading accounting fraud set out by the Ninth Circuit in Daou. The court explained that the plaintiffs must plead enough details to establish that the alleged violations were not just technical in nature but rather that they affected the companys financial statements in a material way. Without these details, the court held that the plaintiffs generalized allegations of manipulation of uncollectible receivables and other miscellaneous accounting violations were insufficient to quantify the impact of the violations on Adeccos financial statements. Sufficiency of Scienter Allegations. The court also held that the complaints allegations, even viewed collectively, failed to give rise to a strong inference of scienter. For example, the court criticized the complaint for failing to allege specific facts indicating that the defendants personally participated in or ratified the alleged accounting violations and rejected the plaintiffs argument that the highest ranking members of Adeccos worldwide operations should be presumed to have knowledge of manipulations that supposedly were occurring systematically throughout Adeccos North American operations. In dismissing the complaint and granting the plaintiffs leave to amend, the court declined to evaluate whether the plaintiffs adequately alleged loss causation, the significance of the lack of a restatement or the viability of the plaintiffs theory of the case. Laurie Smilan (VA), co-chair of the Securities Litigation and Professional Liability Practice Group, successfully argued the motion for Adecco.
Circuit and State Round-Up

Second Circuit
In Seippel v. Sidley, Austin, Brown & Wood, 2005 WL 1423370 (S.D.N.Y. June 16, 2005), the court addressed whether primary liability existed for a secondary actor a law firm under Section 10(b). The plaintiffs alleged that defendants Sidley, Austin, Brown & Wood (Sidley Austin) and Deutsche Bank defrauded plaintiffs through the development, marketing and sale of tax shelters that they knew would be challenged by the IRS. After the court initially held that the plaintiffs RICO claims were barred by the Private Securities Litigation Reform Act of 1995 (PSLRA), the plaintiffs amended their complaint to allege securities fraud claims. The defendants moved to dismiss for failure to satisfy the PSLRAs heightened pleading requirements, failure to satisfy the statute of limitations and claim of aiding and abetting. After summarily rejecting the defendants pleading with a particularity argument, the court addressed the notice required for purposes of triggering the statute of limitations in a securities action. The court pointed out that the statute of limitations generally begins to run when information establishes a probability, not possibility of fraud and that dismissal for failure to satisfy the statute of limitations is only appropriate in extreme circumstances. Even when such information exists, however, the statute of limitations will not begin to run if the warning signs are accompanied by reassurances from the defendants. Because Sidley Austin allegedly made representations regarding the legality of the tax shelters, and plaintiffs were entitled to rely on those due to Sidley Austins status as a law firm with expert knowledge of the tax laws, the court found that the plaintiffs did not have early notice of fraud and thus the statute of limitations had not expired.
The Selective Waiver Doctrine and the McKesson Cases

By David M. Friedman and Brian T. Glennon In this era of heightened corporate scrutiny, the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) frequently request companies to produce documents and information protected by the attorneyclient privilege and work product doctrine. The SEC and the DOJ cannot force a company to produce privileged materials. Nonetheless, whether or not a company under investigation voluntarily produces such materials is a factor that these agencies consider when deciding whether to pursue formal charges. Faced with such a choice, many companies elect to produce the
Brian T. Glennon
David M. Friedman
privileged materials subject to confidentiality agreements. The hope is that these confidentiality agreements will ensure that the privileged materials are not disclosed to shareholder plaintiffs or other adverse parties. The agreements frequently contain provisions limiting the disclosure of the materials, often provide that the materials are being produced pursuant to a purported common interest, and state that the production shall not be deemed a waiver of any applicable privileges as to anyone but the respective government agencies. Courts have not reached a consensus as to the effectiveness of these confidentiality agreements. Ultimately,

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The defendants also argued that the plaintiffs claims were barred because, at most, they alleged that defendants aided and abetted the party that sold the tax shelters, Ernst & Young, in inducing the plaintiffs to enter into the questioned tax transactions. Under Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), the Supreme Court held that there is no private cause of action under the federal securities laws for aiding and abetting a violation of Section 10(b). And the Second Circuit in Wright v. Ernst & Young, 152 F.3d 169 (2d Cir. 1998), interpreted Central Bank to mean that, in order to be held liable under Section 10(b), a defendant must actually make a false or misleading statement and must know or should know that the statement will be communicated to investors, and the statement must be attributable to the defendant. Although a failure to satisfy those conditions means that there is no liability because a defendant merely
aided and abetted, Wright held that secondary actors can nonetheless be liable as primary violators if the requirements for primary liability are met. It further held that the alleged violator need not have directly communicated the alleged misrepresentations to the plaintiffs. Applying Wright, the court determined that the plaintiffs alleged more than mere aiding and abetting by alleging that Sidley Austin engineered and were key members of the conspiracy to defraud and that the misrepresentations were caused by the defendants and made on their behalf. The plaintiffs alleged that Sidley Austin helped devise the tax shelter and agreed to use Ernst & Young to sell it. The court decided that Sidley Austin could thus be held liable for making misrepresentations albeit indirectly, using [Ernst & Young] as their agent and mouthpiece.

whether the production of privileged materials to a government agency subject to such an agreement will prevent a privilege and work product waiver depends on whether the jurisdiction has adopted the selective waiver doctrine. This doctrine allows a party to waive the privileges as to one party, but not to another. Federal courts of appeals and various state courts have split on the adoption of this doctrine, with most courts rejecting it. However, a recent decision by a district court for the Northern District of California and some dicta in a recent Ninth Circuit decision provide some hope to companies that have elected to, or are deciding whether they should, produce privileged materials. That said, the current state of the law, and in particular, the cases regarding the
McKesson and HBO & Company (HBOC) restatement, indicate that companies should assume privileged documents produced to government agencies will be produced to at least some shareholder plaintiffs.
The McKesson Cases

The McKesson cases are instructive, as several different courts were asked to determine whether the same privileged materials McKesson produced to the SEC and DOJ should be produced to various adverse parties. The courts split on the issue, resulting in a situation where certain plaintiffs are entitled to the materials, while others are not. Due to these inconsistent rulings, access to the materials depended on the vagaries of where plaintiffs chose to bring the litigation. The McKesson Restatement Shortly after the merger between McKesson and HBOC, McKesson

Bernd-Wilhelm Schmitz
This, however, is often not effective as plaintiffs may choose to retain different attorneys and have no means of coordinating their efforts. In an ongoing securities action against Deutsche Telekom, for example, (represented by Latham & Watkins Frankfurt office) more than 14,000 plaintiffs have filed 2,200 actions against Deutsche Telekom in Frankfurt district court. This extraordinarily high number of actions has exposed the Frankfurt District Court to enormous problems. The first oral hearing before the Frankfurt District Court was scheduled three and a half years after the first action was filed. In the oral hearing, the judge stated that it would take the court approximately fifteen years to decide all cases in the first instance, if the legislature does not pronounce new procedural rules for mass proceedings.
positive, then the legislature will consider a broader application of the law. The Master Proceedings Act will become effective as of November 1, 2005.
Compared to U.S. Class Actions, it is Class Action Light

German master proceedings will be distinctively different from a U.S.-style class action. The first, most important difference under the German rules are that there will not be an abstract class definition. Each investor has to opt in by filing his claim with the court and sharing in the costs of the litigation. It is foreseeable that under this opt-in solution, only a limited number of investors will take part in the master proceedings, thus reducing the amount at stake. The second important difference is that the German master plaintiff, unlike the lead plaintiff in U.S. class action proceedings, will not be entitled to settle the claims for all plaintiffs. If a defendant in a master proceeding intends to settle a dispute, the defendant will have to negotiate the settlement with each plaintiff separately, therefore making a quick settlement of all disputes virtually impossible.
Master Proceedings Act Aims to Reduce Plaintiffs Risks and Simplify Proceedings
Mathias Fischer
The Act on Master Proceedings in Disputes Relating to Capital Markets Law (Master Proceedings Act), just passed by the German legislature, aims to solve the problems encountered by courts handling a large number of claims relating to common facts. The German legislature reasoned that the traditional provisions in German civil procedure allowing for a consolidation of claims are insufficient for plaintiffs to litigate their claims effectively. The legislature recognized that, particularly in securities litigation, a single investor often suffers only relatively small damages, making it economically unreasonable for him to bring his claim to court. When a single claim is brought by a large number of investors, however, the total damages can be enormous. The legislature has limited the applicability of the Master Proceedings Act to securities litigation in order to give the courts practical experience in one area of litigation. If practical experience turns out to be
Introduction of Entirely New Proceedings

Master proceedings can be initiated upon the motion of any party. The motion for initiation of a master proceeding must seek a decision regarding questions of necessary facts or law. Master proceedings can only be initiated if the dispute relates to information involving the public capital markets and a multitude of investors. If the Court of First Instance admits the motion for initiation of a master proceeding, the motion is published in a specified public register on the internet. The public registration provides notice to other potential plaintiffs who may want to join in the master proceeding. If the motion for initiation of master proceedings is joined by nine additional plaintiffs within four months, the Court of First Instance must initiate the master

proceeding by seeking a decision of the Court of Appeals regarding the common questions of fact or law. During the pendency of the master proceeding, all other disputes depending on the decision in the master proceeding are stayed. Following the initiation of the master proceeding by the Court of First Instance, the court of appeals singles out a master plaintiff. As jury trials are foreign to German civil procedure, the Court of Appeals in a bench trial decides all questions of fact and law that have been addressed by the court of first instance. Finally, the Court of Appeals renders a master decision that is binding for all plaintiffs of all disputes stayed during the master proceeding. There are no means for a plaintiff to opt out of the binding effect of the master decision and an individual plaintiff cannot influence which plaintiff is appointed as the master plaintiff. The master decision can only be appealed to the German Civil Supreme Court. Although only the plaintiffs who choose to join the appeal of the master decision take part in the appeal, the Civil Supreme Courts decision is binding for all plaintiffs.
One of the important differences with a U.S. class action is that the German master plaintiff, unlike the lead plaintiff in U.S. class action proceedings, will not be entitled to settle the claims for all plaintiffs. If a defendant in a master proceeding intends to settle a dispute, the defendant will have to negotiate the settlement with each plaintiff separately, therefore making a quick settlement of all disputes virtually impossible.
hundreds of plaintiffs file separate court briefs, it is virtually impossible for the court of appeals to address all facts and questions of law. After the master decision has become final, the Court of First Instance must then decide each action on a case-by-case basis. Although the master decision may be dispositive on a number of common issues raised in each case, it is possible that the Court of First Instance still has to decide a variety of questions that are not common to several actions. favorable for plaintiffs, but they can bear significant risks, as each plaintiff must share in the costs if he does not withdraw his claim within two weeks after being served with the decision to stay the first instance proceedings. At this early stage, it can be impossible for the plaintiff to determine the ultimate costs and the number of plaintiffs that will eventually join the proceedings and share the costs. Thus, even under the Act, a small number of plaintiffs may ultimately bear costs that are still grossly out of proportion to the amount in dispute.
Does the Master Proceedings Act Really Reduce Plaintiffs Risks?

Other important provisions of the Master Proceedings Act relate to costs. Under German law, the loser has to pay all court fees as well as the prevailing partys reasonable attorneys fees. The plaintiff must advance court fees, his own attorneys fees, and often expert fees. In many cases, expert fees are out of proportion to the amount at stake in an individual case. Therefore, a plaintiff may lose his case only because he has failed to advance expert fees. The Master Proceedings Act addresses this problem by providing that plaintiffs need not advance expert fees. In addition, if the plaintiffs lose, all fees are divided proportionally among the plaintiffs. The Acts cost rules might seem
Conclusion
It is questionable whether the legislatures aims to simplify mass proceedings in securities litigation and to reduce plaintiffs risks can be achieved by the Master Proceedings Act. Thus, judges and even plaintiffs lawyers have expressed concerns regarding the practicality of the proposed master proceedings. Instead of modifying and supplementing the existing rules of civil procedure, the legislature has introduced an entirely new and complicated procedure, without having exhaustively considered the practical problems that might arise. With the Deutsche Telekom case as the first test case under the Master Proceedings Act, Latham & Watkins will be on the front line as Germany monitors the success of the Act.
Does the Master Proceedings Act Really Simplify the Proceedings?

To satisfy German constitutional due process requirements, the legislature has invented a rather complicated and burdensome procedure: All plaintiffs before the Court of First Instance can plead and file motions during the master proceedings. The Court of Appeals must consider all pleadings and motions as long as they do not contradict the pleadings and motions of the master plaintiff. If
Robert J. Malionek
the GAOs conclusion is an ironic development that underscores the practical challenges and increased pressures facing public companies, management and auditors in the wake of the new internal control requirements brought about by the Sarbanes-Oxley Act of 2002 (SOX). Adding to the irony of the GAOs report is its timing. In May 2005 just days before the release of that report the SEC and the Public Company Accounting Oversight Board (PCAOB) finally issued guidance to the companies, management and auditors facing SOXs overhaul of the internal control structure and the corresponding pressure from all fronts. Clearly, the guidance is much-needed.
For decades, management was only expected to have in place internal controls designed to give reasonable assurances that, among other things, transactions are sufficiently recorded in order to allow financial statements to be prepared in accordance with Generally Accepted Accounting Principles (GAAP). Auditors were not required to audit internal controls at all, but rather could either rely upon them or choose instead to perform substantive testing to form their opinions. SOX dramatically changed this approach to internal control.
Managements New Responsibilities Certifications and Reports on Controls

Against this backdrop, SOX brought sweeping additions to managements responsibilities on a personal level for the process and the disclosures regarding a companys internal controls. Management Certifications Section 302 of SOX requires the principal executive and financial officers of qualifying issuers typically the CEOs and CFOs to include certain certifications with reports filed under the Securities Exchange Act of 1934, including Forms 10-K and 10-Q. The officers must, among other things, certify that they have personally reviewed the entire report, thus requiring a level of personal due diligence not previously demanded of a companys most senior officers. This pressure placed on management by Section 302 is compounded by the responsibilities added under 906 of SOX. Officers who certify financial statement reports knowing that they do not fairly present in all material respects the financial condition of the company may face criminal penalties under 906 of up to 20 years in prison and/or $5 million in fines. Section 302 also requires the senior officers to certify that together they have developed or overseen the development of internal controls designed to provide reasonable assurance of the reliability of
The Impact of Sarbanes-Oxley

SOXs internal control requirements were long preceded by passage of the Foreign Corrupt Practices Act of 1977, which for the first time made the creation and implementation of a system of internal controls over accounting and financial reporting a requirement of federal securities regulation. In 1990, significant internal control guidance was issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission in a report entitled Internal Control Integrated Framework. The COSO Report defined internal controls simply as a process to ensure accurate financial reporting and compliance with applicable laws. The so-called COSO standards established five components constituting a framework for internal controls: control environment, risk assessment, control activities, information, and communication systems and monitoring. The definition and description of controls from the COSO Report were adopted by the American Institute of Certified Public Accountants in 1997, in AU 319 of the Codification of Statements on Auditing Standards.
financial reporting in accordance with GAAP. Likewise, 302 requires management to certify that any material changes to internal controls made over the quarter are disclosed in that report, and that each officer has disclosed significant deficiencies and material weaknesses in internal controls, as well as fraud involving those with responsibility over internal controls, to the companys independent auditors and audit committee. While facing added responsibilities with respect to accurate financial statement reporting, senior officers have been required, since shortly after the passage of SOX, to provide certain certifications regarding their personal responsibility for establishing and maintaining disclosure controls and procedures a new concept under SOX and internal control over financial reporting. Pursuant to the SECs Exchange Act Rules 13a-15 and 15d-15, on a quarterly and annual basis, the senior officers must certify that together they have developed or overseen the development of disclosure controls which are designed to ensure that all material information relating to the company is made known to them. Management Reports on Internal Controls Adding to the responsibilities of management under SOX 302 and 906, 404(a) required the SEC to adopt rules mandating that public company management prepare an annual report (1) stating its responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting and (2) containing an assessment of the effectiveness thereof.2 On May 27, 2003, the SEC adopted such rules and defined internal control over financial reporting as a process to provide reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with [GAAP]. This definition encompasses the subset of internal controls in the COSO Report relating to financial reporting objectives. Under the rules adopted by the SEC, managements report, in addition to the content required by Section 404(a), must include a statement identifying the framework used to evaluate the effectiveness of internal control over financial reporting, a statement disclosing any material weakness in internal controls and a statement that a registered auditor issued an attestation report on managements assessment. Managements evaluation of the effectiveness of the companys internal control over financial reporting must be based upon a framework, such as that provided by the COSO Report, which provides a suitable, recognized control framework that is established by a body or group that has followed due-process procedures, including the broad distribution of the framework for public comment. Management is prohibited from delegating its responsibility to perform its own assessment, and may not deem internal control to be effective if there are one or more identified material weaknesses.3 In short, pressure on senior management with respect to a companys internal control has never been greater.
Auditors New Responsibilities

The increased internal control burden upon auditors is rooted in SOX Sections 404(b) and 103(a).4 On March 9, 2004, the PCAOB implemented these sections by adopting Auditing Standard No. 2 (AS No. 2), An Audit Of Internal Control Over Financial Reporting Performed In Conjunction With An Audit Of Financial Statements. Failure to conduct audits in accordance with AS No. 2 could lead to a PCAOB investigation and ultimately disciplinary sanctions, which include monetary penalties and revocation of the ability to conduct public company audits.5
The underlying theme driving AS No. 2 is that only an integrated audit an audit of a companys financial statements and of managements assessment of the effectiveness of internal control may effectively enable an auditor to express an audit opinion on either financial statements or internal controls. AS No. 2 requires that an auditor, in order to support its opinion on whether managements assessment on the effectiveness of internal control is stated fairly, must perform its own tests of controls, conduct walkthroughs of certain transactions and numerous other activities such as identifying significant accounts and documenting and reporting on controls. In a sharp departure from earlier auditing standards, auditors are now also required to test and evaluate the design effectiveness and operating effectiveness of internal controls as part of any audit. An auditor may express an unqualified opinion only if, after performing all the procedures the auditor considers necessary, no material weaknesses in internal control have been identified. In addition, an adverse opinion should be rendered on managements assessment whenever the auditor finds a material weakness that management did not. As these requirements make clear, wherever there could be a loosening of the tension placed on management with respect to internal controls, the pressure placed on auditors is there to pick up the slack.
internal control have been confusion and substantial compliance costs. Prior to the recent guidance, the SEC was required to issue several extensions for Section 404 compliance as companies struggled to bring their controls in line. The SEC also issued two Frequently Asked Questions guides Section 404 implementation, and the PCAOB likewise published four separate Staff Questions and Answers to clarify AS No. 2. Estimates of the compliance costs of SOX per issuer range from $1.6 million to $4.4 million per year.7 A recent survey also found that Section 404 compliance was the primary cause of the increase in amended filings for financial restatements due to accounting errors, which saw a 28% increase from 2003 to 2004.8 Following the first cycle of annual Section 404 reports for accelerated filers, the lingering questions and substantial costs associated with SOXs internal control rules and regulations were discussed at a roundtable hosted by the SEC on April 13, 2005.9 Company representatives, accountants, attorneys and members of the PCAOB debated the benefits, difficulties and ambiguities surrounding the new requirements. Facing increased costs stemming from increased pressure under SOX, but unsure of the level of scrutiny that would be applied by regulators to their approach to internal control assessment, companies and auditors needed a clear understanding of the SECs and the PCAOBs objectives.
SEC Internal Control Guidance to Issuers

On May 16, 2005 the SEC Staff for the Division of Corporate Finance and the Office of the Chief Accountant issued guidance on Section 404, noting that recent commentary, including from the SEC roundtable, identified implementation areas that need further attention or clarification to reduce any unnecessary costs and other burdens without jeopardizing the benefits of the new requirements.10
Confusion and Costly Compliance Lead to Guidance

We are just now beginning to see the effect of SOX internal control requirements as the SEC gave accelerated filers until November 15, 2004 and other filers until July 15, 2006 to comply.6 The immediate effects from implementation of the SECs and the PCAOBs rules and standards regarding
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The SEC Staff adopted the theme that one size does not fit all under Section 404 i.e., management can choose the internal controls approach that works best for the company. Not all internal controls must be the focus of assessment as part of managements annual review of internal controls, but rather the focus should be on those items that could result in material errors in the financial statements. The amount of testing and documentation required by management in its annual review should not be overburdensome, but rather should be guided by a standard of reasonableness, judgment and personal experience. With this background, the SEC Staffs guidance was full of suggestions for management to step back from the detail-based (and expensive), checkthe-box testing of all internal controls existing in the enterprise likely undertaken out of fear of the unknown scope of SEC enforcement of Section 404 requirements. The Staff advised, among other things, that: Management may determine that not every individual step comprising a control is required to be tested in order to determine that the overall control is operating effectively. Even though Section 404 reports must be as of year-end, management may appropriately rely upon interim testing performed throughout the year in order to conclude that the controls are effective without performing separate year-end testing. A material weakness in internal controls is both a quantitative and qualitative determination, and management should thus keep in mind that not all restatements due to errors, for example, are the result of controls deficiencies rising to the level of a material weakness.
Not all material weaknesses are the same, and because the ultimate goal when reporting such is relevant disclosure of internal control deficiencies to the public, companies may, and are strongly encouraged to, provide disclosure that allows investors to assess the potential impact of each particular material weakness. Consulting with auditors throughout the year on issues of internal control is not a per se independence violation, and frank communications by management to auditors of preliminary financial information e.g., providing auditors with draft financial statements which initially contain errors should not be considered per se internal control deficiencies. In addition to expressing support for a common sense, risk-based, no frills approach to internal control testing, the SEC Staff promised to continue to assess Section 404 with an eye towards ensuring that its benefits are achieved in a sensible and cost-effective manner.
PCAOB Internal Control Guidance to Auditors

On the same day, the PCAOB released substantive guidance to auditors regarding their internal control review obligations. The PCAOB issued a Policy Statement regarding the implementation of AS No. 2 and technical guidance in the form of Staff Questions & Answers. Like the SEC guidance, the PCAOB emphasized that auditors must employ the use of professional judgment to tailor their audit plans in a manner that addresses the nature and complexity of the audit client. One-size-fits-all audit plans driven by standardized checklists however extensive may have little to do with the unique issues of a particular client and actually reflect poor training and audit planning. Judgment must be exercised to focus an audit on areas that pose higher risks of misstatement due to error and fraud.
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Recent and Upcoming Seminars and Speaking Engagements

Partner William Baker (DC) was a featured speaker at the ABA Section of Business Law Spring Meeting held in Nashville from March 31-April 3. Partner John J. Huber (DC) appeared as a panelist on the Securities and Exchange Commissions Roundtable on Implementation of Internal Control Reporting Provisions of Sarbanes-Oxley Section 404, on April 13 in Washington, D.C. Partners David Brodsky (NY) and William Baker (DC) participated in the 2005 SIA Compliance & Legal Division Annual Seminar from April 36 in Palm Desert. Mr. Brodsky also participated as a co-chair at the 3rd National Corporate Counsels Guide to Conducting and Managing Internal & External Investigations, a program hosted by the American Conference Institute, from April 18-19 in New York. Partner Laurie Smilan (VA) participated in the 2005 Risk and Insurance Management Society Annual Conference from April 18-20 in Philadelphia. In addition, she was a featured speaker at the SEC Institutes seminar on SEC Enforcement and Litigation on May 27 in Pentagon City and PLIs 2005 Audit Committee Workshop on June 15 in New York. Partner Peter Benzian (SD) will speak at the next Select Topics For Trial Lawyers: Class Actions in California seminar on August 26 in San Diego. The seminar is sponsored by Lorman Education Services.
The Scope of SLUSAs Covered Class Action Requirement

By J. Christian Word and Dane A. Holbrook Congress enacted the Private Securities Litigation Reform Act of 1995 (PSLRA)1 and the Securities Litigation Uniform Standards Act of 1998 (SLUSA)2 to stem abusive securities class action litigation by standardizing the appointment of lead plaintiffs, heightening the pleading standards, making federal law the sole basis for liability, and designating federal courts the exclusive forum for securities fraud class actions. Despite these legislative efforts, the abuses continue through the proliferation of individual shareholder lawsuits brought in state courts based on state law that piggy-back onto the shareholder class actions filed in federal court but yet fall outside the reach of the PSLRA and SLUSA. These piecemeal, de facto class actions undermine the purpose and intent of Congress legislative reforms and impose substantial (and unnecessary) expense on public companies. The solution is obvious: Congress should amend SLUSA to make federal courts the exclusive venue for all lawsuits involving nationally traded securities.3 securities litigation was investordriven, as opposed to lawyerdriven.5 In addition, the PSLRA requires that the securities fraud claims be pled with particularized facts describing the alleged fraud in precise detail and each defendants involvement.6 In the years after the PLSRAs enactment, securities plaintiffs were able to evade its reforms, and thereby subvert Congress intention, simply by bringing their class actions in state court and under state law where the PSLRA did not apply. Congress enacted SLUSA in 1998 to put an end to this practice. As its name reflects, SLUSA was intended
The Statutory Reforms

Congress enacted the PSLRA to eliminate securities fraud strike suits.4 It did so, in part, with a procedural reform and a substantive pleading reform. Procedurally, the PSLRA vests control of the litigation in a lead plaintiff to ensure that
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to create uniform standards for class actions alleging fraud in the purchase or sale of nationally marketed securities by designating federal courts as the exclusive venue for such class actions, and that the claims be governed exclusively by federal law.7 Defendants to a securities class action improvidently brought in state court are empowered under SLUSA to remove the action to federal court for dismissal. However, rather than completely preempt state law with respect to all fraud actions concerning securities purchased on our national securities markets, Congress predicated SLUSA preemption on the number of persons who bring the action (or actions). This covered class action limitation makes securities fraud claims the exclusive province of federal courts and federal law only where the action is brought on behalf of more than 50 persons (either as a single lawsuit or as a group of lawsuits pending in the same court and proceeding as a single action).8 In other words, an individual plaintiff could still avoid the PSLRA by filing in state court and any number of individuals could do so as long as they strategically limited the total number of persons filing in any one court. Hence, Congress perhaps well-intentioned desire to preserve individual state suits has permitted plaintiffs to undermine the overarching objective to standardize mass actions asserting fraud claims against the nations public companies.
officers and directors is that they are forced to litigate parallel actions in multiple jurisdictions with varying pleading standards. Moreover, the defendants face the risk of inconsistent judicial rulings on discovery, evidentiary and other legal issues that can dramatically impact the outcome of the case. A recent example of this behavior is the WorldCom litigation.9 There, the court noted that after losing its motion for appointment as lead plaintiff and lead plaintiffs counsel, the one law firm engaged in an active campaign to encourage pension funds not to participate in the class action and instead to file individual actions with [the firm] as their counsel. This campaign resulted in the firm fil[ing] at least forty-seven Individual Actions on behalf of over one hundred and twenty pension funds. The burden on the parties and the court system from this strategy of conducting a parallel, quasi class action has been enormous, observed the court, resulting in the expenditure of significant resources by the defendants and placing a significant burden on Lead Counsel for the class who had to correct misinformation about the options available to putative class members. The individual actions against the WorldCom defendants were based upon the same underlying conduct and sought the same relief as the federal class action, relief the individual could have obtained by participating in the federal class action. Regardless of the ultimate outcome of these individual actions, the WorldCom defendants were faced with the added expense and burden posed by the duplicative litigation. These new, copy-cat actions are simply a different variety of the mass actions Congress sought to standardize through SLUSA. However, this new variety of mass actions is not subject to SLUSA unless (1) plaintiffs imprudently trigger preemption by filing a suit that satisfies SLUSAs covered class action requirement, or (2) federal courts otherwise have jurisdiction over state court actions.
Dane A. Holbrook
The Emergence Of Abusive Individual Actions

With an open invitation to state courts for securities fraud suits by individuals, it did not take long before plaintiffs figured out how to RSVP to their benefit. Indeed, plaintiffs quickly recognized that they could maintain state court actions that were a virtual carbon copy of the federal class action but only brought under state law so long as they limited the number of participants. This was especially the case for plaintiffs that, filed a federal complaint but were not appointed lead plaintiff. The result for the defendant company and its
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is thus not a covered class action under SLUSA, and that Defendants have failed to show otherwise. Accordingly, the Enron court held that the defendants removal was improper because the case involved only eight plaintiffs and the defendants failed to link their action to the consolidated Enron class action. SLUSA permits the result in Enron. It allows individual shareholder actions (i.e., suits involving 50 or fewer plaintiffs) brought in a state court based on state law that mirror a shareholder class action filed in federal court. Prudent plaintiffs firms are likely to follow the model of Enron and thereby avoid triggering SLUSA preemption. In WorldCom, the court held that SLUSA preempted a group of 10 separate lawsuits filed by the same attorneys in separate state courts that asserted identical securities fraud claims. Each of the 10 actions in Worldcom was brought on behalf of between five and fortyeight plaintiffs, asserted exclusively state securities fraud and negligence claims against, inter alia, officers and directors of the bankrupt corporation WorldCom, and explicitly renounced federal causes of action. The 10 actions were removed to federal court as they related to the WorldCom bankruptcy, and then were formally consolidated for pretrial purposes. Moving to dismiss, the defendants argued that SLUSA preempted the actions as covered class actions. The WorldCom court agreed, dismissing the 10 actions with prejudice. The court determined that the 10 actions constituted a group of lawsuits that were removable to federal court under SLUSA because the aggregated actions: were brought on behalf of more than 50 persons, involved common questions of fact, were pending in the same court, and were formally consolidated for pretrial purposes. Importantly, the predicate for finding federal jurisdiction in Worldcom rested not on the application of the federal securities laws
The deficiency in SLUSAs scope is highlighted in two of the only decisions that have directly addressed SLUSAs covered class action requirement. In In re Enron Corporation Securities, Derivatives & ERISA Litigation (Enron),10 the plaintiffs strategically circumvented SLUSA by filing an individual state action that mirrored the Enron class action but nevertheless involved fewer than 50 plaintiffs. In In re WorldCom, Inc. Securities Litigation (WorldCom),11 although the court ultimately found that SLUSA preempted the plaintiffs state law claims, the predicate for finding federal jurisdiction was federal bankruptcy law rather than the federal securities law. In Enron, eight insurance and investment companies brought a securities suit in state court against, inter alia, certain Enron officials alleging violations of Texas law. The defendants removed the case to federal court, arguing the case was preempted by SLUSA because it had been consolidated with other similar Enron-related suits in state court, and because it arose of the same nucleus of operative facts, i.e., securities claims against Enron officials and auditors . . . . Following removal of the case to federal court and consolidation with a pending federal securities class action against Enron, the plaintiffs moved to remand the case back to state court because, they asserted, the defendants failed to satisfy the covered class action requirement of SLUSA. The Enron court agreed with the plaintiffs, concluding that it lacked federal jurisdiction over the plaintiffs state court petition. According to this court, the petition: was not brought on behalf of any other similarly situated plaintiffs, no less 50 persons or prospective class members, was not consolidated by the state court judge with any other Enron securities state court suits, and
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Endnotes:
1
Pub. L. 104-67, 109 Stat. 737 (1995) (codified in part at 15 U.S.C. 78u). Pub L. No. 105-353, 112 Stat. 3227 (1998) (codified at 15 U.S.C. 77p(b), 78bb(f)(1)). S. REP. NO. 105-182, at 2-3 (1998). See also H.R. CONF. REP. NO. 105-803, at 15 (1998) (noting that the solution to the problem of disparate state liability regimes was to make Federal court the exclusive venue for most securities fraud class action litigation involving nationally traded securities). Spielman v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 332 F.3d 116, 122 (2d Cir. 2003). In re Initial Pub. Offering Sec. Litig., No. 21 MC 92, 2002 U.S. Dist LEXIS 23823 (S.D.N.Y. Dec. 12, 2002). See also S. REP. NO. 104-98 at 4 (1995) (the purpose of the PSLRA is to empower investors so that they -- not their lawyers -- exercise primary control over private securities litigation). Spielman, 332 F.3d at 122. Id. at 123-24. See also In re WorldCom, Inc. Sec. Litig., 308 F. Supp. 2d 236, 244 (S.D.N.Y. 2004). 15 U.S.C. 77p(f)(2)(A). SLUSA exempts certain categories of actions from being considered covered class actions. For instance, SLUSA preserves state court actions not involving publicly traded securities. THOMAS LEE HAZEN, 1 THE LAW OF SECURITIES REGULATION 12.15[2], at 602 (4th ed. 2002). It also safeguards certain state court actions brought under the laws of the issuers state of incorporation, and class actions by states and their political subdivisions and by state pension plans. 15 U.S.C. 77p(d). In addition, derivative actions are expressly excluded from the category of covered class actions. Id. 78bb(f)(2)(B). In re WorldCom, Inc. Sec. Litig., Alaska Electrical Pension Fund v. Citigroup, Inc., et al., Nos. 02 Civ. 3288 (DLC), 03 Civ. 8269, 03 Civ. 8923, 03 Civ. 9168, 03 Civ. 9400, and 03 Civ. 9401, 2004 WL 113484, at *3 (S.D.N.Y. Jan. 26, 2004). No. G-02-0084, 2002 WL 32151695, at *1 (S.D. Tex. Jul. 19, 2002). See also In re Enron Corp. Securities, Derivatives & ERISA Litigation, No. MDL-1446, 2002 WL 32107216, at *2-*5 (S.D. Tex. Aug. 12, 2002). 308 F. Supp. 2d 236 (S.D.N.Y. 2004).
to a group of lawsuits affecting nationally traded securities, but rather on applying the federal bankruptcy laws. The Enron and Worldcom decisions demonstrate that plaintiffs are subverting Congress intended reform. Even after SLUSA, sophisticated plaintiffs firms are migrating to state court with actions affecting nationally traded securities some with individual actions (e.g., Enron), and others with disaggregated class actions filed as multiple actions across various jurisdictions (e.g., Worldcom). This migration frustrates any goal of uniformity, as state law actions that mirror federal securities class actions may fall outside the reach of the PSLRA and SLUSA. It also undermines Congress intent to create an atmosphere of fair and efficient securities litigation, subverts the core purpose of the PSLRA to impose heightened pleading requirements, decreases judicial economy, and increases the litigation burdens on public company defendants.
Conclusion
SLUSA is deficient. Confronted with dimmed prospects of success in securities fraud actions after the PSLRA and SLUSA, plaintiffs lawyers are carefully designing suits to avoid the designation covered class action. SLUSAs limited scope allows this. If uniformity is the goal in actions affecting nationally traded securities, then why does SLUSA sanction a private enforcement system that operates through concurrent state and federal jurisdiction? SLUSA should foreclose all securities actions affecting nationally traded securities not just covered class actions from proceeding in state court.
9
10
11
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announced the companys discovery of more than $42 million in improperlyrecognized revenue. After the announcement, McKessons Audit Committee, with the assistance of counsel, conducted an internal investigation to review its accounting policies and to prepare for the inevitable shareholder lawsuits. McKessons counsel met with representatives of the SEC, and informed them that McKesson would be willing to share the results of the internal investigation, including its investigation report and back-up materials such as interview memoranda. McKesson then entered into a confidentiality agreement with the SEC. The confidentiality agreement stated that McKesson had a common interest with the SEC and that the production of the materials would not waive any applicable work product protections or the attorney-client privilege. The SEC agreed that it would keep the materials confidential, except to the extent that the SEC Staff determines that disclosure is otherwise required by federal law or in furtherance of the Commissions discharge of its duties and responsibilities. McKesson entered into a similar agreement with the U.S. Attorney. McKesson then produced the report and backup materials to both the U.S. Attorneys Office (USAO) and the SEC pursuant to these agreements. Shareholders pursuing claims in California, Georgia and Delaware state courts, and plaintiffs in federal securities class action cases, consolidated in the Northern District of California, sought the production of the materials provided to the SEC and USAO. Former McKesson executives facing federal prosecutions in the Northern District of California also sought the materials. The Recent Northern District of California Decision The most recent court to address the issue on the merits was the Northern
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District of California. In In re McKesson HBOC, Inc. Securities Litigation, 2005 U.S. Dist. LEXIS 7098 (N.D. Cal. Mar. 31, 2005), the court (Judge Ronald M. Whyte) held that federal securities plaintiffs and plaintiffs in an ERISA action were not entitled to the report and back-up materials. The court first determined that the documents were not protected by the attorney-client privilege, because at the time the documents were created and communicated, McKesson intended to disclose the information to a third partythe SEC and USAO. The parties conceded that the materials were protected by the work product doctrine. The issue was whether the production of the materials to a third party waived the work product privilege. McKesson first argued that the disclosure of these materials retained their protection under the common interest doctrine. Under this widelyaccepted doctrine, work product protection is not waived by the mere sharing of information between parties that have a common interest or joint defense. The court rejected this argument, finding that the SEC and USAO were at least potential adversaries. The court noted that although the agreements with the SEC and USAO stated that McKesson was not a target of the investigation, the government reserved the right to change its position. The court also pointed to the facts that the SEC issued a formal order of investigation and a Wells notice to the company. McKesson next urged that the court adopt the selective waiver doctrine. The court recognized that the doctrine was not accepted in the majority of jurisdictions, and that the doctrine normally lacks merit as a party could pick and choose when a document is protected. However, the court found that an exception should exist for disclosure to governmental entities. The court found that such a rule would encourage cooperation with the government, and would benefit the entire public from an increase in the governments

enforcement capabilities. The court also determined that the doctrine would further the truth-finding process, which is the aim of the work product doctrine. After adopting the doctrine, the court further found that McKessons agreements with the USAO and the SEC were sufficient to ensure the materials remained confidential as to all other parties. The court also determined that fairness did not require production to shareholder plaintiffs, as McKesson was not using the documents as a sword and shield. The Ninth Circuit Left the Door Open to the Selective Waiver Doctrine Only a few days after Judge Whytes decision, the Ninth Circuit issued its opinion as to whether former executives of McKesson, indicted for securities and mail and wire fraud, should have access to the materials provided to the government. The lower court, Judge Martin J. Jenkins of the Northern District, had rejected the selective waiver doctrine, finding that it is inherently unfair to permit an entity to choose to disclose materials to one outsider while withholding them from another on grounds of privilege. U.S. v. Bergonzi, 216 F.R.D. 487 (N.D. Cal. 2003). McKesson appealed to the Ninth Circuit. Rather than deciding the issue on the merits, the Ninth Circuit determined that the appeal was moot as the criminal defendants had gained access to the documents. U.S. v. Bergonzi, 403 F.3d 1048 (9th Cir. 2005). Although the appeal was dismissed, the per curiam opinion offered a glimmer of hope, stating that the selective waiver doctrine in the Ninth Circuit is an open question. The State Courts Split State courts in California, Georgia and Delaware have also debated the issue of the selective waiver doctrine as it applies to the McKesson materials. In California, the First Appellate District refused to adopt the selective waiver doctrine. The
court expressed doubt as to the policy arguments in favor of the doctrine, stating that it was not sure if future investigative targets will be reluctant to share protected documents if disclosure was ordered. However, the court declined to adopt the doctrine, as there was no statutory support for the doctrine, and any policy determination was the province of the legislature, not the court. Thus, the court affirmed the trial courts decision to order the materials produced. McKesson HBOC, Inc. v. The Superior Court, 115 Cal. App. 4th 1229 (2004). The state courts in Georgia reached a similar result. The Georgia Court of Appeals determined that work product was waived, as there was no common interest and because the confidentiality agreements were illusory. McKesson Corp. v. Green, 266 Ga. App. 157 (2004). On appeal, the Georgia Supreme Court affirmed, and actually stated that allowing a selective waiver may hinder the operation of the work-product doctrine because outside counsel conducting the investigation may hesitate to pursue unfavorable information or legal theories since that information would then be disclosed to the government. McKesson Corp. v. Green, 279 Ga. 95 (2005). The Delaware Chancery Court, in a well-reasoned decision by Chancellor William B. Chandler, III. , reached the opposite result, and refused to order the McKesson documents produced to a shareholder who instituted a corporate books and records proceeding. The court found that selective waiver benefits law enforcement agencies, and allows the SEC to resolve its investigations expeditiously and efficiently. The court then found that the efficiencies and cost savings would in turn benefit the investing shareholder, because the integrity of the capital markets would be preserved at a lower cost to society. The court also flatly rejected any unfairness argument, as it could see no reason why confidential disclosure to the government should result in disclosure to a plaintiff. (I know of no good reason
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Although this application of Wright seems to create a broad sphere of liability for secondary actors, the court does narrow that liability somewhat by noting that the plaintiffs dealt with and paid fees directly to the defendants, not just Ernst & Young, and by requiring that the statements at issue be publicly attributable to the defendants. In this case, the plaintiffs did allege facts showing that they were aware of Sidley Austins participation in the transaction and that the representations were made by it and the other defendants, albeit through Ernst & Young.
Third Circuit
In Rowinski v. Salomon Smith Barney Inc., 398 F.3d 294 (3d Cir. 2005), the Third Circuit addressed Securities Litigation Uniform Standards Act (SLUSA) preemption by considering specifically whether the complaint alleged both a material misrepresentation and, if so, whether the misrepresentation was in connection with the purchase or sale of a covered security. The complaint alleged that Salomon Smith Barney (SSB) artificially inflates the ratings and analysis of its investment banking clients [in order to] curry favor with investment banking clients and reap hundreds of millions of dollars in investment banking fees. The complaint was filed in Pennsylvania state court and sought relief under various state law theories. SSB removed and filed a motion to dismiss based on SLUSA preemption. The trial court granted the motion, and the Third Circuit, holding that the claims were preempted because both the misrepresentation and in connection elements were satisfied, affirmed.
The court held that the misrepresentation prong of SLUSA was satisfied because the allegations of a material misrepresentation served as the factual predicate of a state law claim. [P]reemption does not turn on whether allegations are characterized as facts or as essential legal elements of a claim, but rather on whether the SLUSA prerequisites are alleged in one form or another. The in connection issue turned on whether plaintiffs class-wide allegations, charging [SSB] with systematically and materially misrepresenting its investment banking clients investment ratings and analyses, [were] connected to the purchase or sale of securities. In concluding that they were, the court cited SEC v. Zandford, 535 U.S. 813 (2002), which held that the in connection element should be read broadly, and the connection is established where a fraudulent scheme and a securities transaction coincide. The Rowinski court applied four non-exclusive factors in determining that the claim was preempted: [F]irst, whether the covered class action alleges a fraudulent scheme that coincides with the purchase or sale of securities; second, whether the complaint alleges a material misrepresentation or omission disseminated to the public in a medium upon which a reasonable investor would rely; third, whether the nature of the parties relationship is such that it necessarily involves the purchase or sale of securities; and fourth, whether the prayer for relief connects the state law claims to the purchase or sale of securities. In applying these factors, the court concluded that the plaintiffs complaint was in fact preempted by SLUSA, and was properly dismissed.
Delaware
In VantagePoint Venture Partners 1996 v. Examen, Inc., 2005 Del. LEXIS 179 (May 5, 2005), the Delaware Supreme Court held that applying a provision of the California Corporations Code, with specific requirements regarding mergers, to a Delaware Corporation would be unconstitutional. The plaintiff, VantagePoint Venture Partners, an 83% holder of Examen, Inc. preferred stock, sought to rescind a merger between Examen and Reed Elsevier. VantagePoint argued that because Examen was a quasi-California corporation under California Corporations Code 2115, the merger required an approval by a majority of each class of stock, and Examen did not obtain such approval. (California Corporations Code 2115 provides that, irrespective of the state of incorporation, foreign corporations articles of incorporation are deemed amended to comply with California law and are subject to the laws of California if certain criteria are met.) Examen, which was incorporated under the laws of Delaware, argued that the California Corporations Code was inapplicable. Examen further argued that under Delaware law, all that was required was a majority vote by all of the outstanding shares of capital stock, and therefore, the merger was valid. The Delaware Supreme Court refused to apply California law, and held that only Delaware corporate laws apply to matters involving the internal affairs of Delaware corporations. The Court found that, under the well-established internal affairs doctrine, only the law of the state of incorporation governs and determines issues relating to a corporations internal affairs. The doctrine applies to matters that pertain to relationships among or between the corporation and its officers, directors and shareholders.
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The court found that the doctrine is not only a conflicts of law principle, but a constitutional principle as well. First, under the Due Process Clause, directors have a right to know by what standards of accountability they should be governed. Second, the court found that under the Commerce Clause, a state has no interest in regulating the internal affairs of foreign corporations. The court determined that applying California Corporations Code 2115 would violate these principles. The court also found that internal affairs require uniformity, and applying California law would prevent such uniformity, cause confusion and create inequalities. The court therefore held that choice of law rules and the U.S. Constitution mandate that Examens internal affairs, and in particular, VantagePoints voting rights, be adjudicated exclusively under the laws of Delaware. The court therefore affirmed the Chancery Courts decision granting judgment on the pleadings to Examen.
In EBC I, Inc. v. Goldman, Sachs & Co., the New York Court of Appeals held for the first time that an underwriter owes a fiduciary duty to reveal any conflict of interest to an issuer when serving as an expert advisor in an IPO.
agreement, eToys agreed to pay Goldman the spread between the IPO price and the price charged to Goldman and the other underwriters. The IPO price was ultimately set at approximately $20 per share, and eToys sold the shares to Goldman and the other underwriters for $18.65 a share. Goldmans potential profit under this arrangement, therefore, was 6.75% of the total IPO proceeds, or approximately $13 million. As alleged by eToys, Goldman also entered into a set of sales arrangements with the purchasers of eToys stock, whereby the purchasers were bound to pay Goldman between 20-40% of any profits they enjoyed resulting from an increase in the IPO price. Goldman never disclosed to eToys this arrangement with the purchasers, which eToys alleged gave Goldman an incentive to keep the IPO offering price low. On the first day of public trading, the stock opened at $79 per share and the price went as high as $85 per share. By the end of 1999, however, the price had fallen back to $25 per share and it soon fell below the IPO price of $20 per share. The stock price never rose above the IPO price again and eToys filed for bankruptcy in March of 2001. The Court of Appeals affirmed the Appellate Divisionss decision that eToyss claim for breach of fiduciary duty should proceed. The court concluded that while the underwriting agreement itself did not create a fiduciary relationship between the parties, eToys had sufficiently pled such a relationship by alleging that Goldman had acted as an expert advisor regarding the IPO price. The court noted that a cause of action for fiduciary duty may survive, for pleading purposes, where the complaining party sets forth allegations that, apart from the terms of the contract, the underwriter and issuer created a relationship of higher trust than would arise from the underwriting agreement alone. The court further concluded that Goldmans failure to disclose its fee arrangement with the purchasers of eToys stock gave eToys the false impression that Goldmans interests were aligned with its own and may have constituted a breach of this fiduciary relationship. The court rejected Goldmans assertion that requiring an underwriter to disclose potential conflicts of interest in the pricing of the securities it is underwriting would run counter to the underwriters general duty to exercise due diligence in the preparation of a registration statement. The court was careful to point out, however, that an underwriters fiduciary duty to an issuer in this context was limited to the underwriters role as advisor, and does not apply when the underwriter is engaged in activities other than rendering expert advice.
New York
In EBC I, Inc. v. Goldman, Sachs & Co., 2005 WL 1346859 (N.Y. June 7, 2005), the New York Court of Appeals held for the first time that an underwriter owes a fiduciary duty to reveal any conflict of interest to an issuer when serving as an expert advisor in an IPO. The plaintiff, the Official Committee of Unsecured Creditors of EBC I., Inc., formerly known as eToys, Inc. (eToys), brought a claim against Goldman, Sachs & Co. (Goldman), the lead managing underwriter of its IPO, alleging several causes of action under state law related to the underwriting agreement, including breach of fiduciary duty. Pursuant to the underwriting
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Supreme Court In Dura Pharmaceuticals Unanimously Endorses Loss Causation Requirement in Fraud-on-the-Market Cases
price was inflated due to the defendants alleged fraud, but not that the price fell following a corrective disclosure.
The Ninth Circuits Decision in Dura

The plaintiffs alleged that Dura Pharmaceuticals artificially boosted the price of its stock at the beginning of the alleged class period by misrepresenting the prospects for Food and Drug Administration (FDA) approval of its asthma-spray device. The plaintiffs sued when the stock price dropped after Dura announced lower than expected earnings due to slow drug sales, even though the truth about the FDA approval was not disclosed. It was not until eight months later, after the close of the class period, that Dura disclosed that the FDA failed to approve the asthmaspray device. Plaintiffs sole allegation regarding their economic loss was that they had paid artificially inflated prices for Dura securities. The Ninth Circuit accepted this allegation as sufficient to plead loss causation.
but that loss is not attributable to the misstatements because the decline is unrelated to the inflation. Moreover, even after the relevant truth is learned by the market, a lower price may reflect, not the earlier misrepresentation, but changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions or other events. Thus, at most, an initially inflated purchase price might mean a later loss. Second, the court concluded that the price inflation theory of loss causation has no historical support in the common law of fraud and deceit on which the federal anti-fraud securities statutes are based. The judicial consensus, as reflected in the Restatement of Torts, is that a person who misrepresents the financial condition of a corporation in order to sell its stock is liable for the loss sustained by the purchaser when the facts become generally known and, as a result, share value depreciates. Given the common-law roots of the securities fraud class action, the court observed that it is not surprising that the other courts of appeals have rejected the Ninth Circuits inflated purchase price approach to proving causation and loss. Third, the court found that the price inflation theory was inconsistent with the purpose of the federal securities statutes. These statutes seek to maintain public confidence in the marketplace. They are not to provide investors with broad insurance against market losses that are not caused by defendants misrepresentations. The Ninth Circuits approach would allow recoveries where a misrepresentation leads to an inflated purchase price but nonetheless does not proximately cause an investors economic loss as, for instance, when a drop in stock price is caused by factors other than disclosure of the truth. In Dura, the truth about FDA approval was not known at the close of the alleged class period. Rather, the drop in stock price that the plaintiffs sought to recover followed an announcement of other unrelated negative developments
The Supreme Courts Decision in Dura

The Supreme Court, in a short and unanimous opinion authored by Justice Stephen Breyer, held that in fraud-onthe-market cases such as Dura, an inflated purchase price will not itself constitute or proximately cause the relevant economic loss. The decision rests on three points. First, the court rejected the notion that mere price inflation means that the investor has suffered an economic loss. For one thing, the court observed, as a matter of pure logic, at the moment the [stock purchase] takes place, the plaintiff has suffered no loss; the inflated purchase payment is offset by ownership of a share that at that instant possesses equivalent value. An investor who sells the stock before the truth is disclosed may suffer a loss if the price declines,
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Supreme Court In Dura Pharmaceuticals Unanimously Endorses Loss Causation Requirement in Fraud-on-the-Market Cases
about Duras business. Thus, the plaintiffs could not demonstrate loss causation. One may wonder why the plaintiffs simply did not extend the class period until the disclosure of the news about FDA approval. The answer appears to be that they would not have been able to demonstrate damages under the Private Securities Litigation Reform Act (PSLRA). When the truth was revealed, Duras stock price momentarily dipped but then quickly recovered. Under the PSLRAs so-called 90-day bounce-back provision, this meant that the plaintiffs likely did not suffer any recoverable damages.
The Supreme Court, in a short and unanimous opinion authored by Justice Stephen Breyer, held that in fraud-on-the-market cases such as Dura, an inflated purchase price will not itself constitute or proximately cause the relevant economic loss.
defense argument that the absence of any negative market reaction to disclosure of the truth establishes that the alleged misrepresentation was not material and, therefore, not actionable. One aspect of the courts decision, however, may be welcomed by plaintiffs. Because Dura was dismissed at the pleading stage, the court considered the level of detail at which plaintiffs must plead loss causation. The court assume[d], rather than held, that neither the [Federal] Rules nor the securities statutes impose any special further requirement for pleading loss causation. As a result, the court evaluated the complaint pursuant to the short and plain statement pleading standard of Rule 8 of the Federal Rules of Civil Procedure. The court observed that, measured only by the requirements of Rule 8, it should not prove burdensome for a plaintiff who has suffered an economic loss to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind. It will be left to the lower courts to decide whether lenient Rule 8 or the heightened pleading requirements of Rule 9(b) (governing allegations of fraud) or the PSRLA (governing securities fraud cases) are applicable to allegations of loss causation. Because most securities fraud class actions are decided at the pleading stage, the standard adopted by the lower courts for loss causation will affect whether at least some securities fraud class actions survive the pleading phase. In the end, while courts and commentators still have plenty of issues to wrestle with in the wake of Dura, the decision is a significant victory for public companies and others named as defendants in securities fraud cases.
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What is the Effect of the Dura Decision?

The Supreme Courts rejection of the price inflation theory of loss causation may have the greatest effect in the Ninth and Eighth Circuits. There, the Dura decision closes the door to a speculative genre of stock drop class actions in which plaintiffs need not plead any loss in stock value due to a defendants alleged fraud. In all jurisdictions, however, the lasting impact of the Dura decision will depend on how parties use and courts interpret the Supreme Courts reasoning. The Supreme Courts embrace of the logical consequences of the efficient market theory strongly supports certain defense arguments in fraud-on-themarket cases. The court perceptively noted that even a decline in stock price after the truth is revealed may not necessarily be attributable to the alleged misrepresentation where other factors are operating on the market price. This supports the long-standing argument that defendants are not liable for the portion of a drop in stock price attributable to factors unrelated to an alleged corrective disclosure. The courts reasoning also seems to support the
Furthermore, explained the PCAOB, AS No. 2 was designed to be implemented from the top down first on company-level controls and then on significant accounts, which lead the auditor to significant processes and, finally, individual controls at the process, transaction, or application levels. As a result, auditors should employ a risk-based approach to increase audit quality and reduce costs and, as part of the risk-assessment, auditors should consider the strength of companylevel controls (which include general and disciplinary controls and those performed on a companywide basis).11 The PCAOB also reemphasized that relying upon the work of others is appropriate and often the most efficient way to avoid unnecessary repetition, minimize costs and ensure that high-risk areas remain the focus of an audit. In addition, as long as management makes its own decisions regarding the application of accounting principles, auditors may freely discuss difficult accounting and internal control issues with management throughout the fiscal year. Indeed, timely information-sharing including sharing draft financial statements is necessary under AS No. 2. The accompanying PCAOB Staff Q&A explained that auditors need not test all controls but instead should obtain evidence about the effectiveness of controls for all relevant assertions related to significant accounts and disclosures in the financial statements. Furthermore, there is no
requirement to perform a quarterly audit of internal control. Rather, auditors need only perform, on a quarterly basis, those procedures generally limited to focusing on the implications of any identified financial misstatements. The PCAOBs release therefore mirrored the SECs guidance that internal control testing should be, in effect, smarter, but not necessarily prohibitively extensive and expensive.
Endnotes
1
U.S. General Accountability Office, Financial Audit, Securities and Exchange Commissions Fiscal Year 2004 Financial Statements (May 2004), available at http://www.gao.gov/new.items/d05244.pdf. See 15 U.S.C. 7262(a). See 17 C.F.R. 229.308. See SOX 103(a)(2)(A)(iii), 15 U.S.C. 7213(a). See PCAOB Release No. 2003-015, Rules on Investigations and Adjudications (September 29, 2003). See SEC Release No. 33-8238, at III.E; Extension of Compliance Dates for NonAccelerated Filers and Foreign Private Issuers Regarding Internal Control Over Financial Reporting Requirements, SEC Press Release No. 2005-25 (March 2, 2005). See Carl Bialik, How Much Is It Really Costing to Comply With Sarbanes-Oxley?, The Wall Street Journal Online (June 16, 2005). See 2004 Annual Review of Financial Reporting Matters, Huron Consulting Group (March 25, 2005), available at http://www.huronconsultinggroup.com/librar y.asp?id=16&archiveID=on&view=papers. See SEC Release No. 2005-74 (Commission Statement on Implementation of Internal Control Reporting Requirements, May 16, 2005). See SEC Staff Statement on Managements Report on Internal Control Over Financial Reporting (May 16, 2005), available at http://www.sec.gov/info/accountants/stafficre porting.htm. See PCAOB Auditing Standard No. 2, An Audit Of Internal Control Over Financial Reporting Performed In Conjunction With An Audit Of Financial Statements 52-54 (March 9, 2004). This article includes contributions made by Houman B. Shadab.
Conclusion
The recent guidance from the SEC and PCAOB may serve to alleviate some of the pressure felt by management and auditors to test and document every aspect of internal control where such activities may be redundant or irrelevant to financial reporting. Of course, by encouraging the greater use of professional judgment in areas such as choosing risk-based controls to test, relying upon the work of others or focusing assessments and audits towards controls likely to have a material impact upon financial statements, the recent guidance leaves the door open for such judgment to be held to the scrutiny of hindsight. Although broad and promising, the usefulness of the guidance will best be gauged, as the GAOs report on the SECs own internal controls indicates, by continuing to watch for further experiences of those entities that are struggling with the difficulties and ambiguities inherent in 404 implementation.
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Recent Victories
In re EMCOR Group, Inc. Sec. Litig.

On July 22, Latham won a motion to dismiss on behalf of clients EMCOR Group, Inc., and three of its senior executives, in a shareholder class action suit in federal court in Connecticut. In re EMCOR Group, Inc. Sec. Litig., Civil Action No. 304-cv-531 (JCH) (D. Conn. July 22, 2005). The plaintiffs claimed that the companys earnings guidance, while accompanied by significant risk warnings, was shown to be false when defendants failed to meet their forecast and supposedly admitted challenges that had not previously been disclosed. Judge Janet Hall rejected the plaintiffs allegations, holding that the plaintiffs failed to demonstrate that any of the challenged statements were false. Judge Hall observed that the complaint had quoted certain of the defendants statements out of
context, and that the defendants purported later admissions of the reasons why they did not meet their forecasts did not show that any of the challenged statements was false when made. Lathams team partners was led by Michele Rose (VA) and Laurie Smilan (VA).
Brazen v. Tyco International Ltd.

On July 22, 2005, in Brazen v. Tyco International Ltd., Case No. 02 CH 11837, the Circuit Court of Cook County, Illinois, dismissed Section 11 and 15 claims brought against the former outside directors of Tyco International Ltd. (Tyco) by former shareholders of the stock of Mallinckrodt, Inc. (MLKT) who received Tyco shares in exchange for shares of MLKT when the two companies merged in 2000. The plaintiffs filed their claims in state court in 2002, the case was removed to federal court, and remanded back to state court. After remand, the outside director defendants moved
to dismiss the state court action for lack of personal jurisdiction. The Illinois Court granted the individual defendants motion to dismiss with prejudice. The plaintiffs had asserted that the nationwide service of process provision of the 1933 Act, 15 U.S.C. 77v(a), granted state court jurisdiction over the individual defendants. Judge Thomas P. Quinn rejected this argument, holding that the language of the provision limits jurisdiction to federal district courts regardless of whether it permits nationwide service. The court held that even if the plaintiffs interpretation of the statute were correct, the court could not exercise jurisdiction over the individual defendants because the plaintiffs did not allege that they had sufficient minimum contacts with Illinois to satisfy due process. The team was led by partners Laurie Smilan (VA) and Janet Link (CH) and associates Marguerite Sullivan (VA), Mike Faris (CH) and Allison ONeill (CH).

why an opponent should borrow the wits of its adversary simply because the adversary was cooperating with a law enforcement agency.). Ultimately, the court adopted the doctrine, stating that such a rule was in the best interests of the shareholders to encourage corporate compliance, and because law enforcement agencies were the first line of defense for shareholders. Saito v. McKesson HBOC, Inc., 2002 Del. Ch. LEXIS 125 (Oct. 25, 2002).
state court and Georgia state court plaintiffs, and the criminal defendants, all have access to the McKesson report and back-up materials. Meanwhile, federal securities plaintiffs and Delaware shareholders seeking to institute litigation are not entitled to the exact same materials. Access to these materials depends solely on where the action was brought. Whether a company should provide privileged materials to government agencies is a business decision requiring a cost-benefit analysis. The uncertainty in the law makes it that much harder for companies to make this decision. The McKesson cases offer guidance as to which arguments may be the most
compelling to courts that continue to struggle with the selectivewaiver doctrine. These cases also suggest the importance of obtaining as restrictive a confidentiality agreement as possible with the SEC and USAO. More than anything, the McKesson cases demonstrate a need for a legislative solution. In absence of legislative action, however, the current state of the law suggests that at least some shareholder plaintiffs will gain access to any privileged materials provided to the SEC or USAO.
What to Do
Ultimately, all of these decisions create a startling result. California
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Chicago
Kevin A. Russell 312-876-7700 kevin.russell@lw.com
New York
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San Diego
Michael J. Weaver 619-236-1234 mike.weaver@lw.com
Frankfurt
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Northern Virginia
Laurie B. Smilan 703-456-1000 laurie.smilan@lw.com
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Peter A. Wald 415-391-0600 peter.wald@lw.com
London
John A. Hull +44-20-7710-1000 john.hull@lw.com
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Boletim Sobre Litigância em Seguros

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Boletim Sobre Litigância em Seguros

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Newsletter

Second Quarter 2005

Securities Litigation and Professional Liability Practice

Inside This Issue:

The Introduction of a Class Action Light in Germany

What is Loss Causation and Does it Matter?

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Circuit and State Round-Up

The Selective Waiver Doctrine and the McKesson Cases

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Circuit and State Round-Up

The Selective Waiver Doctrine and the McKesson Cases

The McKesson Cases

Securities Litigation and Professional Liability Practice, Second Quarter 2005

The Introduction of a Class Action Light in Germany

Compared to U.S. Class Actions, it is Class Action Light

Introduction of Entirely New Proceedings

Securities Litigation and Professional Liability Practice, Second Quarter 2005

The Introduction of a Class Action Light in Germany

Does the Master Proceedings Act Really Reduce Plaintiffs Risks?

Does the Master Proceedings Act Really Simplify the Proceedings?

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Managements New Responsibilities Certifications and Reports on Controls

The Impact of Sarbanes-Oxley

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Auditors New Responsibilities

Securities Litigation and Professional Liability Practice, Second Quarter 2005

SEC Internal Control Guidance to Issuers

Confusion and Costly Compliance Lead to Guidance

Securities Litigation and Professional Liability Practice, Second Quarter 2005

PCAOB Internal Control Guidance to Auditors

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Recent and Upcoming Seminars and Speaking Engagements

The Scope of SLUSAs Covered Class Action Requirement

The Statutory Reforms

Securities Litigation and Professional Liability Practice, Second Quarter 2005

The Scope of SLUSAs Covered Class Action Requirement

The Emergence Of Abusive Individual Actions

Securities Litigation and Professional Liability Practice, Second Quarter 2005

The Scope of SLUSAs Covered Class Action Requirement

Securities Litigation and Professional Liability Practice, Second Quarter 2005

The Scope of SLUSAs Covered Class Action Requirement

Securities Litigation and Professional Liability Practice, Second Quarter 2005

The Selective Waiver Doctrine and the McKesson Cases

Securities Litigation and Professional Liability Practice, Second Quarter 2005

The Selective Waiver Doctrine and the McKesson Cases

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Circuit and State Round-Up

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Circuit and State Round-Up

Securities Litigation and Professional Liability Practice, Second Quarter 2005

The Ninth Circuits Decision in Dura

The Supreme Courts Decision in Dura

Securities Litigation and Professional Liability Practice, Second Quarter 2005

What is the Effect of the Dura Decision?

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Securities Litigation and Professional Liability Practice, Second Quarter 2005

In re EMCOR Group, Inc. Sec. Litig.

Brazen v. Tyco International Ltd.

The Selective Waiver Doctrine and the McKesson Cases

Securities Litigation and Professional Liability Practice, Second Quarter 2005

Securities Litigation and Professional Liability Practice, Second Quarter 2005