The dismissal of the federal securities fraud case against Zimmer Holdings, Inc., illustrates the hurdles shareholders must leap to move securities cases forward and stirs the arguments both for and against these kinds of lawsuits.
In 2008, the Plumbers and Pipefitters Local Union 719 Pension Fund of West Virginia filed a complaint against the Warsaw-based orthopedic products maker, alleging the company downplayed the significance of difficulties it was experiencing with the manufacture of the Durom Acetabular Component and delayed revealing quality control problems at the Zimmer plant in Dover, Ohio.
Through the course of 2008, Zimmer lowered its January projections of 10 to 11 percent growth as the problems with the Durom Cup and the Ohio plant were made public. In July 2008, projections were 8.5 to 9 percent growth. The plaintiffs maintain the company committed fraud by not using these lower estimates at the start of the year.
The 7th Circuit Court of Appeals issued its ruling on Plumbers and Pipefitters Local Union 719 Pension Fund and Carpenters Pension Fund of West Virginia v. Zimmer Holdings, Inc; David C. Dvorak; and James T. Crines, No. 11-1471, in May. The court affirmed the ruling by the District Court that the plaintiffs failed to show the defendants knowingly provided false information.
Scott Gilchrist, partner at Cohen & Malad LLP, served on the team representing the pension fund, and Paul Wolfla, partner at Faegre Baker Daniels LLP, was among the attorneys representing Zimmer. Both declined to comment specifically on the Zimmer case, but they did speak about securities fraud cases and the Private Securities Litigation Reform Act of 1995, the federal law designed to stem what are believed to be unwarranted securities lawsuits.
Gilchrist sees the PSLRA as having had some “chilling effect” on this type of class-action litigation but, he noted, these complaints continue to be filed because they are a remedy for shareholders against securities fraud.
“I think the plaintiff is faced with a pretty challenging environment when it comes to finding a remedy for a (fraud) that happens in the marketplace or happens to them as a consumer,” he said.
Wolfla agreed that plaintiffs must meet a high standard to even get to the discovery stage. Specifically, the PSLRA will automatically stay any discovery after the initial complaint is filed until the courts consider a motion to dismiss.
This provision bars plaintiffs from using the traditional tools of discovery like having the company produce documents and records or making corporate representatives available for depositions. In the Zimmer complaint, the union relied on statements made in quarterly earnings calls and at a conference at Deutsche Bank, reports filed with the Securities and Exchange Commission, and the testimony of 14 confidential witnesses.
The idea behind that provision, Wolfla said, was the concern Congress had about the number of “strike suits” which lawyers file immediately after a company announces bad news then look for a reason later.
A central point in many of these types of cases is the stock price. Company stock prices can be artificially inflated when information disclosed to the market is either withheld or misleading. When the true information comes out that is material to the price of the stock, the market will push the price down and shareholders’ stakes in the company will not be worth as much.
Securities fraud cases are very onerous on companies and impose a heavy and costly burden on the courts, Wolfla said.
To survive a motion to dismiss, securities fraud cases must clear what Gilchrist called two tricky areas in court. The first is lost causation (where the plaintiff must show the losses were caused by information that was misrepresented or not disclosed) and the second is scienter.
The scienter provision requires the plaintiff to state the facts that give rise to a “strong inference” as to the defendant’s state of mind. In Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), the U.S. Supreme Court defined the phrase “strong inference” as being more than plausible or reasonable and, instead, must be “cogent and compelling.”
In Zimmer, the Circuit Court found the plaintiffs’ contention to infer scienter was “too generic to satisfy Tellabs.”
Writing for the majority, Chief Judge Frank Easterbrook stated, “The allegations of this complaint concern the problems Zimmer faced in 2008; in a different year the headaches would have come from a different plant or a different product, but the fact that these particular problems occurred – and the information came out over time, as more news accumulated – does not imply that any manager was lying to investors.”
Reviewing “classic filings,” the Stanford Law School Securities Class Action Clearinghouse found a decline in federal securities class-action filing activity during the first half of 2012. Through the end of June, 88 filings had been made, a decrease of 6 percent from both the first and second halves of 2011.
Stanford projected 2012 will end with 176 filings. This is less than the 1993 to 2011 average of 193 but in line with the 2009 to 2011 average of 177. The drop in total filings was primarily attributed to a “substantial decline” in merger and acquisition filings and in Chinese reverse mergers, where a Chinese-based company will merge with a defunct U.S. company, then use its ticker symbol.
In companion research with Stanford, Cornerstone Research has reported that the number of securities class-action settlements approved in 2011 was the lowest in more than a decade. In 2011, there were 65 court-approved securities class-action settlements involving $1.4 billion in total settlement funds.
Wolfla is also seeing a decline in certain types of securities fraud cases. He speculated the downward trend may be a reflection of publicly traded companies becoming “better disciplined” about disclosing material to shareholders and the public. In addition, a lot of corporate governance reform followed the 2001 Enron scandal which has resulted in companies following better processes and procedures.
In being more disciplined, Wolfla said, companies are giving more thought and care, in particular about financial performance. The result is this makes it more difficult for shareholders to allege fraud has been committed on the basis that material information has been omitted.
Although securities fraud cases may be decreasing, shareholders are still active.
Paul Vink, partner at Bose McKinney & Evans LLP, said within the past decade it has become virtually certain that shareholders will file a complaint in court any time a company makes an announcement of a merger or similar transaction.
Vink traced the increase in these shareholder actions to plaintiff law firms that seek such cases as well as to the economic collapse of 2008.
“The biggest factor is the overall suspicion that most members of the public have of corporate America and Wall Street,” Vink said. “There isn’t a level of trust that there was 20 years ago because of some of the scandals we’ve seen.”
One example is the complaint filed by shareholders against Fortune Industries Inc. in April. Here, shareholders sought to prevent the company from being purchased because, they believed, the share price was too low.
Vink was an attorney representing Fortune in the case.
In August, the shareholders voluntarily dropped their claim because it conflicted with Indiana’s dissenters’ rights statute, Vink said. The statute prevents a minority of shareholders from challenging or enjoining a transaction. •