boletim sobre litigância em seguros

Second Quarter 2005

Securities Litigation andProfessional Liability Practice

Newsletter

Issue No. 11

A Note from the European Co-ChairIn recent years, European legislatures have strengthened shareholders’ rights, andmany additional regulatory measures are under way. As a consequence, we anticipatethe corresponding substantial increase in corporate governance litigation, securitieslitigation and professional liability cases to continue all over Europe. Particularly insecurities litigation, clients operating in the United States and Europe can expect toface not only U.S.-based class actions but also parallel proceedings in Europe.

Latham & Watkins has established leading securities litigation and professionalliability practices in Paris, London and Frankfurt during the last two years. To reflectthe continuing growth of our international practice and the globalization of ourclients’ litigation needs, this newsletter aims to keep you informed about all majorEuropean legislative actions and legal decisions relating to securities law, in additionto 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 andMathias Fischer

Class actions have been common to civilprocedure in the United States for quitesome time. Other legal systems, likethose of the United Kingdom, Franceand Sweden, have also established rulesallowing a group of plaintiffs to litigatesimilar claims in one action. Germancivil procedure, on the other hand,knows only a very limited scope ofpossibilities for plaintiffs to bring theirclaims under one action. The mostpopular way for multiple plaintiffs to filetheir claims against a defendant in oneaction is to consolidate them.

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.

(Continued on Page 6)

SEC and PCAOB Provide

Needed Guidance on

New Internal Control

Requirements

By Robert J. Malionek

In May 2005, the U.S. GeneralAccountability Office (GAO) issued areport on its “Financial Audit” of theSecurities and Exchange Commission’s(SEC) financial statements for fiscalyear 2004.1 While finding that the SEC’s financial statements were fairlypresented in all material respects, theGAO also found that the “SEC did notmaintain effective internal control overfinancial reporting” as of the end of theSEC’s fiscal year, which was September30, 2004. While noting that the SEC “iscurrently working to improve controls,”


Inside This Issue:

A Note from the

European Co-Chair

1

The Introduction of a

Class Action “Light”

in Germany

1

SEC and PCAOB

Provide Needed

Guidance on New

Internal Control

Requirements

1

Supreme Court

in DuraPharmaceuticalsUnanimously

Endorses “Loss

Causation”

Requirement in

Fraud-on-the-Market

Cases

2

Recent Victories 3

Circuit and State

Round-Up

4

The “Selective

Waiver” Doctrine and

the McKesson Cases

4

Out in Front 12 12

The Scope of

SLUSA’s Covered

Class Action

Requirement

12

Contact Information 24

Securities Litigation and Professional Liability Practice, Second Quarter 20052

In a landmark decision, the UnitedStates Supreme Court has reversed theNinth Circuit in a fraud-on-the-marketsecurities class action. Unlike almost allother federal courts, the Ninth Circuit –which encompasses nine western statesincluding California – had adopted a“price inflation” theory of loss causation.This theory, had it been allowed to stand,would have allowed investors to sue acompany merely by claiming that theypaid too much for the company’s stockbecause of a defendant’s allegedmisrepresentations. A unanimousSupreme Court in Dura Pharmaceuticals,Inc. v. Broudo, 125 S. Ct. 1627, 2005 WL885109 (April 19, 2005), however,rejected the theory with eight words: “Inour view, the Ninth Circuit is wrong.”Although no lower courts haveinterpreted Dura in published decisionsas of this writing, there is no doubt as tothe significance of this opinion insecurities litigation for years to come.

What is “Loss Causation” and

Does it Matter?

The Private Securities LitigationReform Act of 1995 (PSLRA) codified alongstanding judicial interpretation ofRule 10b-5 requiring plaintiffs to provethat their investment losses were causedby the defendant’s misrepresentations.This causation requirement has twocomponents: (i) transaction causation(that the plaintiff relied on thedefendant’s alleged misrepresentationsin making the investment decision), and(ii) loss causation (that the allegedmisrepresentation caused the plaintiff’sinvestment loss). These requirements are designed to insure that defendantsare only held liable for investment losses actually resulting from theirmisrepresentations – and not for stockprice declines attributable to otherfactors, such as adverse changes inmarket conditions or other negativebusiness developments.

In 1988, the Supreme Court enabledso-called “stock drop” class actions byallowing plaintiffs to plead the firstcomponent of causation – transactioncausation or reliance – based on a“fraud-on-the-market” theory. In Basic v.Levinson, 485 U.S. 224 (1988), the courtheld that all investors who trade stock inan “efficient market” – such as the NewYork Stock Exchange or the NASDAQ –inherently rely on the integrity of themarket price because that price shouldrapidly reflect all available materialinformation. Accordingly, class actionplaintiffs may plead transactioncausation by alleging that a defendant’smaterial misrepresentation was a fraud-on-the-market that artificially inflatedthe stock price on which investors relied.

The efficient market theory also comesinto play in the second component ofcausation: loss causation. The so-called“truth-on-the-market” theory is that, inan efficient market, an artificiallyinflated stock price remains inflated untilthe “truth” comes out. As the SupremeCourt in Dura explained, this means thatinvestors do not suffer an economic loss“caused” by the allegedmisrepresentations until their falsity isdisclosed and absorbed by the efficientmarket causing the stock price to drop(deflate). It logically follows that anyadverse price movement prior to acorrective disclosure is caused by eventsother than the alleged misrepresentationbecause the negative truth is not yetknown and, therefore, not reflected inthe stock price. Thus, investors who buyafter the misrepresentation but sellbefore the truth comes out have not beeninjured.

Herein lay the problem with the NinthCircuit’s Dura decision: It permittedplaintiffs to maintain a securities fraudsuit while pleading only that the stock

Supreme Court in Dura PharmaceuticalsUnanimously Endorses “Loss Causation”

Requirement in Fraud-on-the-Market Cases

By Pamela S. Palmer, Jeff G. Hammel and J. Christian Word

Jeff G. Hammel

Pamela S. Palmer

J. Christian Word


Securities Litigation and Professional Liability Practice, Second Quarter 2005 3

Alaska ElectricalPension Fund v.Adecco S.A.Latham recently won a significantvictory in a published decisiondismissing a securities fraud actionagainst Adecco S.A., a Swissstaffing company, and several of itsofficers and directors. In AlaskaElectrical Pension Fund v. AdeccoS.A., 371 F. Supp. 2d 1203 (2005),the U.S. District Court for theSouthern District of Californiadismissed a securities fraudcomplaint, holding that theplaintiffs’ allegations of accountingimproprieties were insufficient tostate a claim, based in large part onthe complaint’s failure to identify itsconfidential sources adequately.

In January 2004, Adecco announcedthat the audit of its consolidatedfinancial statements for fiscal year2003 would be delayed because of its auditor’s identification ofweaknesses in internal controls inthe company’s North Americanoperations. After the resulting dropin Adecco’s stock price the plaintiffsfiled suit, asserting claims underSections 10(b) and 20(a) and Rule10b-5 and alleging that Adeccowould ultimately be restating itsfinancial statements. However, uponthe conclusion of an extensiveinvestigation in June 2004, Adecco’sauditors provided a “clean” opinionon Adecco’s financial statementswithout the need for a restatement.Rather than drop the suit, theplaintiffs filed an amendedcomplaint, alleging that Adecco’stakeover of a U.S. company inMarch 2000 resulted in millions ofdollars in uncollectible receivablesin its North American operationsand therefore resulted inmisrepresented financial statements.The defendants moved to dismissthe complaint arguing, inter alia,that the plaintiffs’ allegations ofaccounting violations were

insufficient to establish thatAdecco’s financial statements werefalse and failed to raise a stronginference of scienter.

Confidential Sources ofAllegations. The court analyzed thecomplaint’s failure to provide detailsregarding its confidential sourcesalleged, applying the standards setout in two recent Ninth Circuitdecisions, Nursing Home PensionFund, Local 144 v. Oracle Corp., 380F.3d 1226 (9th Cir. 2004), and In reDaou Sys., Inc. Sec. Litig., 397 F.3d704, 710 (9th Cir. 2004). In Daou, theNinth Circuit looked to the standardadopted by the Second Circuit andborrowed additional criteria fromthe First Circuit to require that acomplaint’s sources be describedwith “sufficient particularity tosupport the probability that a personin the position occupied by thesource would possess theinformation alleged, and byengaging in an assessment of the reliability of the witnesses.

Although the complaint in Adeccodid not provide any detailsregarding the confidential witnessesreferenced, the plaintiffs argued thatthe Ninth Circuit’s decision in Daouexcused them from providingspecificity about the sources of theallegations so long as other facts inthe complaint provided an adequatebasis for believing defendants’statements were false. Holding that“the absence of any description ofthe confidential witnesses uponwhich the Complaint relies requiresdismissal,” the court rejected theplaintiffs’ interpretation, explainingthat while Daou did not necessarilyrequire that sources be identified byname, it did require a meaningfuldescription of confidential witnessesin addition to, not as a substitute for,corroborating facts.

Sufficiency of Accounting FraudAllegations. The court then heldthat the plaintiffs’ generalized

allegations that the defendantsunderstated and hid uncollectibleaccounts in its financial statementswere insufficient to satisfy therequirements for pleadingaccounting fraud set out by theNinth Circuit in Daou. The courtexplained that the plaintiffs mustplead enough details to establishthat the alleged violations were notjust technical in nature but ratherthat they affected the company’sfinancial statements in a materialway. Without these details, the courtheld that the plaintiffs’ generalizedallegations of manipulation ofuncollectible receivables and othermiscellaneous accounting violationswere insufficient to quantify theimpact of the violations on Adecco’sfinancial statements.

Sufficiency of Scienter Allegations.The court also held that thecomplaint’s allegations, even viewedcollectively, failed to give rise to astrong inference of scienter. Forexample, the court criticized thecomplaint for failing to allegespecific facts indicating that thedefendants personally participatedin or ratified the alleged accountingviolations and rejected the plaintiffs’argument that the highest rankingmembers of Adecco’s worldwideoperations should be presumed tohave knowledge of manipulationsthat supposedly were occurringsystematically throughout Adecco’sNorth American operations.

In dismissing the complaint andgranting the plaintiffs leave toamend, the court declined toevaluate whether the plaintiffsadequately alleged loss causation,the significance of the lack of arestatement or the viability of theplaintiffs’ theory of the case. Laurie Smilan (VA), co-chair of the Securities Litigation andProfessional Liability PracticeGroup, successfully argued themotion for Adecco.

Recent Victories



Circuit and State Round-Up

In this era of heightened corporatescrutiny, the Securities and ExchangeCommission (SEC) and the Departmentof Justice (DOJ) frequently requestcompanies to produce documents andinformation protected by the attorney-client privilege and work productdoctrine. The SEC and the DOJ cannotforce a company to produce privilegedmaterials. Nonetheless, whether or nota company under investigationvoluntarily produces such materials is afactor that these agencies considerwhen deciding whether to pursueformal charges.

Faced with such a “choice,” manycompanies elect to produce the

privileged materials subject toconfidentiality agreements. The hope isthat these confidentiality agreements willensure that the privileged materials arenot disclosed to shareholder plaintiffs orother adverse parties. The agreementsfrequently contain provisions limiting thedisclosure of the materials, often providethat the materials are being producedpursuant to a purported “commoninterest,” and state that the productionshall not be deemed a waiver of anyapplicable privileges as to anyone butthe respective government agencies.

Courts have not reached a consensusas to the effectiveness of theseconfidentiality agreements. Ultimately,

Second Circuit

In Seippel v. Sidley, Austin, Brown &Wood, 2005 WL 1423370 (S.D.N.Y. June16, 2005), the court addressed whetherprimary liability existed for a secondaryactor – a law firm – under Section 10(b).The plaintiffs alleged that defendantsSidley, Austin, Brown & Wood (SidleyAustin) and Deutsche Bank defraudedplaintiffs through the development,marketing and sale of tax shelters thatthey knew would be challenged by theIRS. After the court initially held thatthe plaintiffs’ RICO claims were barredby the Private Securities LitigationReform Act of 1995 (PSLRA), theplaintiffs amended their complaint toallege securities fraud claims. Thedefendants moved to dismiss for failureto satisfy the PSLRA’s heightenedpleading requirements, failure to satisfythe statute of limitations and claim ofaiding and “abetting.”

After summarily rejecting the defendants’pleading with a particularity argument,the court addressed the notice requiredfor purposes of triggering the statute oflimitations in a securities action. Thecourt pointed out that the statute oflimitations generally begins to run wheninformation establishes a “probability, notpossibility” of fraud and that dismissal forfailure to satisfy the statute of limitationsis only appropriate in extremecircumstances. Even when suchinformation exists, however, the statute oflimitations will not begin to run if thewarning signs are accompanied byreassurances from the defendants.Because Sidley Austin allegedly maderepresentations regarding the legality ofthe tax shelters, and plaintiffs wereentitled to rely on those due to SidleyAustin’s status as a law firm with expertknowledge of the tax laws, the courtfound that the plaintiffs did not haveearly notice of fraud and thus the statuteof limitations had not expired.

The “Selective Waiver” Doctrine and the McKesson CasesBy David M. Friedman and Brian T. Glennon

David M. Friedman

Brian T. Glennon (Continued on Page 5)



whether the production of privilegedmaterials to a government agencysubject to such an agreement willprevent a privilege and work productwaiver depends on whether thejurisdiction has adopted the selectivewaiver doctrine. This doctrine allows aparty to waive the privileges as to oneparty, but not to another.

Federal courts of appeals and variousstate courts have split on the adoption ofthis doctrine, with most courts rejectingit. However, a recent decision by adistrict court for the Northern District ofCalifornia and some dicta in a recentNinth Circuit decision provide somehope to companies that have elected to,or are deciding whether they should,produce privileged materials. That said,the current state of the law, and inparticular, the cases regarding the

McKesson and HBO & Company(HBOC) restatement, indicate thatcompanies should assume privilegeddocuments produced to governmentagencies will be produced to at leastsome shareholder plaintiffs.

The McKesson Cases

The McKesson cases are instructive, asseveral different courts were asked todetermine whether the same privilegedmaterials McKesson produced to theSEC and DOJ should be produced tovarious adverse parties. The courts spliton the issue, resulting in a situationwhere certain plaintiffs are entitled tothe materials, while others are not. Dueto these inconsistent rulings, access tothe materials depended on the vagariesof where plaintiffs chose to bring thelitigation.

The McKesson Restatement

Shortly after the merger betweenMcKesson and HBOC, McKesson

The defendants also argued that theplaintiffs’ claims were barred because, atmost, they alleged that defendants aidedand abetted the party that sold the taxshelters, Ernst & Young, in inducing theplaintiffs to enter into the questioned taxtransactions. Under Central Bank ofDenver v. First Interstate Bank of Denver,511 U.S. 164 (1994), the Supreme Courtheld that there is no private cause ofaction under the federal securities lawsfor aiding and abetting a violation ofSection 10(b). And the Second Circuit inWright v. Ernst & Young, 152 F.3d 169 (2dCir. 1998), interpreted Central Bank tomean that, in order to be held liableunder Section 10(b), a defendant mustactually make a false or misleadingstatement and must know or shouldknow that the statement will becommunicated to investors, and thestatement must be attributable to thedefendant. Although a failure to satisfythose conditions means that there is noliability because a defendant merely

aided and abetted, Wright held thatsecondary actors can nonetheless beliable as primary violators if therequirements for primary liability aremet. It further held that the allegedviolator need not have directlycommunicated the allegedmisrepresentations to the plaintiffs.

Applying Wright, the court determinedthat the plaintiffs alleged more than mereaiding and abetting by alleging thatSidley Austin “engineered and were keymembers of the conspiracy to defraud”and that the misrepresentations werecaused by the defendants and made ontheir behalf. The plaintiffs alleged thatSidley Austin helped devise the taxshelter and agreed to use Ernst & Youngto sell it. The court decided that SidleyAustin could thus be held liable formaking misrepresentations “albeitindirectly, using [Ernst & Young] as theiragent and mouthpiece.”



Circuit and State Round-Up(Continued from Page 4)

The “Selective Waiver” Doctrine and the McKesson Cases(Continued from Page 4)


This, however, is often not effective asplaintiffs may choose to retain differentattorneys and have no means ofcoordinating their efforts. In an ongoingsecurities action against DeutscheTelekom, for example, (represented byLatham & Watkins’ Frankfurt office)more than 14,000 plaintiffs have filed2,200 actions against Deutsche Telekomin Frankfurt district court. Thisextraordinarily high number of actionshas exposed the Frankfurt District Courtto enormous problems. The first oralhearing before the Frankfurt DistrictCourt was scheduled three and a halfyears after the first action was filed. Inthe oral hearing, the judge stated that itwould take the court approximatelyfifteen years to decide all cases in thefirst instance, if the legislature does notpronounce new procedural rules formass proceedings.

Master Proceedings Act Aims to

Reduce Plaintiffs’ Risks and

Simplify Proceedings

The Act on Master Proceedings inDisputes Relating to Capital MarketsLaw (“Master Proceedings Act”), justpassed by the German legislature, aimsto solve the problems encountered bycourts handling a large number of claimsrelating to common facts. The Germanlegislature reasoned that the traditionalprovisions in German civil procedureallowing for a consolidation of claims areinsufficient for plaintiffs to litigate theirclaims effectively. The legislaturerecognized that, particularly in securitieslitigation, a single investor often suffersonly relatively small damages, making iteconomically unreasonable for him tobring his claim to court. When a singleclaim is brought by a large number ofinvestors, however, the total damagescan be enormous. The legislature haslimited the applicability of the MasterProceedings Act to securities litigationin order to give the courts practicalexperience in one area of litigation. Ifpractical experience turns out to be

positive, then the legislature willconsider 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 bedistinctively different from a U.S.-styleclass action. The first, most importantdifference under the German rules arethat there will not be an abstract classdefinition. Each investor has to opt inby filing his claim with the court andsharing in the costs of the litigation. It isforeseeable that under this opt-insolution, only a limited number ofinvestors will take part in the masterproceedings, thus reducing the amountat stake. The second importantdifference is that the German masterplaintiff, unlike the lead plaintiff in U.S.class action proceedings, will not beentitled to settle the claims for allplaintiffs. If a defendant in a masterproceeding intends to settle a dispute,the defendant will have to negotiate thesettlement with each plaintiff separately,therefore making a quick settlement ofall disputes virtually impossible.

Introduction of Entirely New

Proceedings

Master proceedings can be initiatedupon the motion of any party. Themotion for initiation of a masterproceeding must seek a decisionregarding questions of necessary factsor law. Master proceedings can only beinitiated if the dispute relates toinformation involving the public capitalmarkets and a multitude of investors. Ifthe Court of First Instance admits themotion for initiation of a masterproceeding, the motion is published in aspecified public register on the internet.The public registration provides noticeto other potential plaintiffs who maywant to join in the master proceeding.

If the motion for initiation of masterproceedings is joined by nine additionalplaintiffs within four months, the Courtof First Instance must initiate the master

The Introduction of a Class Action “Light” in Germany(Continued from Page 1)

Bernd-Wilhelm Schmitz

Mathias Fischer



proceeding by seeking a decision ofthe Court of Appeals regarding thecommon questions of fact or law.During the pendency of the masterproceeding, all other disputesdepending on the decision in themaster proceeding are stayed.

Following the initiation of themaster proceeding by the Court ofFirst Instance, the court of appealssingles out a master plaintiff. Asjury trials are foreign to Germancivil procedure, the Court of Appealsin a bench trial decides allquestions of fact and law that havebeen addressed by the court of firstinstance. Finally, the Court ofAppeals renders a master decisionthat is binding for all plaintiffs of alldisputes stayed during the masterproceeding. There are no means fora plaintiff to opt out of the bindingeffect of the master decision andan individual plaintiff cannotinfluence which plaintiff isappointed as the master plaintiff.

The master decision can only beappealed to the German CivilSupreme Court. Although only theplaintiffs who choose to join theappeal of the master decision take part in the appeal, the CivilSupreme Court’s decision isbinding for all plaintiffs.

Does the Master Proceedings

Act Really Simplify the

Proceedings?

To satisfy German constitutionaldue process requirements, thelegislature has invented a rathercomplicated and burdensomeprocedure: All plaintiffs before theCourt of First Instance can pleadand file motions during the masterproceedings. The Court of Appealsmust consider all pleadings andmotions as long as they do notcontradict the pleadings andmotions of the master plaintiff. If

hundreds of plaintiffs file separatecourt briefs, it is virtually impossiblefor the court of appeals to addressall facts and questions of law.

After the master decision hasbecome final, the Court of FirstInstance must then decide eachaction on a case-by-case basis.Although the master decision maybe dispositive on a number ofcommon issues raised in eachcase, it is possible that the Courtof First Instance still has to decidea variety of questions that are notcommon to several actions.

Does the Master

Proceedings Act Really

Reduce Plaintiffs’ Risks?

Other important provisions of theMaster Proceedings Act relate tocosts. Under German law, the loserhas to pay all court fees as well asthe prevailing party’s reasonableattorneys’ fees. The plaintiff mustadvance court fees, his ownattorneys’ fees, and often expertfees. In many cases, expert fees areout of proportion to the amount atstake in an individual case.Therefore, a plaintiff may lose hiscase only because he has failed toadvance expert fees.

The Master Proceedings Actaddresses this problem by providingthat plaintiffs need not advanceexpert fees. In addition, if theplaintiffs lose, all fees are dividedproportionally among the plaintiffs.The Act’s cost rules might seem

favorable for plaintiffs, but they canbear significant risks, as eachplaintiff must share in the costs if hedoes not withdraw his claim withintwo weeks after being served withthe decision to stay the first instanceproceedings. At this early stage, itcan be impossible for the plaintiff todetermine the ultimate costs andthe number of plaintiffs that willeventually join the proceedings andshare the costs. Thus, even underthe Act, a small number of plaintiffsmay ultimately bear costs that arestill grossly out of proportion to theamount in dispute.

Conclusion

It is questionable whether thelegislature’s aims to simplify massproceedings in securities litigationand to reduce plaintiffs’ risks can beachieved by the Master ProceedingsAct. Thus, judges and evenplaintiffs’ lawyers have expressedconcerns regarding the practicalityof the proposed master proceedings.Instead of modifying andsupplementing the existing rules ofcivil procedure, the legislature hasintroduced an entirely new andcomplicated procedure, withouthaving exhaustively considered thepractical problems that might arise.With the Deutsche Telekom case asthe first test case under the MasterProceedings Act, Latham & Watkinswill be on the front line as Germanymonitors the success of the Act. �

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.

The Introduction of a Class Action “Light” in Germany(Continued from Page 6)


the GAO’s conclusion is an ironicdevelopment that underscores thepractical challenges and increasedpressures facing public companies,management and auditors in the wakeof the new internal control requirementsbrought about by the Sarbanes-OxleyAct of 2002 (SOX). Adding to the ironyof the GAO’s report is its timing. In May2005 – just days before the release ofthat report – the SEC and the PublicCompany Accounting Oversight Board(PCAOB) finally issued guidance to thecompanies, management and auditorsfacing SOX’s overhaul of the internalcontrol structure and the correspondingpressure from all fronts. Clearly, theguidance is much-needed.

The Impact of Sarbanes-Oxley

SOX’s internal control requirementswere long preceded by passage of theForeign Corrupt Practices Act of 1977,which for the first time made thecreation and implementation of asystem of internal controls overaccounting and financial reporting arequirement of federal securitiesregulation. In 1990, significant internalcontrol guidance was issued by theCommittee of Sponsoring Organizations(COSO) of the Treadway Commissionin a report entitled Internal Control –Integrated Framework. The COSOReport defined internal controls simplyas a process to ensure accuratefinancial reporting and compliance withapplicable laws. The so-called “COSOstandards” established five componentsconstituting a framework for internalcontrols: control environment, riskassessment, control activities,information, and communicationsystems and monitoring. The definitionand description of controls from theCOSO Report were adopted by theAmerican Institute of Certified PublicAccountants in 1997, in AU § 319 of theCodification of Statements on AuditingStandards.

For decades, management was onlyexpected to have in place internalcontrols designed to give “reasonableassurances” that, among other things,transactions are sufficiently recorded inorder to allow financial statements tobe prepared in accordance withGenerally Accepted AccountingPrinciples (GAAP). Auditors were notrequired to “audit” internal controls atall, but rather could either rely uponthem or choose instead to performsubstantive testing to form theiropinions. SOX dramatically changedthis approach to internal control.

Management’s New

Responsibilities – Certifications

and Reports on Controls

Against this backdrop, SOX broughtsweeping additions to management’sresponsibilities – on a personal level –for the process and the disclosuresregarding a company’s internal controls.

Management Certifications

Section 302 of SOX requires theprincipal executive and financialofficers of qualifying issuers – typicallythe CEOs and CFOs – to includecertain certifications with reports filedunder the Securities Exchange Act of1934, including Forms 10-K and 10-Q.The officers must, among other things,certify that they have personallyreviewed the entire report, thusrequiring a level of personal duediligence not previously demanded ofa company’s most senior officers. Thispressure placed on management bySection 302 is compounded by theresponsibilities added under § 906 ofSOX. Officers who certify financialstatement reports “knowing” that theydo not “fairly present in all materialrespects the financial condition” of thecompany may face criminal penaltiesunder § 906 of up to 20 years in prisonand/or $5 million in fines.

Section 302 also requires the seniorofficers to certify that together they havedeveloped or overseen the developmentof internal controls designed to providereasonable assurance of the reliability of

Robert J. Malionek

SEC and PCAOB Provide NeededGuidance on New Internal ControlRequirements (Continued from Page 1)



financial reporting in accordance withGAAP. Likewise, § 302 requiresmanagement to certify that any materialchanges to internal controls made overthe quarter are disclosed in that report,and that each officer has disclosed“significant deficiencies and materialweaknesses” in internal controls, aswell as fraud involving those withresponsibility over internal controls, tothe company’s independent auditorsand audit committee.

While facing added responsibilities withrespect to accurate financial statementreporting, senior officers have beenrequired, since shortly after the passageof SOX, to provide certain certificationsregarding their personal responsibilityfor establishing and maintaining“disclosure controls and procedures” – anew concept under SOX – and “internalcontrol over financial reporting.”Pursuant to the SEC’s Exchange ActRules 13a-15 and 15d-15, on a quarterlyand annual basis, the senior officersmust certify that together they havedeveloped or overseen the developmentof “disclosure controls” which aredesigned to ensure that all materialinformation relating to the company ismade known to them.

Management Reports on Internal Controls

Adding to the responsibilities ofmanagement under SOX § 302 and 906,§ 404(a) required the SEC to adoptrules mandating that public companymanagement prepare an annual report(1) stating its responsibility forestablishing and maintaining anadequate internal control structure andprocedures for financial reporting and(2) containing an assessment of theeffectiveness thereof.2 On May 27, 2003,the SEC adopted such rules anddefined “internal control over financialreporting” as a process “to providereasonable assurance regarding thereliability of financial reporting and the

preparation of financial statements forexternal purposes in accordance with[GAAP].” This definition encompassesthe subset of internal controls in theCOSO Report relating to financialreporting objectives.

Under the rules adopted by the SEC,management’s report, in addition to thecontent required by Section 404(a),must include a statement identifyingthe framework used to evaluate theeffectiveness of internal control overfinancial reporting, a statementdisclosing any material weakness ininternal controls and a statement that aregistered auditor issued an attestationreport on management’s assessment.Management’s evaluation of theeffectiveness of the company’s internalcontrol over financial reporting must bebased upon a framework, such as thatprovided by the COSO Report, whichprovides “a suitable, recognized controlframework that is established by a bodyor group that has followed due-processprocedures, including the broaddistribution of the framework for publiccomment.” Management is prohibitedfrom delegating its responsibility toperform its own assessment, and maynot deem internal control to be“effective” if there are one or moreidentified material weaknesses.3

In short, pressure on senior managementwith respect to a company’s internalcontrol has never been greater.

Auditors’ New Responsibilities

The increased internal control burdenupon auditors is rooted in SOX Sections404(b) and 103(a).4 On March 9, 2004,the PCAOB implemented these sectionsby adopting Auditing Standard No. 2(AS No. 2), An Audit Of InternalControl Over Financial ReportingPerformed In Conjunction With AnAudit Of Financial Statements. Failureto conduct audits in accordance withAS No. 2 could lead to a PCAOBinvestigation and ultimately disciplinarysanctions, which include monetarypenalties and revocation of the abilityto conduct public company audits.5




The underlying theme driving AS No. 2is that only an “integrated audit” – anaudit of a company’s financial statementsand of management’s assessment of theeffectiveness of internal control – mayeffectively enable an auditor to expressan audit opinion on either financialstatements or internal controls. AS No. 2requires that an auditor, in order tosupport its opinion on whethermanagement’s assessment on theeffectiveness of internal control is statedfairly, must perform its own tests ofcontrols, conduct walkthroughs of certaintransactions and numerous otheractivities such as identifying significantaccounts and documenting and reportingon controls. In a sharp departure fromearlier auditing standards, auditors arenow also required to test and evaluatethe “design effectiveness” and“operating effectiveness” of internalcontrols as part of any audit.

An auditor may express an unqualifiedopinion only if, after performing all theprocedures the auditor considersnecessary, no material weaknesses ininternal control have been identified. Inaddition, an adverse opinion should berendered on management’s assessmentwhenever the auditor finds a materialweakness that management did not.

As these requirements make clear,wherever there could be a loosening ofthe tension placed on management withrespect to internal controls, the pressureplaced on auditors is there to pick up the slack.

Confusion and Costly Compliance

Lead to Guidance

We are just now beginning to see the effect of SOX internal controlrequirements as the SEC gaveaccelerated filers until November 15,2004 and other filers until July 15, 2006to comply.6 The immediate effects fromimplementation of the SEC’s and thePCAOB’s rules and standards regarding

internal control have been confusion andsubstantial compliance costs. Prior to therecent guidance, the SEC was requiredto issue several extensions for Section404 compliance as companies struggledto bring their controls in line. The SECalso issued two “Frequently AskedQuestions” guides Section 404implementation, and the PCAOBlikewise published four separate Staff Questions and Answers to clarifyAS No. 2.

Estimates of the compliance costs of SOXper issuer range from $1.6 million to $4.4million per year.7 A recent survey alsofound that Section 404 compliance wasthe primary cause of the increase inamended filings for financialrestatements due to accounting errors,which saw a 28% increase from 2003 to 2004.8

Following the first cycle of annualSection 404 reports for accelerated filers,the lingering questions and substantialcosts associated with SOX’s internalcontrol rules and regulations werediscussed at a roundtable hosted by theSEC on April 13, 2005.9 Companyrepresentatives, accountants, attorneysand members of the PCAOB debated thebenefits, difficulties and ambiguitiessurrounding the new requirements.Facing increased costs stemming fromincreased pressure under SOX, butunsure of the level of scrutiny that wouldbe applied by regulators to theirapproach to internal control assessment,companies and auditors needed a clearunderstanding of the SEC’s and thePCAOB’s objectives.

SEC Internal Control

Guidance to Issuers

On May 16, 2005 the SEC Staff for theDivision of Corporate Finance and theOffice of the Chief Accountant issuedguidance on Section 404, noting thatrecent commentary, including from theSEC roundtable, “identifiedimplementation areas that need furtherattention or clarification to reduce anyunnecessary costs and other burdenswithout jeopardizing the benefits of thenew requirements.”10




The SEC Staff adopted the theme that“one size does not fit all” under Section404 – i.e., management can choose theinternal controls approach that worksbest for the company. Not all internalcontrols must be the focus ofassessment as part of management’sannual review of internal controls, butrather the focus should be on “thoseitems that could result in materialerrors in the financial statements.” Theamount of testing and documentationrequired by management in its annualreview should not be overburdensome,but rather should be guided by astandard of reasonableness, judgmentand personal experience.

With this background, the SEC Staff’sguidance was full of suggestions formanagement to step back from thedetail-based (and expensive), “check-the-box” testing of all internal controlsexisting in the enterprise – likelyundertaken out of fear of the unknownscope of SEC enforcement of Section404 requirements. The Staff advised,among other things, that:

• “Management may determine thatnot every individual step comprisinga control is required to be tested inorder to determine that the overallcontrol is operating effectively.”

• Even though Section 404 reportsmust be “as of” year-end,management may appropriately relyupon interim testing performedthroughout the year in order toconclude that the controls areeffective without performingseparate year-end testing.

• A “material weakness” in internalcontrols is both a quantitative andqualitative determination, andmanagement should thus keep inmind that not all restatements due toerrors, for example, are the result ofcontrols deficiencies rising to thelevel of a material weakness.

• Not all “material weaknesses” arethe same, and because the ultimategoal when reporting such is relevantdisclosure of internal controldeficiencies to the public,“companies may, and are stronglyencouraged to, provide disclosurethat allows investors to assess thepotential impact of each particularmaterial weakness.”

• Consulting with auditors throughoutthe year on issues of internal controlis not a per se independenceviolation, and frank communicationsby management to auditors ofpreliminary financial information –e.g., providing auditors with draftfinancial statements which initiallycontain errors – should not beconsidered per se internal controldeficiencies.

In addition to expressing support for acommon sense, risk-based, no frillsapproach to internal control testing, theSEC Staff promised to continue to assessSection 404 with an eye towardsensuring that its benefits are “achievedin a sensible and cost-effective manner.”

PCAOB Internal Control

Guidance to Auditors

On the same day, the PCAOB releasedsubstantive guidance to auditorsregarding their internal control reviewobligations. The PCAOB issued a PolicyStatement regarding the implementationof AS No. 2 and technical guidance inthe form of Staff Questions & Answers.

Like the SEC guidance, the PCAOBemphasized that auditors must employthe use of professional judgment to tailortheir audit plans in a manner thataddresses the nature and complexity ofthe audit client. One-size-fits-all auditplans driven by standardized checklists –however extensive – may have little todo with the unique issues of a particularclient and actually reflect poor trainingand audit planning. Judgment must beexercised to focus an audit on areas thatpose higher risks of misstatement due toerror and fraud.




Recent and Upcoming Seminars and Speaking Engagements

• Partner William Baker (DC) was a featured speaker atthe ABA Section of Business Law Spring Meetingheld in Nashville from March 31-April 3.

• Partner John J. Huber (DC) appeared as a panelist onthe Securities and Exchange Commission’sRoundtable on Implementation of Internal ControlReporting 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 & LegalDivision Annual Seminar from April 3–6 in PalmDesert. Mr. Brodsky also participated as a co-chair atthe 3rd National Corporate Counsel’s Guide toConducting and Managing Internal & ExternalInvestigations, a program hosted by the AmericanConference Institute, from April 18-19 in New York.

• Partner Laurie Smilan (VA) participated in the 2005Risk and Insurance Management Society AnnualConference from April 18-20 in Philadelphia. Inaddition, she was a featured speaker at the SECInstitute’s seminar on SEC Enforcement and Litigationon May 27 in Pentagon City and PLI’s 2005 AuditCommittee Workshop on June 15 in New York.

• Partner Peter Benzian (SD) will speak at the nextSelect Topics For Trial Lawyers: Class Actions inCalifornia seminar on August 26 in San Diego. Theseminar is sponsored by Lorman Education Services.

Congress enacted the PrivateSecurities Litigation Reform Act of1995 (PSLRA)1 and the SecuritiesLitigation Uniform Standards Act of 1998 (SLUSA)2 to stem abusivesecurities class action litigation bystandardizing the appointment oflead plaintiffs, heightening thepleading standards, making federallaw the sole basis for liability, anddesignating federal courts theexclusive forum for securities fraudclass actions. Despite theselegislative efforts, the abusescontinue through the proliferation of “individual” shareholder lawsuitsbrought in state courts based onstate law that piggy-back onto theshareholder class actions filed infederal court but yet fall outside thereach of the PSLRA and SLUSA.

These piecemeal, de facto classactions undermine the purpose and intent of Congress’ legislativereforms and impose substantial (andunnecessary) expense on publiccompanies.

The solution is obvious: Congressshould amend SLUSA to makefederal courts the exclusive venuefor aallll lawsuits involving nationallytraded securities.3

The Statutory Reforms

Congress enacted the PSLRA toeliminate securities fraud strikesuits.4 It did so, in part, with aprocedural reform and a substantivepleading reform. Procedurally, thePSLRA vests control of the litigationin a “lead plaintiff” “to ensure that

securities litigation was investor-driven, as opposed to lawyer-driven.”5 In addition, the PSLRArequires that the securities fraudclaims be pled with particularizedfacts describing the alleged fraud inprecise detail and each defendant’sinvolvement.6 In the years after thePLSRA’s enactment, securitiesplaintiffs were able to evade itsreforms, and thereby subvertCongress’ intention, simply bybringing their class actions in statecourt and under state law where thePSLRA did not apply.

Congress enacted SLUSA in 1998 toput an end to this practice. As itsname reflects, SLUSA was intended

The Scope of SLUSA’s Covered Class Action Requirement By J. Christian Word and Dane A. Holbrook



to create uniform standards for class actionsalleging fraud in the purchase or sale ofnationally marketed securities bydesignating “federal courts as the exclusivevenue for such class actions,” and that theclaims “be governed exclusively by federallaw.”7 Defendants to a securities classaction improvidently brought in state courtare empowered under SLUSA to removethe action to federal court for dismissal.

However, rather than completely preemptstate law with respect to all fraud actionsconcerning securities purchased on ournational securities markets, Congresspredicated SLUSA preemption on thenumber of persons who bring the action(or actions). This “covered class action”limitation makes securities fraud claims theexclusive province of federal courts andfederal law only where the action isbrought on behalf of more than 50 persons(either as a single lawsuit or as a group oflawsuits pending in the same court andproceeding as a single action).8 In otherwords, an individual plaintiff could stillavoid the PSLRA by filing in state court andany number of individuals could do so aslong as they strategically limited the totalnumber of persons filing in any one court.Hence, Congress’ perhaps well-intentioneddesire to preserve individual state suits haspermitted plaintiffs to undermine theoverarching objective to standardize “massactions” asserting fraud claims against thenation’s public companies.

The Emergence Of Abusive

Individual Actions

With an open invitation to state courts forsecurities fraud suits by “individuals,” itdid not take long before plaintiffs figuredout how to RSVP to their benefit. Indeed,plaintiffs quickly recognized that theycould maintain state court actions thatwere a virtual carbon copy of the federalclass action but only brought under statelaw so long as they limited the number ofparticipants. This was especially the casefor plaintiffs that, filed a federal complaintbut were not appointed lead plaintiff. Theresult for the defendant company and its

officers and directors is that they areforced to litigate parallel actions inmultiple jurisdictions with varyingpleading standards. Moreover, thedefendants face the risk of inconsistentjudicial rulings on discovery, evidentiaryand other legal issues that candramatically impact the outcome of the case.

A recent example of this behavior is theWorldCom litigation.9 There, the courtnoted that after losing its motion forappointment as lead plaintiff and leadplaintiffs’ counsel, the one law firm“engaged in an active campaign toencourage pension funds not toparticipate in the class action and insteadto file individual actions with [the firm] astheir counsel.” This campaign resulted inthe firm “fil[ing] at least forty-sevenIndividual Actions on behalf of over onehundred and twenty pension funds.”“The burden on the parties and the courtsystem from this strategy of conducting aparallel, quasi class action has beenenormous,” observed the court, resultingin “the expenditure of significantresources” by the defendants and placinga “significant burden on Lead Counselfor the class” who had to correctmisinformation about the options availableto putative class members. The individualactions against the WorldCom defendantswere based upon the same underlyingconduct and sought the same relief as thefederal class action, relief the individualcould have obtained by participating inthe federal class action. Regardless of theultimate outcome of these individualactions, the WorldCom defendants werefaced with the added expense and burdenposed by the duplicative litigation.

These new, copy-cat actions are simply adifferent variety of the mass actionsCongress sought to standardize throughSLUSA. However, this new variety of massactions is not subject to SLUSA unless (1)plaintiffs imprudently trigger preemptionby filing a suit that satisfies SLUSA’scovered class action requirement, or (2)federal courts otherwise have jurisdictionover state court actions.


Dane A. Holbrook

The Scope of SLUSA’s Covered Class Action Requirement (Continued from Page 12)


The deficiency in SLUSA’s scope ishighlighted in two of the only decisionsthat have directly addressed SLUSA’scovered class action requirement. In Inre Enron Corporation Securities,Derivatives & “ERISA” Litigation(Enron),10 the plaintiffs strategicallycircumvented SLUSA by filing anindividual state action that mirrored theEnron class action but neverthelessinvolved fewer than 50 plaintiffs. In In reWorldCom, Inc. Securities Litigation(WorldCom),11 although the courtultimately found that SLUSA preemptedthe plaintiffs’ state law claims, thepredicate for finding federal jurisdictionwas federal bankruptcy law rather thanthe federal securities law.

In Enron, eight insurance and investmentcompanies brought a securities suit instate court against, inter alia, certainEnron officials alleging violations ofTexas law. The defendants removed thecase to federal court, arguing the casewas preempted by SLUSA because ithad been “consolidated with othersimilar Enron-related suits in statecourt,” and because it arose of the “samenucleus of operative facts, i.e., securitiesclaims against Enron officials andauditors . . . .” Following removal of thecase to federal court and consolidationwith a pending federal securities classaction against Enron, the plaintiffs’moved to remand the case back to statecourt because, they asserted, thedefendants failed to satisfy the coveredclass action requirement of SLUSA.

The Enron court agreed with theplaintiffs, concluding that it lackedfederal jurisdiction over the plaintiff’sstate court petition. According to thiscourt, the petition:

was not brought on behalf of anyother similarly situated plaintiffs, noless ‘50 persons or prospective classmembers,’ was not consolidated bythe state court judge with any otherEnron securities state court suits, and

is thus not a ‘covered class action’under SLUSA, and that Defendantshave failed to show otherwise.

Accordingly, the Enron court held thatthe defendants’ “removal was improper”because the case involved only eightplaintiffs and the defendants failed tolink their action to the consolidatedEnron class action.

SLUSA permits the result in Enron. Itallows individual shareholder actions(i.e., suits involving 50 or fewer plaintiffs)brought in a state court based on statelaw that mirror a shareholder class actionfiled in federal court. Prudent plaintiffs’firms are likely to follow the model ofEnron and thereby avoid triggeringSLUSA preemption.

In WorldCom, the court held that SLUSApreempted a group of 10 separatelawsuits filed by the same attorneys inseparate state courts that assertedidentical securities fraud claims. Each ofthe 10 actions in Worldcom was broughton behalf of “between five and forty-eight plaintiffs,” asserted “exclusivelystate securities fraud and negligenceclaims” against, inter alia, officers anddirectors of the bankrupt corporationWorldCom, and explicitly renouncedfederal causes of action. The 10 actionswere removed to federal court as theyrelated to the WorldCom bankruptcy,and then were formally consolidated forpretrial purposes. Moving to dismiss,the defendants argued that SLUSApreempted the actions as covered class actions.

The WorldCom court agreed, dismissingthe 10 actions with prejudice. The courtdetermined that the 10 actionsconstituted a “group of lawsuits” thatwere removable to federal court underSLUSA because the aggregated actions:were brought on behalf of more than 50persons, involved common questions offact, were pending in the same court,and were formally consolidated forpretrial purposes. Importantly, thepredicate for finding federal jurisdictionin Worldcom rested not on theapplication of the federal securities laws




to a group of lawsuits affectingnationally traded securities, but rather onapplying the federal bankruptcy laws.

The Enron and Worldcom decisionsdemonstrate that plaintiffs are subvertingCongress’ intended reform. Even afterSLUSA, sophisticated plaintiffs’ firms aremigrating to state court with actionsaffecting nationally traded securities –some with individual actions (e.g.,Enron), and others with disaggregatedclass actions filed as multiple actionsacross various jurisdictions (e.g.,Worldcom). This migration frustrates anygoal of uniformity, as state law actionsthat mirror federal securities class actionsmay fall outside the reach of the PSLRAand SLUSA. It also underminesCongress’ intent to create an atmosphereof fair and efficient securities litigation,subverts the core purpose of the PSLRAto impose heightened pleadingrequirements, decreases judicialeconomy, and increases the litigationburdens on public company defendants.

Conclusion

SLUSA is deficient. Confronted withdimmed prospects of success insecurities fraud actions after the PSLRAand SLUSA, plaintiffs’ lawyers arecarefully designing suits to avoid thedesignation “covered class action.”SLUSA’s limited scope allows this.

If “uniformity” is the goal in actionsaffecting nationally traded securities,then why does SLUSA sanction aprivate enforcement system thatoperates through concurrent state andfederal jurisdiction? SLUSA shouldforeclose all securities actions affectingnationally traded securities – not justcovered class actions – from proceedingin state court. �

Endnotes:

1 Pub. L. 104-67, 109 Stat. 737 (1995) (codified in part

at 15 U.S.C. § 78u).

2 Pub L. No. 105-353, 112 Stat. 3227 (1998) (codified

at 15 U.S.C. §§ 77p(b), 78bb(f)(1)).

3 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”).

4 Spielman v. Merrill Lynch, Pierce, Fenner & Smith,

Inc., 332 F.3d 116, 122 (2d Cir. 2003).

5 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”).

6 Spielman, 332 F.3d at 122.

7 Id. at 123-24. See also In re WorldCom, Inc. Sec.

Litig., 308 F. Supp. 2d 236, 244 (S.D.N.Y. 2004).

8 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 issuer’s 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).

9 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).

10 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).

11 308 F. Supp. 2d 236 (S.D.N.Y. 2004).



announced the company’s discovery ofmore than $42 million in improperly-recognized revenue. After theannouncement, McKesson’s AuditCommittee, with the assistance ofcounsel, conducted an internalinvestigation to review its accountingpolicies and to prepare for the inevitableshareholder lawsuits.

McKesson’s counsel met withrepresentatives of the SEC, and informedthem that McKesson would be willing toshare the results of the internalinvestigation, including its investigationreport and back-up materials such asinterview memoranda. McKesson thenentered into a confidentiality agreementwith the SEC. The confidentialityagreement stated that McKesson had a“common interest” with the SEC andthat the production of the materialswould not waive any applicable workproduct protections or the attorney-clientprivilege. The SEC agreed that it wouldkeep the materials confidential, “exceptto the extent that the SEC Staffdetermines that disclosure is otherwiserequired by federal law or in furtheranceof the Commission’s discharge of itsduties and responsibilities.” McKessonentered into a similar agreement withthe U.S. Attorney. McKesson thenproduced the report and backupmaterials to both the U.S. Attorney’sOffice (USAO) and the SEC pursuant tothese agreements.

Shareholders pursuing claims inCalifornia, Georgia and Delaware statecourts, and plaintiffs in federal securitiesclass action cases, consolidated in theNorthern District of California, soughtthe production of the materials providedto the SEC and USAO. FormerMcKesson executives facing federalprosecutions in the Northern District ofCalifornia also sought the materials.

The Recent Northern District ofCalifornia Decision

The most recent court to address theissue on the merits was the Northern

District of California. In In re McKessonHBOC, Inc. Securities Litigation, 2005U.S. Dist. LEXIS 7098 (N.D. Cal. Mar. 31,2005), the court (Judge Ronald M.Whyte) held that federal securitiesplaintiffs and plaintiffs in an ERISAaction were not entitled to the report andback-up materials. The court firstdetermined that the documents werenot protected by the attorney-clientprivilege, because at the time thedocuments were created andcommunicated, McKesson intended todisclose the information to a thirdparty—the SEC and USAO.

The parties conceded that the materialswere protected by the work productdoctrine. The issue was whether theproduction of the materials to a thirdparty waived the work product privilege.McKesson first argued that thedisclosure of these materials retainedtheir protection under the commoninterest doctrine. Under this widely-accepted doctrine, work productprotection is not waived by the meresharing of information between partiesthat have a common interest or jointdefense. The court rejected thisargument, finding that the SEC andUSAO were at least potentialadversaries. The court noted thatalthough the agreements with the SECand USAO stated that McKesson wasnot a target of the investigation, thegovernment reserved the right to changeits position. The court also pointed to thefacts that the SEC issued a formal orderof investigation and a Wells notice tothe company.

McKesson next urged that the courtadopt the selective waiver doctrine. Thecourt recognized that the doctrine wasnot accepted in the majority ofjurisdictions, and that the doctrinenormally lacks merit as a party couldpick and choose when a document isprotected. However, the court found thatan exception should exist for disclosureto governmental entities. The courtfound that such a rule would encouragecooperation with the government, andwould benefit the entire public from anincrease in the government’s




enforcement capabilities. The court alsodetermined that the doctrine wouldfurther the truth-finding process, whichis the aim of the work product doctrine.After adopting the doctrine, the courtfurther found that McKesson’sagreements with the USAO and the SECwere sufficient to ensure the materialsremained confidential as to all otherparties. The court also determined thatfairness did not require production toshareholder plaintiffs, as McKesson wasnot using the documents as a swordand shield.

The Ninth Circuit Left the Door Open tothe Selective Waiver Doctrine

Only a few days after Judge Whyte’sdecision, the Ninth Circuit issued itsopinion as to whether former executivesof McKesson, indicted for securities andmail and wire fraud, should have accessto the materials provided to thegovernment. The lower court, JudgeMartin J. Jenkins of the NorthernDistrict, had rejected the selective waiverdoctrine, finding that “it is inherentlyunfair to permit an entity to choose todisclose materials to one outsider whilewithholding them from another ongrounds 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 themerits, the Ninth Circuit determined thatthe appeal was moot as the criminaldefendants had gained access to thedocuments. U.S. v. Bergonzi, 403 F.3d1048 (9th Cir. 2005). Although the appealwas dismissed, the per curiam opinionoffered a glimmer of hope, stating thatthe selective waiver doctrine in theNinth Circuit “is an open question.”

The State Courts Split

State courts in California, Georgia andDelaware have also debated the issue ofthe selective waiver doctrine as it appliesto the McKesson materials. In California,the First Appellate District refused toadopt the selective waiver doctrine. The

court expressed doubt as to the policyarguments in favor of the doctrine,stating that it was “not sure if futureinvestigative targets will be reluctant toshare protected documents” if disclosurewas ordered. However, the courtdeclined to adopt the doctrine, as therewas no statutory support for the doctrine,and any policy determination was theprovince of the legislature, not the court.Thus, the court affirmed the trial court’sdecision to order the materials produced.McKesson HBOC, Inc. v. The SuperiorCourt, 115 Cal. App. 4th 1229 (2004).

The state courts in Georgia reached asimilar result. The Georgia Court ofAppeals determined that work productwas waived, as there was no commoninterest and because the confidentialityagreements were illusory. McKessonCorp. v. Green, 266 Ga. App. 157 (2004).On appeal, the Georgia Supreme Courtaffirmed, and actually stated thatallowing a selective waiver “may hinderthe operation of the work-productdoctrine” because outside counselconducting the investigation mayhesitate to pursue unfavorableinformation or legal theories since thatinformation would then be disclosed tothe government. McKesson Corp. v.Green, 279 Ga. 95 (2005).

The Delaware Chancery Court, in awell-reasoned decision by ChancellorWilliam B. Chandler, III. , reached theopposite result, and refused to order theMcKesson documents produced to ashareholder who instituted a corporatebooks and records proceeding. The courtfound that selective waiver benefits lawenforcement agencies, and allows theSEC to resolve its investigationsexpeditiously and efficiently. The courtthen found that the efficiencies and costsavings would in turn benefit theinvesting shareholder, because theintegrity of the capital markets would bepreserved at a lower cost to society. Thecourt also flatly rejected any unfairnessargument, as it could see no reason why confidential disclosure to thegovernment should result in disclosure toa plaintiff. (“I know of no good reason




Although this application of Wrightseems to create a broad sphere ofliability for secondary actors, thecourt does narrow that liabilitysomewhat by noting that theplaintiffs dealt with and paid feesdirectly to the defendants, not justErnst & Young, and by requiringthat the statements at issue bepublicly attributable to thedefendants. In this case, theplaintiffs did allege facts showingthat they were aware of SidleyAustin’s participation in thetransaction and that therepresentations were made by itand the other defendants, albeitthrough Ernst & Young.

Third Circuit

In Rowinski v. Salomon SmithBarney Inc., 398 F.3d 294 (3d Cir.2005), the Third Circuit addressedSecurities Litigation UniformStandards Act (SLUSA) preemptionby considering specifically whetherthe complaint alleged both a“material misrepresentation” and,if so, whether the misrepresentationwas “in connection with thepurchase or sale of a coveredsecurity.” The complaint allegedthat Salomon Smith Barney (SSB)“artificially inflates the ratings andanalysis of its investment bankingclients [in order to] curry favor withinvestment banking clients andreap hundreds of millions of dollarsin investment banking fees.” The complaint was filed inPennsylvania state court andsought relief under various statelaw theories. SSB removed andfiled a motion to dismiss based onSLUSA preemption. The trial courtgranted the motion, and the ThirdCircuit, holding that the claimswere preempted because both the“misrepresentation” and “inconnection” elements weresatisfied, affirmed.

The court held that the“misrepresentation” prong ofSLUSA was satisfied because theallegations of a materialmisrepresentation served as thefactual predicate of a state lawclaim. “[P]reemption does not turn on whether allegations arecharacterized as facts or asessential legal elements of a claim,but rather on whether the SLUSAprerequisites are ‘alleged’ in oneform or another.” The “inconnection” issue turned on“whether plaintiff’s class-wideallegations, charging [SSB] withsystematically and materiallymisrepresenting its investmentbanking clients’ investment ratingsand analyses, [were] ‘connected’ tothe purchase or sale of securities.”In concluding that they were, thecourt cited SEC v. Zandford, 535U.S. 813 (2002), which held thatthe “in connection” elementshould be read broadly, and theconnection is established where afraudulent scheme and a securitiestransaction coincide. The Rowinskicourt applied four non-exclusivefactors in determining that theclaim was preempted:

[F]irst, whether the coveredclass action alleges a“fraudulent scheme” that“coincides” with the purchaseor sale of securities; second,whether the complaint alleges amaterial misrepresentation oromission “disseminated to thepublic in a medium upon whicha reasonable investor wouldrely;” third, whether the natureof the parties’ relationship issuch that it necessarily involvesthe purchase or sale ofsecurities; and fourth, whetherthe prayer for relief “connects”the state law claims to thepurchase or sale of securities.

In applying these factors, the courtconcluded that the plaintiff’scomplaint was in fact preemptedby SLUSA, and was properlydismissed.

Delaware

In VantagePoint Venture Partners1996 v. Examen, Inc., 2005 Del.LEXIS 179 (May 5, 2005), theDelaware Supreme Court held thatapplying a provision of theCalifornia Corporations Code, withspecific requirements regardingmergers, to a Delaware Corporationwould be unconstitutional. Theplaintiff, VantagePoint VenturePartners, an 83% holder of Examen,Inc. preferred stock, sought torescind a merger between Examenand Reed Elsevier. VantagePointargued that because Examen was aquasi-California corporation underCalifornia Corporations Code §2115, the merger required anapproval by a majority of each classof stock, and Examen did not obtainsuch approval. (CaliforniaCorporations Code § 2115 providesthat, irrespective of the state ofincorporation, foreign corporations’articles of incorporation are deemedamended to comply with Californialaw and are subject to the laws ofCalifornia if certain criteria are met.)

Examen, which was incorporatedunder the laws of Delaware, arguedthat the California CorporationsCode was inapplicable. Examenfurther argued that under Delawarelaw, all that was required was amajority vote by all of theoutstanding shares of capital stock,and therefore, the merger was valid.

The Delaware Supreme Courtrefused to apply California law, andheld that only Delaware corporatelaws apply to matters involving the“internal affairs” of Delawarecorporations. The Court found that,under the well-established internalaffairs doctrine, “only the law of thestate of incorporation governs anddetermines issues relating to acorporation’s internal affairs.” Thedoctrine applies to matters thatpertain to relationships among orbetween the corporation and itsofficers, directors and shareholders.

Circuit and State Round-Up(Continued from Page 5)



The court found that the doctrine isnot only a conflicts of law principle,but a constitutional principle aswell. First, under the Due ProcessClause, directors have a right toknow by what standards ofaccountability they should begoverned. Second, the court foundthat under the Commerce Clause, astate has no interest in regulatingthe internal affairs of foreigncorporations.

The court determined that applyingCalifornia Corporations Code § 2115would violate these principles. Thecourt also found that internal affairsrequire uniformity, and applyingCalifornia law would prevent suchuniformity, cause confusion andcreate inequalities. The courttherefore held that choice of lawrules and the U.S. Constitutionmandate that Examen’s internalaffairs, and in particular,VantagePoint’s voting rights, beadjudicated exclusively under thelaws of Delaware. The courttherefore affirmed the ChanceryCourt’s decision granting judgmenton the pleadings to Examen.

New York

In EBC I, Inc. v. Goldman, Sachs &Co., 2005 WL 1346859 (N.Y. June7, 2005), the New York Court ofAppeals held for the first time thatan underwriter owes a fiduciaryduty to reveal any conflict ofinterest to an issuer when servingas an expert advisor in an IPO. Theplaintiff, the Official Committee ofUnsecured Creditors of EBC I.,Inc., formerly known as eToys, Inc.(eToys), brought a claim againstGoldman, Sachs & Co. (Goldman),the lead managing underwriter ofits IPO, alleging several causes ofaction under state law related tothe underwriting agreement,including breach of fiduciary duty.Pursuant to the underwriting

agreement, eToys agreed to payGoldman the spread between theIPO price and the price charged to Goldman and the otherunderwriters. The IPO price wasultimately set at approximately $20 per share, and eToys sold theshares to Goldman and the otherunderwriters for $18.65 a share.Goldman’s potential profit underthis arrangement, therefore, was6.75% of the total IPO proceeds, or approximately $13 million.

As alleged by eToys, Goldman also entered into a set of salesarrangements with the purchasersof eToys stock, whereby thepurchasers were bound to payGoldman between 20-40% of anyprofits they enjoyed resulting froman increase in the IPO price.Goldman never disclosed to eToysthis arrangement with thepurchasers, which eToys allegedgave Goldman an incentive tokeep the IPO offering price low.

On the first day of public trading,the stock opened at $79 per shareand the price went as high as $85per share. By the end of 1999,however, the price had fallen backto $25 per share and it soon fellbelow the IPO price of $20 pershare. The stock price never roseabove the IPO price again andeToys filed for bankruptcy inMarch of 2001.

The Court of Appeals affirmed theAppellate Divisions’s decision thateToys’s claim for breach of fiduciaryduty should proceed. The courtconcluded that while theunderwriting agreement itself didnot create a fiduciary relationshipbetween the parties, eToys had

sufficiently pled such a relationshipby alleging that Goldman had actedas an expert advisor regarding theIPO price.

The court noted that “a cause ofaction for fiduciary duty maysurvive, for pleading purposes,where the complaining party setsforth allegations that, apart from theterms of the contract, theunderwriter and issuer created arelationship of higher trust thanwould arise from the underwritingagreement alone.” The court furtherconcluded that Goldman’s failure todisclose its fee arrangement withthe purchasers of eToys stock gaveeToys the false impression thatGoldman’s interests were alignedwith its own and may haveconstituted a breach of this fiduciaryrelationship.

The court rejected Goldman’sassertion that requiring anunderwriter to disclose potentialconflicts of interest in the pricing ofthe securities it is underwritingwould run counter to theunderwriter’s “general duty toexercise due diligence in thepreparation of a registrationstatement.”

The court was careful to point out,however, that an underwriter’sfiduciary duty to an issuer in thiscontext was limited to theunderwriter’s role as advisor, anddoes not apply when theunderwriter is engaged in activitiesother than rendering expertadvice. �

Circuit and State Round-Up(Continued from Page 18) 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.


price was inflated due to the defendant’salleged fraud, but not that the price fellfollowing a corrective disclosure.

The Ninth Circuit’s

Decision in DuraThe plaintiffs alleged that DuraPharmaceuticals artificially boosted theprice of its stock at the beginning of thealleged class period by misrepresentingthe prospects for Food and DrugAdministration (FDA) approval of itsasthma-spray device. The plaintiffs suedwhen the stock price dropped afterDura announced lower than expectedearnings due to slow drug sales, eventhough the “truth” about the FDAapproval was not disclosed. It was notuntil eight months later, after the close ofthe class period, that Dura disclosed thatthe FDA failed to approve the asthma-spray device. Plaintiffs’ sole allegationregarding their economic loss was thatthey had “paid artificially inflated pricesfor Dura securities.” The Ninth Circuitaccepted this allegation as sufficient toplead loss causation.

The Supreme Court’s

Decision in DuraThe Supreme Court, in a short andunanimous opinion authored by JusticeStephen Breyer, held that in fraud-on-the-market cases such as Dura, “aninflated purchase price will not itselfconstitute or proximately cause therelevant economic loss.” The decisionrests on three points.

First, the court rejected the notion thatmere price inflation means that theinvestor has suffered an economic loss.“For one thing,” the court observed, “asa matter of pure logic, at the moment the[stock purchase] takes place, the plaintiffhas suffered no loss; the inflatedpurchase payment is offset by ownershipof a share that at that instant possessesequivalent value.” An investor who sellsthe stock before the truth is disclosedmay suffer a loss if the price declines,

but that loss is not attributable to themisstatements because the decline isunrelated to the inflation. Moreover,even after the “relevant truth” is learnedby the market, a “lower price mayreflect, not the earlier misrepresentation,but changed economic circumstances,changed investor expectations, newindustry-specific or firm-specific facts,conditions or other events.” Thus, atmost, “an initially inflated purchaseprice might mean a later loss.”

Second, the court concluded that theprice inflation theory of loss causationhas no historical support in the commonlaw of fraud and deceit on which thefederal anti-fraud securities statutes arebased. The judicial consensus, asreflected in the Restatement of Torts, isthat a person who “misrepresents thefinancial condition of a corporation inorder to sell its stock” is liable “for theloss” sustained by the purchaser “whenthe facts … become generally known”and, as a result, share value depreciates.“Given the common-law roots of thesecurities fraud class action,” the courtobserved that “it is not surprising thatthe other courts of appeals have rejectedthe Ninth Circuit’s ‘inflated purchaseprice’ approach to proving causationand loss.”

Third, the court found that the priceinflation theory was inconsistent with thepurpose of the federal securities statutes.These statutes “seek to maintain publicconfidence in the marketplace.” Theyare “not to provide investors with broadinsurance against market losses” thatare not caused by defendant’smisrepresentations. The Ninth Circuit’sapproach “would allow recoveries wherea misrepresentation leads to an inflatedpurchase price but nonetheless does notproximately cause” an investor’seconomic loss – as, for instance, when adrop in stock price is caused by factorsother than disclosure of “the truth.”

In Dura, the truth about FDA approvalwas not known at the close of thealleged class period. Rather, the drop instock price that the plaintiffs sought torecover followed an announcement ofother unrelated negative developments

Supreme Court In Dura Pharmaceuticals

Unanimously Endorses “Loss Causation”Requirement in Fraud-on-the-Market Cases(Continued from Page 2)



about Dura’s business. Thus, theplaintiffs could not demonstrate losscausation.

One may wonder why the plaintiffssimply did not extend the class perioduntil the disclosure of the news aboutFDA approval. The answer appears tobe that they would not have been ableto demonstrate damages under thePrivate Securities Litigation ReformAct (PSLRA). When “the truth” wasrevealed, Dura’s stock price momentarilydipped but then quickly recovered.Under the PSLRA’s so-called “90-daybounce-back” provision, this meant thatthe plaintiffs likely did not suffer anyrecoverable damages.

What is the Effect of the DuraDecision?

The Supreme Court’s rejection of theprice inflation theory of loss causationmay have the greatest effect in theNinth and Eighth Circuits. There, theDura decision closes the door to aspeculative genre of stock drop classactions in which plaintiffs need notplead any loss in stock value due to adefendant’s alleged fraud. In alljurisdictions, however, the lasting impactof the Dura decision will depend onhow parties use and courts interpret theSupreme Court’s reasoning.

The Supreme Court’s embrace of thelogical consequences of the efficientmarket theory strongly supports certaindefense arguments in fraud-on-the-market cases. The court perceptivelynoted that even a decline in stock priceafter the “truth” is revealed may notnecessarily be attributable to the allegedmisrepresentation where other factorsare operating on the market price. Thissupports the long-standing argumentthat defendants are not liable for theportion of a drop in stock priceattributable to factors unrelated to analleged corrective disclosure. The court’sreasoning also seems to support the

defense argument that the absence ofany negative market reaction todisclosure of “the truth” establishes thatthe alleged misrepresentation was notmaterial and, therefore, not actionable.

One aspect of the court’s decision,however, may be welcomed by plaintiffs.Because Dura was dismissed at thepleading stage, the court consideredthe level of detail at which plaintiffsmust plead loss causation. The court“assume[d],” rather than held, “thatneither the [Federal] Rules nor thesecurities statutes impose any specialfurther requirement” for pleading losscausation. As a result, the courtevaluated the complaint pursuant to the“short and plain statement” pleadingstandard of Rule 8 of the Federal Rulesof Civil Procedure. The court observedthat, measured only by the requirementsof Rule 8, “it should not proveburdensome for a plaintiff who hassuffered an economic loss to provide adefendant with some indication of theloss and the causal connection that theplaintiff has in mind.” It will be left tothe lower courts to decide whetherlenient Rule 8 or the heightenedpleading requirements of Rule 9(b)(governing allegations of fraud) or thePSRLA (governing securities fraud cases)are applicable to allegations of losscausation. Because most securities fraudclass actions are decided at the pleadingstage, the standard adopted by the lowercourts for loss causation will affectwhether at least some securities fraudclass actions survive the pleading phase.

In the end, while courts andcommentators still have plenty of issuesto wrestle with in the wake of Dura, thedecision is a significant victory forpublic companies and others named asdefendants in securities fraud cases. �

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.”

Supreme Court In Dura Pharmaceuticals

Unanimously Endorses “Loss Causation”Requirement in Fraud-on-the-Market Cases(Continued from Page 20)


Furthermore, explained the PCAOB,AS No. 2 was designed to beimplemented from the “top down” –“first on company-level controls andthen on significant accounts, whichlead the auditor to significantprocesses and, finally, individualcontrols at the process, transaction,or application levels.” As a result,auditors should employ a risk-basedapproach to increase audit qualityand reduce costs and, as part of therisk-assessment, auditors shouldconsider the strength of company-level controls (which includegeneral and disciplinary controlsand those performed on a company-wide basis).11

The PCAOB also reemphasized thatrelying upon the work of others isappropriate and often the mostefficient way to avoid unnecessaryrepetition, minimize costs andensure that high-risk areas remainthe focus of an audit. In addition, aslong as management makes its owndecisions regarding the applicationof accounting principles, auditorsmay freely discuss difficultaccounting and internal controlissues with management throughoutthe fiscal year. Indeed, timelyinformation-sharing – includingsharing draft financial statements –is necessary under AS No. 2.

The accompanying PCAOB StaffQ&A explained that auditors neednot test all controls but insteadshould obtain evidence about theeffectiveness of controls for allrelevant assertions related tosignificant accounts and disclosuresin the financial statements.Furthermore, there is no

requirement to perform a quarterlyaudit of internal control. Rather,auditors need only perform, on aquarterly basis, those proceduresgenerally limited to focusing on theimplications of any identifiedfinancial misstatements.

The PCAOB’s release thereforemirrored the SEC’s guidance thatinternal control testing should be, ineffect, “smarter,” but not necessarilyprohibitively extensive andexpensive.

Conclusion

The recent guidance from the SECand PCAOB may serve to alleviatesome of the pressure felt bymanagement and auditors to testand document every aspect ofinternal control – where suchactivities may be redundant orirrelevant to financial reporting. Ofcourse, by encouraging the greateruse of professional judgment inareas such as choosing “risk-based”controls to test, relying upon thework of others or focusingassessments and audits towardscontrols likely to have a materialimpact upon financial statements,the recent guidance leaves the dooropen for such judgment to be heldto the scrutiny of hindsight.Although broad and promising, theusefulness of the guidance will bestbe gauged, as the GAO’s report onthe SEC’s own internal controlsindicates, by continuing to watch forfurther experiences of those entitiesthat are struggling with thedifficulties and ambiguities inherentin § 404 implementation. �

Endnotes

1 U.S. General Accountability Office,

“Financial Audit, Securities and Exchange

Commission’s Fiscal Year 2004 Financial

Statements” (May 2004), available at

http://www.gao.gov/new.items/d05244.pdf.

2 See 15 U.S.C. § 7262(a).

3 See 17 C.F.R. 229.308.

4 See SOX § 103(a)(2)(A)(iii), 15 U.S.C. 7213(a).

5 See PCAOB Release No. 2003-015, “Rules on

Investigations and Adjudications”

(September 29, 2003).

6 See SEC Release No. 33-8238, at III.E;

“Extension of Compliance Dates for Non-

Accelerated Filers and Foreign Private

Issuers Regarding Internal Control Over

Financial Reporting Requirements”, SEC

Press Release No. 2005-25 (March 2, 2005).

7 See Carl Bialik, “How Much Is It Really

Costing to Comply With Sarbanes-Oxley?”,

The Wall Street Journal Online (June 16,

2005).

8 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.

9 See SEC Release No. 2005-74 (Commission

Statement on Implementation of Internal

Control Reporting Requirements, May 16,

2005).

10 See SEC Staff Statement on Management’s

Report on Internal Control Over Financial

Reporting (May 16, 2005), available at

http://www.sec.gov/info/accountants/stafficre

porting.htm.

11 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).

12 This article includes contributions made by

Houman B. Shadab.



why an opponent should borrow thewits of its adversary simply becausethe adversary was cooperating witha law enforcement agency.”).Ultimately, the court adopted thedoctrine, stating that such a rulewas in the best interests of theshareholders to encourage corporatecompliance, and because lawenforcement agencies were the firstline of defense for shareholders. Saitov. McKesson HBOC, Inc., 2002 Del.Ch. LEXIS 125 (Oct. 25, 2002).

What to Do

Ultimately, all of these decisionscreate a startling result. California

state court and Georgia state courtplaintiffs, and the criminaldefendants, all have access to theMcKesson report and back-upmaterials. Meanwhile, federalsecurities plaintiffs and Delawareshareholders seeking to institutelitigation are not entitled to theexact same materials. Access tothese materials depends solely onwhere the action was brought.

Whether a company should provideprivileged materials to governmentagencies is a business decisionrequiring a cost-benefit analysis.The uncertainty in the law makes itthat much harder for companies tomake this decision. The McKessoncases offer guidance as to whicharguments may be the most

compelling to courts that continueto struggle with the selective-waiver doctrine. These cases alsosuggest the importance of obtainingas restrictive a confidentialityagreement as possible with the SECand USAO. More than anything,the McKesson cases demonstrate aneed for a legislative solution.

In absence of legislative action,however, the current state of the lawsuggests that at least someshareholder plaintiffs will gainaccess to any privileged materialsprovided to the SEC or USAO. �


In re EMCOR Group,Inc. Sec. Litig.On July 22, Latham won a motion todismiss on behalf of clients EMCORGroup, Inc., and three of its seniorexecutives, in a shareholder classaction suit in federal court inConnecticut. In re EMCOR Group,Inc. Sec. Litig., Civil Action No. 3-04-cv-531 (JCH) (D. Conn. July 22,2005). The plaintiffs claimed that thecompany’s earnings guidance, whileaccompanied by significant riskwarnings, was shown to be falsewhen defendants failed to meettheir forecast and supposedly“admitted” challenges that had notpreviously been disclosed. JudgeJanet Hall rejected the plaintiffs’allegations, holding that theplaintiffs failed to demonstrate thatany of the challenged statementswere false. Judge Hall observed thatthe complaint had quoted certain ofthe defendants’ statements out of

context, and that the defendants’purported later “admissions” of thereasons why they did not meet theirforecasts did not show that any ofthe challenged statements was falsewhen made. Latham’s team partnerswas led by Michele Rose (VA) andLaurie Smilan (VA).

Brazen v. TycoInternational Ltd.On July 22, 2005, in Brazen v. TycoInternational Ltd., Case No. 02 CH11837, the Circuit Court of CookCounty, Illinois, dismissed Section11 and 15 claims brought againstthe former outside directors of TycoInternational Ltd. (Tyco) by formershareholders of the stock ofMallinckrodt, Inc. (MLKT) whoreceived Tyco shares in exchangefor shares of MLKT when the twocompanies merged in 2000. Theplaintiffs filed their claims in statecourt in 2002, the case was removedto federal court, and remanded backto state court. After remand, theoutside director defendants moved

to dismiss the state court action forlack of personal jurisdiction. TheIllinois Court granted the individualdefendants’ motion to dismiss withprejudice. The plaintiffs hadasserted that the nationwide serviceof process provision of the 1933 Act,15 U.S.C. § 77v(a), granted statecourt jurisdiction over the individualdefendants. Judge Thomas P. Quinnrejected this argument, holding thatthe language of the provision limitsjurisdiction to federal district courtsregardless of whether it permitsnationwide service. The court heldthat even if the plaintiffs’interpretation of the statute werecorrect, the court could not exercisejurisdiction over the individualdefendants because the plaintiffsdid not allege that they hadsufficient minimum contacts withIllinois to satisfy due process. Theteam was led by partners LaurieSmilan (VA) and Janet Link (CH)and associates Marguerite Sullivan(VA), Mike Faris (CH) and AllisonO’Neill (CH). �

Recent Victories(Continued from Page 3)


ChicagoKevin A. Russell

312-876-7700

[email protected]

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+49-69-6062-6550

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[email protected]

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