In this edition of Dechert’s Securities & Derivative Litigation Quarterly Update, we:

• Highlight the Third Circuit’s adoption of the de novo standard of review in evaluating appeals of derivative litigation demand-futility decisions;
• Explore the Sixth Circuit’s recognition of the applicability of the “bespeaks caution” doctrine and the heightened pleading standard for certain ’33 Act Claims; and
• Preview the U.S. Supreme Court’s decision to hear appeals that will provide enhanced guidance on the pleading requirements and disclosure-based liability in securities fraud lawsuits.

En Banc Third Circuit Joins Sister Circuits and Delaware In Adopting De Novo Standard Of Review In Evaluating Demand-Futility Decisions

On May 3, 2024, the en banc United States Court of Appeals for the Third Circuit adopted a de novo standard of review when evaluating district court orders dismissing stockholder derivative actions for failure to plead demand futility under Federal Rule of Civil procedure 23.1.¹ This decision vacated decades-old Third Circuit authority requiring that the court review those dismissal for an abuse of discretion.² In adopting the de novo standard of review, the Third Circuit aligned itself with the United States Courts of Appeals for the First, Second, Seventh, Eighth, and Tenth Circuits, as well as the Delaware Supreme Court.³

Background

In In re Cognizant, stockholders of Cognizant Technology Solutions Corporation (the “Company”) filed a consolidated derivative action in the United States District Court for the District of New Jersey, alleging that various Company directors and officers breached their fiduciary duties by ignoring red flags indicating that employees at their facilities in India were potentially engaged in bribery and violations of the Foreign Corrupt Practices Act.⁴ Company stockholders failed to make a pre-suit demand on the Company’s Board, and the defendants moved to dismiss.⁵ The District Court granted the motions to dismiss, concluding that the stockholders’ complaint failed to state with particularity why demand would have been futile.⁶

Third Circuit’s Reasoning

On appeal, the en banc Third Circuit considered the proper standard of appellate review that should apply when a district court dismisses stockholder derivative actions based on a plaintiffs’ failure to plead demand futility under Rule 23.1.⁷ After reviewing the guiding principles of corporate law, the Court evaluated its 1992 decision in Blasband v. Rales,⁸ in which the Court “explained, for the first time . . . , that a district court’s ‘determination of demand futility’ is ‘reviewed for abuse of discretion,’ though ‘its choice of legal precepts’ in making that determination is reviewed de novo.”⁹ The Court acknowledged that “when other courts largely disapprove of our reasoning in more recent decisions, those contrary views may impel us to consider whether the reasoning applied by our colleagues elsewhere is persuasive.”¹⁰ “This is one such occasion,” the Third Circuit concluded.¹¹ The Court noted that “[j]ust eight years after Blasband, the Delaware Supreme Court abandoned the abuse-of-discretion standard in favor of de novo review for demand futility dismissals under the analogous Delaware Chancery Court Rule 23.1” and that many of its sister circuits “have all adopted de novo review for demand futility cases.”¹²

In overturning Rales, the Third Circuit further explained that its decision in Rales “did not offer much, if any, rationale for adopting the abuse-of-discretion standard.”¹³ This fact, along with the consensus of the Delaware Supreme Court and its sister circuits, compelled the Third Circuit to concluded that “a district court’s decision to dismiss a derivative action for failure to plead demand futility under Rule 23.1 is reviewed de novo.”¹⁴

Analysis

In joining the Delaware Supreme Court and its sister circuits in exercising de novo review over orders dismissing derivative actions for failure to plead demand futility, the Third Circuit aligns itself with the consensus approach and further harmonizes the authority on this point. Directors and officers facing stockholder derivative suits in federal court in Delaware, Pennsylvania, New Jersey, and the U.S. Virgin Islands should be aware of the Third Circuit’s newly adopted standard of review in considering district court orders dismissing those suits.

Sixth Circuit Recognizes Applicability of the Bespeaks Caution Doctrine and Use of Heightened Pleading Standard for Certain 1933 Act Claims

On April 29, 2024, a three-judge panel of the United States Court of Appeals for the Sixth Circuit issued a decision in Kolominsky v. Root, Inc., affirming the U.S. District Court for the Southern District of Ohio’s dismissal of a putative securities class action against insurance company Root, Inc. and certain of its directors, officers, and underwriters (“Defendants”).

In their complaint, Plaintiffs, who were investors in Root, alleged that certain statements made by Root in relation to its customer-acquisition cost (“CAC”) constituted false or misleading statements or omissions giving rise to liability under Sections 10(b) of the Securities Exchange Act of 1934, and Sections 11, 12(a)(2), and 15 of the Securities Act of 1933. Plaintiffs’ claims were primarily based on three statements contained in Root’s Registration Statement: (1) a statement indicating that Root designed a customer acquisition strategy “delivering customer acquisition costs below the average cost of doing so”; (2) a statement indicating that “the efficiency of [the] customer acquisition strategy has resulted in a cost acquisition advantage” and “over the period from August 2018 to August 2020 [the] average customer acquisition cost was $332”¹⁵; and (3) a disclosure that as the company grows, it “may struggle to maintain cost-effective marketing strategies and [the] customer acquisition costs could rise substantially.”¹⁶ After the district court dismissed all of the claims with prejudice for failure to state a claim,¹⁷ the Sixth Circuit conducted de novo review and affirmed.¹⁸

Starting first with the pleading requirements, the Court upheld the district court’s application of Rule 9(b) to the Plaintiff’s claims under Sections 11 and 12(a)(2) to hold that when fraud and negligence claims are premised on a “unified course of fraudulent conduct,” the complaint “sounds in fraud” and Rule 9(b) applies.¹⁹ The Court explained that a Plaintiff’s mere disclaimer that it is not pleading fraud is insufficient to defeat the application of Rule 9(b).²⁰ In an opinion dissenting in part and concurring in the judgment, Circuit Judge Clay rejected the Court’s “categorical approach” which he argued would “subject almost every negligence claim under Sections 11 or 12 to a heightened pleading standard when pleaded alongside fraud claims,” and would “undoubtedly lead some plaintiffs to shed some potentially meritorious claims so as to avoid triggering the demanding Rule 9(b) standard.”²¹

The Court also affirmed dismissal of the complaint for failure to state a claim for relief.²² First, the Court found that two statements accurately described Root’s past customer acquisition costs.²³ Next, the Court created new circuit law and joined other circuits, recognizing the applicability of the Bespeaks Caution doctrine despite codification of a safe harbor provision in the Private Securities Litigation Reform Act (“PSLRA”).²⁴ This ruling was critical to the Court’s decision affirming dismissal because the PSLRA’s safe harbor for forward-looking statements does not apply to statements made in connection with an IPO, whereas the Bespeaks Caution doctrine does. In particular, the Court held that when companies such as Root make forward-looking statements contained in a registration statement or in connection with an initial public offering, the Bespeaks Caution doctrine “will shield those companies from liability when forward-looking statements are accompanied by meaningful cautionary language. . . .”²⁵ As such, the Court held that Root’s disclosure indicating the CACs could rise substantially was properly dismissed because the forward-looking statement contained meaningfully cautionary language, warranting the application of the Bespeaks Caution doctrine.²⁶ Lastly, the Court dismissed Plaintiffs’ Section 15 claim, explaining that such a claim cannot exist where primary liability cannot be established.²⁷

The Sixth Circuit’s decision provides prospective litigants guidance on when Rule 9(b)’s heightened pleading standard will apply to Section 11 and 12 claims that are brought alongside Section 10(b) claims and confirms the continued application of the Bespeaks Caution doctrine. What remains to be seen, and will likely be the focus of future litigation, is how Courts will ascertain what constitutes a “unified course of fraudulent conduct.”

Supreme Court to Hear Appeals from Ninth Circuit Decisions in Securities Fraud Cases

On June 17, 2024, the United States Supreme Court agreed to hear appeals of two Ninth Circuit decisions in securities fraud class actions involving companies NVIDIA and Facebook.²⁸ The Supreme Court’s rulings will provide guidance on pleading requirements and disclosure-based liability in the securities fraud context.

NVIDIA Corp. v. E. Ohman J:OR Fonder AB (No. 23-970)

In NVIDIA Corp. v. E. Ohman,²⁹ plaintiffs allege that NVIDIA and three of its officers (“defendants”) made materially false and misleading statements regarding the impact of cryptocurrency sales on NVIDIA’s revenues, by failing to reveal, or materially understating, the amount of NVIDIA's revenue growth that was due to crypto-related purchases of GPUs.³⁰ Plaintiffs alleging securities fraud pursuant to Section 10(b) of the Securities Exchange Act are required to state with particularity both the circumstances constituting fraud and “facts giving rise to a strong inference that the defendant acted with the required state of mind.”³¹ In their complaint, plaintiffs reference two external reports demonstrating that NVIDIA underreported the amount of revenue attributed to cryptocurrency sales, along with the statements of two former employees suggesting the defendant-officers’ knowledge of revenue details, based in part on the existence of internal records accessible to the defendant-officers. The Ninth Circuit overturned the lower court’s decision and found that plaintiffs sufficiently alleged that false or misleading statements were made with the requisite intent, sustaining the claims against NVIDIA and one officer.³²

On appeal, NVIDIA argues that the Ninth Circuit erred in finding that the allegations were sufficiently particularized to raise a strong inference of scienter. NVIDIA argues that not only did plaintiffs fail to allege the actual content of internal records they claim supports their allegations, but plaintiffs also hired an independent expert—with no connection to the company—in an attempt to bolster their inadequate allegations. The questions presented to the Court include (i) whether plaintiffs seeking to allege scienter under the Private Securities Litigation Reform Act (“PSLRA”) based on allegations regarding internal company records must plead with particularity the contents of those documents, and (ii) whether plaintiffs can satisfy the PSLRA’s falsity requirement by relying on an expert opinion to substitute for particularized allegations of fact.³³ According to NVIDIA, the Supreme Court should rule that plaintiffs must adequately allege particularized facts demonstrating defendants’ access to internal records that contradict publicly available information and cannot use an outside expert to overcome the absence of particularized facts regarding the actual contents of internal records. Oral argument is scheduled on November 13, 2024.

Facebook, Inc. v. Amalgamated Bank (No. 23-980)

In the Facebook appeal, the Supreme Court granted certiorari to address allegations against Facebook and three of its executives relating to risk factors set forth in the company’s public filings. Faced with a company’s robust disclosures, plaintiffs often attempt to argue that the risk disclosures themselves are misleading because the company presented the risk as “hypothetical” when, in fact, the “risk” had already materialized. In Facebook, plaintiffs alleged that risk disclosures set forth in the company’s Form 10-K relating to the risk of third parties obtaining access to user data was false and misleading because Facebook had already experienced third party access and use of its data. The Ninth Circuit held that the plaintiffs had adequately alleged this statement was false and misleading because the risk was either not presented, or presented as “purely hypothetical” when it had already “materialized.”³⁴

On appeal, the question presented by Facebook is whether alleging fraud based on risk disclosures encompassing risks that have materialized are viable theories of liability under Section 10(b), in light of the “probabilistic” nature of such disclosures.³⁵ Facebook argues that a risk factor is forward-looking in nature and cannot reasonably be interpreted as representing that the risk has never occurred in the past and will not affect the company in the future. As such, Facebook argues that the Ninth Circuit’s decision should be overturned because it would require companies to disclose a past event, even though there is no known threat of ongoing or future harm to the company associated with that past event. Furthermore, Facebook argues that the Ninth Circuit’s ruling would lead to more burdensome disclosure requirements that would potentially drown inventors in irrelevant information.³⁶ Amicus briefs have been filed by several parties³⁷ in support of defendants, arguing that adopting plaintiffs’ theory of liability would cause unnecessarily excessive disclosures, resulting in information overload and the filing of meritless lawsuits. The Court will hear oral argument in this case on November 6, 2024, with a decision expected by summer of 2025.

1. In re Cognizant Technology Solutions Corporation Derivative Litigation, 101 F.4th 250 (3d Cir. 2024) (en banc).
2. See id. at 254.
3. Id. at 255.
4. See id. at 255-56.
5. See id. at 256.
6. Id.
7. Id.
8. 971 F.2d 1034 (3d Cir. 1992).
9. In re Cognizant, 101 F.4th at 257-58 (quoting Rales, 971 F.2d at 1040).
10. Id. at 258 (cleaned up).
11. Id.
12. Id. (cleaned up).
13. Id at 261.
14. Id. at 262.
15. According to Plaintiffs, traditional car companies have CACs between $500 and $800. Kolominsky v. Root, Inc., 100 F.4th 675, 681 (6th Cir. 2024).
16. Id. at 681-82.
17. Kolominsky v. Root, Inc., 667 F. Supp. 3d 685, 702 (S.D. Ohio 2023).
18. Kolominsky, 100 F.4th at 689.
19. Id. at 683.
20. Id. at 684.
21. Id. at 692 (Clay, J., concurring).
22. Id. at 684-89.
23. Id. at 686-87.
24. Id. at 687-88.
25. Id. at 689.
26. Id.
27. Id.
28. NVIDIA Corp. v. Ohman J, No. 23-970, 2024 WL 3014476, at *1 (U.S. June 17, 2024) (granting certiorari); Facebook, Inc. v. Amalgamated Bank, No. 23-980, 2024 WL 2883752, at *1 (U.S. June 10, 2024) (same).
29. NVIDIA Corp. v. E. Ohman J:OR Fonder AB, No. 23-970.
30. GPUs (Graphics processing units) are a processing hardware that can be used for crypto-mining.
31. 15 U.S.C. § 78u–4(b)(2).
32. E. Ohman J:or Fonder AB v. NVIDIA Corp., 81 F.4th 918, 947 (9th Cir. 2023), cert. granted sub nom. NVIDIA Corp. v. Ohman J, No. 23-970, 2024 WL 3014476 (U.S. June 17, 2024).
33. NVIDIA CORP. and Jensen Huang, Petitioners, v. E. OHMAN J:OR FONDER AB and Stichting Pensioenfonds PGB, Respondents., 2024 WL 3843034, at *i.
34. See In re Facebook, Inc. Sec. Litig., 87 F.4th 934, 949 (9th Cir. 2023), cert. granted in part sub nom. Facebook, Inc. v. Amalgamated Bank, No. 23-980, 2024 WL 2883752 (U.S. June 10, 2024).
35. FACEBOOK, INC., et al., Petitioners, v. AMALGAMATED BANK, et al., 2024 WL 3815071, at *2.
36. FACEBOOK, INC., et al., Petitioners, v. AMALGAMATED BANK, et al., 2024 WL 3815071, at *32.
37. The following entities have filed amicus briefs: Washington Legal Foundation; the Chamber of Commerce of the United States and the Securities Industry and Financial Markets Association; Law Professors and Former Officials of the Securities and Exchange Commission; and the Society for Corporate Governance.