Tuesday, March 01, 2016

Court Denied Petitions on Definition of Customer, Application of Safe Harbor

By Rodney F. Tonkovic, J.D.

The Supreme Court has denied certiorari in two securities-related cases. First, a petition by CarVal UK Limited asked about the definition of "customer" under the Securities Investor Protection Act (SIPA). The second petition denied today was brought by Harman International Industries, Inc. and concerned the PSLRA safe harbor provision.

CarVal UK. CarVal UK was the successor to an entity which had entered into repurchase agreements with Lehman Brothers as the buyer. Lehman entered SIPA liquidation in 2008, before the predecessor entity could repurchase the securities, and, while claims were filed in the liquidation, the SIPA trustee denied them on the basis that the entity was not a “customer” of Lehman.

If CarVal's predecessor were a customer under SIPA, it would be entitled to a return of any property that Lehman was holding on its behalf. Under the Second Circuit’s 1974 Baroff decision, an investor must have “entrusted” property to the broker-dealer in order to be a customer under SIPA. In this case, the Second Circuit found that the predecessor did not entrust anything to Lehman, which had acquired full legal title to the securities and had discretion to use them as it saw fit. CarVal, therefore, was not a customer.

CarVal's petition asked whether a participant in a repurchase transaction qualifies as a customer under SIPA. According to CarVal, since 1986 all courts that have considered the issue have followed the rule that an investor participating in a repurchase agreement with a broker-dealer is deemed a "customer" under SIPA. The Second Circuit's decision, the petition asserted, created a circuit split by imposing an entrustment requirement that is nowhere to be found in SIPA's express definition of the term "customer." Underscoring the importance of this conflict, the petition emphasized, is the fact that the nation's financial center is in the Second Circuit, and that court's narrowing of the definition of customer will make bankruptcy protection uncertain for the trillions of dollars' worth of repurchase agreements that are executed yearly.

Harman. Also facing the music today was audio equipment maker Harman International Industries, Inc. Harman's petition asked the court whether a purported misrepresentation is sufficient to preclude safe harbor protection, and whether courts can consider an issuer's alleged knowledge to determine whether cautionary statements are "meaningful." The petition also presented a separate question asking whether a vague and immeasurable characterization of results was immaterial puffery.

In June 2015, the D.C. Circuit sent Harman's case back to the district court, finding that the lower court erred in finding that the complaint failed to allege actionable misstatements or omissions. The action arose out of Harman's announcement of its likely acquisition in 2007 and accompanying statements predicting a rosy future for the company. The circuit court found that the cautionary information accompanying the contested statements by Harman executives was not meaningful. The absence of historical data from Harman’s statements about the obsolescence of its products and how that fact could impact sales made the statements misleading because they were not meaningful; “meaningful” in this context requires statements that are specifically tailored to the forward-looking statement. Also, Harman's assertion that sales were “very strong” sales did not qualify as protected puffery due to Harman’s specificity about which product and the timing of expected sales gains in its annual report.

Harman urged the court to resolve what it identified as a conflict between the D.C. Circuit's holding and Third, Seventh, and Eleventh Circuit decisions holding that the misleading nature of a cautionary statement cannot preclude the safe harbor’s application. Requiring that an element be alleged, that a threshold be reached, or that the issuer not have knowledge, the petition said, guts the safe harbor and departs from the approach used by the majority of the circuits. Regarding the puffery question, the petition noted that two circuits have recognized that "strong" is well-recognized as puffery and that four more circuits have held that similarly rosy prognostications are too vague and subjective to be actionable.

The petitions are Nos. 15-372 (CarVal) and 15-694 (Harman).

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