Judge grants investors rare early discovery in securities case vs SAC

By Alison Frankel
July 24, 2013

It’s safe to say that the besieged hedge fund SAC Capital has lots more to worry about than a class action by investors in Elan Corporation, one of the companies whose shares the fund supposedly traded on the basis of inside information. The New York Times and The Wall Street Journal reported Wednesday that federal prosecutors in New York are on the verge of indicting SAC, the culmination of an insider trading investigation in which four onetime fund employees have pleaded guilty and two more, including the star portfolio manager Michael Steinberg, are facing criminal charges. SAC founder Steven Cohen is busy defending against Securities and Exchange Commission allegations that could knock him out of the industry, and SAC outside investors have pulled $5 billion out of the fund.

Amid those woes, a ruling Tuesday by U.S. Magistrate Kevin Fox of Manhattan – granting Elan investors early access to materials the SEC and the Justice Department have turned over to former SAC portfolio manager Mathew Martoma – is the equivalent of a flea bite. But for the securities class action bar, Fox’s order is big news: It’s a very rare instance of a judge permitting shareholders to obtain discovery before they’ve survived a defense dismissal motion.

As you know, the Private Litigation Securities Reform Act bars investors from serving discovery demands on class action defendants until shareholder pleadings have been tested by a defense dismissal motion and deemed adequate by the judge overseeing the case. In the 18 years since PSLRA was passed, federal judges have generally stuck by that stricture and refused to let shareholder lawyers obtain discovery even from defendants that have already settled with the SEC or the Justice Department. Only in very unusual circumstances – when, for instance, class action plaintiffs are competing with other claimants for a limited pool of resources or when shareholders need trading records to establish their standing – have judges bent the rule on pre-dismissal discovery. For years, class action lawyers have complained long and loud about the consequences of Congress’s restriction on discovery, which has led to the phenomenon of confidential witnesses who later recant accusations against their former employees. But aside from recently persuading U.S. Senior District Judge Jed Rakoff that the securities class action system is awry, they haven’t made much headway.

The Elan investors nevertheless made a pitch for early discovery to U.S. District Judge Victor Marrero of Manhattan. Their case is not a typical securities class action because they’re not suing a company in which they own shares. Instead, shareholder lawyers at Wohl & Fruchter and Pomerantz Grossman Hufford Dahlstrom & Gross claim that Elan investors are entitled to about $685 million in profits SAC realized from insider trades in Elan stock and losses SAC avoided, plus interest. (They claim that the $685 million is on top of the $260 million SAC disgorged to the SEC in connection with Elan trading.) In May, at a case management conference in the SEC’s case against SAC subsidiary CR Intrinsic Investors, shareholder lawyers in the Elan case asked Marrero to authorize limited access to SAC trading records so that the Wohl and Pomerantz firms could state their clients’ losses in a lead plaintiff bid. (Marrero is overseeing the SEC case and related private class actions against SAC.)

The judge asked SAC’s lawyer, Daniel Kramer of Paul, Weiss, Rifkind, Wharton & Garrison, whether it wouldn’t make sense for the Elan investors’ lawyers to see additional discovery from the SEC case. Kramer replied that SAC was prepared to turn over discovery – but later in the case, after the defendants had moved to dismiss the suit. “Most courts – not all, Your Honor, but most courts – who have faced this issue do find that private plaintiffs are different than the government,” Kramer said. “(They) do find that Congress in the PSLRA meant what it said when it said there is a stay and plaintiffs must plead a claim before being entitled to discovery.”

Marrero ordered briefing and referred the dispute to Magistrate Fox. In their motion for relief from the PSLRA stay on discovery, shareholder lawyers asked to see everything that the SEC and the Justice Department have turned over to SAC and to Martoma, as well as SAC trading records. They argued that other federal judges in Manhattan have permitted shareholders access to similar discovery in cases involving parallel regulatory actions for fear that class action plaintiffs would otherwise be unduly prejudiced. Shareholders also argued that the pullouts by SAC’s outside investors put their eventual recovery in danger, so they should be permitted to speed up their case. SAC responded that only a very few judges have authorized early discovery, and none of them were overseeing cases involving a well-capitalized defendant. There was simply no reason, according to SAC, to depart from the PSLRA’s rules in the Elan case.

Clearly, Judge Fox disagreed. Without holding a hearing or explaining his order, he said shareholder lawyers could see all of the material the SEC and Justice have produced to SAC and Martoma, though he denied them access to SAC’s trading records. Plaintiffs lawyer Ethan Wohl of Wohl & Fruchter and a spokesman for SEC declined to comment on the ruling.

In practical terms, the discovery won’t make much difference to the Elan investors’ chances of surviving SAC’s dismissal motion. There’s virtually no doubt that they can adequately plead this case, given the SEC settlement and the criminal proceedings. Instead, the material will help them assert that SAC didn’t disgorge all of its illicit profits to the SEC and will speed up the damages phase of the case. It’s also significant that Judge Marrero has consolidated for pretrial purposes the Elan class action with a separate class action by Wyeth investors asserting the same illicit-profits theory against SAC. Presumably, the magistrate will order whatever early discovery SAC produces to the Elan shareholders to be turned over to the Wyeth investors as well.

It’s not easy to be a securities class action lawyer these days. One look at Cornerstone Research’s newly released midyear assessment of filings will confirm that truism: This year’s filings are on track to reach the second-lowest levels since 1997. The discovery stay, and consequent difficulty in drafting a dismissal-proof complaint, is one big reason why. And for that reason, Fox’s ruling is a rare bit of good news for the shareholder bar.

(Reporting by Alison Frankel)

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