MEDIA

September 8, 2016

Scienter and Securities Law; Federal Tort Claims Act; Tax Prosecution

Published in: New York Law Journal | volume 256

This column reports on several significant, representative decisions handed down recently in the U.S. District Court for the Eastern District of New York. Judge Frederic Block found a complaint’s allegations sufficient to plead scienter under the Private Securities Litigation Reform Act. Judge Margo K. Brodie held that the military exception to the waiver of immunity under the Federal Tort Claims Act did not apply where plaintiff’s injuries were not incident to military service. And Judge William F. Kuntz, II, saw no reason to admit into evidence Internal Revenue Code provisions and regulations to demonstrate the defendant tax preparer’s lack of willfulness, when the court would instruct the jury on the law.

Scienter–Securities Act

In Gauquie v. Albany Molecular Research, 14-CV-6637 (EDNY, July 26, 2016), Judge Block shed light on the application of the heightened pleading standards of the Private Securities Litigation Reform Act (PSLRA), 15 U.S.C. §78u-4, while denying a motion to dismiss claims under §§10(b) and 20(a) of the Securities Exchange Act of 1934 (the “’34 Act”).

Section 10(b) of the ’34 Act prohibits “any manipulative or deceptive device in contravention of such rules and regulation as the [Securities and Exchange] Commission may prescribe” in connection with the purchase or sale of any security, and §20 extends liability to certain persons who control an offending entity. Rule 10b-5 of the Securities and Exchange Commission makes it unlawful “[t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. . . .”

Plaintiffs sued Albany Molecular Research, Inc. (AMRI) and two of its executives, alleging that defendants violated Rule 10b-5 when they continued to extoll the value of a recently acquired laboratory (OSO), to praise OSO’s regulatory-compliance reputation, and to issue “positive outlook-driven statements,” all while delaying release of information concerning a power failure at OSO that had “resulted in the contamination of 40-50% of its product and manufacturing delays” and led to the discovery of mold contamination.

Defendants moved to dismiss arguing, among other things, that plaintiffs had failed to plead facts sufficient to demonstrate either materiality or that they had acted with the “[r]equired state of mind”, as prescribed by §78u-4(b)(2) of the PSLRA. Block denied the motion.

Materiality was established, for pleading purposes, by the market’s response to the eventual disclosure, including the immediate lowering of the target price for AMRI by analysts and a 35 percent drop in its stock price.

Scienter was also adequately pleaded. Scienter can be found from “strong circumstantial evidence of conscious misbehavior or recklessness.” ATSI Communications v. The Shaar Fund, 493 F.3d 87, 99 (2d Cir. 2007). AMRI had spent three-fourths of its cash capital on OSO–which was part of its “core operation”–and had “consistently asserted that AMRI was focused on acquisition with facilities that had clean regulatory records.” This supported an inference that defendants were sufficiently focused on the operations of OSO to be aware of the incident there during the period, prior to public disclosure, in which AMRI was making positive statements.

In addition, plaintiffs pleaded statements from a confidential witness claiming that AMRI was aware of the mold problem during that period. Plaintiffs could rely on this statement because it was “‘described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.'” Slip op. 5-7, quoting In re Gentiva Securities Litigation, 932 F.Supp.2d 352, 375 (EDNY 2013).

Federal Tort Claims Act

In Kloner v. United States, 13 CV 3171 (EDNY, July 21, 2016), Judge Brodie held that Feres v. United States did not bar a suit brought under the Federal Tort Claims Act (FTCA) by a retired Rear Admiral of the New York Militia in connection with an injury he suffered while at a U.S. Coast Guard (USCG) retirement ceremony to give a religious invocation.

When the accident occurred, Rabbi William Kloner was 82 years old and had a civilian contract with the USCG to provide Jewish Worship Services. On June 24, 2010, Rabbi Kloner attended a USCG retirement ceremony at the Snug Harbor Cultural and Botanical Center in Staten Island which the USCG had rented for that event.

At the venue for the ceremony, there was a main staircase, without hand rails, ascending over the orchestra pit and onto the stage. Before the ceremony Rabbi Kloner was escorted over the stairway to the stage so that he could see his seat assignment. He then returned to the ground floor. When the ceremony was about to start, he made his way to the stage staircase on his own. Near the top of the staircase, he lost his balance and fell six feet into the orchestra pit, suffering serious injuries. After months of rehab, he requires 24-hour nursing care and cannot perform the basic activities of life without assistance.

The FTCA waives sovereign immunity for torts committed by federal employees while acting within the scope of their employment. Feres v. United States, 340 U.S. 135 (1950), carves out an exception to federal government liability under the FTCA for injuries that “arise out of or are in the course of activity incident to [military] service.” Underlying the Feres doctrine are: (1) the concern for keeping courts out of questions involving military discipline; (2) the intent to replace local tort law with a uniform federal scheme; and (3) achieving this uniformity exclusively through the military death and disability system. Slip op. 10.

Brodie concluded that the Feres doctrine did not apply here. Rabbi Kloner was not injured while on military service. He had retired in 1988 and, at the time of the accident, was a part-time civilian contractor being paid about $10,000 per year to provide Jewish Worship Services at military events.

The nature of the activity also showed that Rabbi Kloner was attending the ceremony only because of his civilian contract with the USCG. He was not a part of the official military party.

Finally, an award to Rabbi Kloner would not involve military discipline or implicate the scheme of federal benefits available to injured service members. As Brodie concluded: “Rabbi Kloner’s accident had ‘nothing to do with’ his military career and ‘was not caused by service except in the sense that all human events depend on what has already transpired.'” Slip op. 14.

The court therefore denied defendant’s motion for summary judgment. Slip op. 26.

Tax Prosecution

In United States v. Jacobs, 14 CR 160 (EDNY, July 12, 2016), Judge Kuntz denied a motion by defendant, a tax preparer, to admit into evidence at trial applicable Internal Revenue Code provisions, regulations and IRS “guidance” (collectively, “IRS provisions”) to show that, in preparing the returns at issue, she had no legal duty to audit her clients’ representations to her and that the IRS provisions were thus relevant to her willfulness and intent.

As Kuntz noted, the IRS provisions are irrelevant and unnecessary, and admitting the evidence would undermine the court’s role to instruct the jury on the applicable law:

To demonstrate willfulness, the Government must show that Defendant fabricated information on the relevant tax returns and knew the returns were false. If the evidence shows that the Defendant’s clients presented false information to her, and Defendant did not know the information was false, she cannot be found to have acted willfully….

Slip op. 3. Similarly, if the evidence shows that defendant had no legal duty to investigate false representations, the court will give an appropriate instruction on willfulness.

Kuntz granted several in limine motions by the prosecution, including its request to permit an IRS agent to remain in the courtroom throughout trial as a summary witness. The agent would not be permitted to opine on the credibility of other witnesses, but could properly perform tax calculations based on the numerical facts those witnesses provide, and his testimony would be subject to cross-examination.

Harvey M. Stone and Richard H. Dolan are partners at Schlam Stone & Dolan. Bennette D. Kramer, a partner of the firm, assisted in the preparation of the article.