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From Securities Regulation Daily, September 10, 2018

Revved-up claims get VW emissions fraud action back on track

By Lene Powell, J.D.

The Northern District of California green-lighted an action by Volkswagen bondholders for fraud relating to emissions failures, finding that new allegations cured deficiencies of reliance and scienter. Although the plaintiffs failed to establish a presumption of reliance via fraud-on-the-market, fraud-created-the-market, or fraud-on-the-regulatory-process theories, newly added facts did support a theory of direct reliance. Additional facts also supported scienter and controlling person claims as to Volkswagen’s U.S. subsidiary and its former CEO. However, the court denied an attempt to add insider trading claims, finding they lacked merit (In re Volkswagen "Clean Diesel" Marketing, Sales Practices, and Products Liability Litigation, September 7, 2018, Breyer, C.).

Emissions fraud. Plaintiffs alleged that statements in a bond offering memorandum about Volkswagen’s R&D priorities and exposure to regulatory risks were misleading because the car manufacturer failed to disclose that it was cheating on vehicle emissions standards. At first, the district court ruled that plaintiffs were entitled to a presumption of reliance under Affiliated Ute, and allowed the action to go forward. However, the court later reconsidered the element of reliance in light of new authority and held that plaintiffs could not rely on Affiliated Ute, and that other theories of reliance were not well pleaded. Consequently, the court dismissed the complaint. Plaintiffs filed an amended complaint, and defendants moved to dismiss.

Reliance established. The court found that plaintiffs adequately pleaded direct reliance on the misrepresentations at issue. New allegations showed that the lead plaintiff’s investment advisor was acting as an authorized agent and that the plaintiff, through its agent, reviewed and relied upon the offering memorandum, including the alleged omissions and misrepresentations. The amended complaint answered the basic "who, what, when, where, and how" questions specifically enough to put defendants on notice and satisfy Rule 9(b).

Although the court found direct reliance to be sufficiently pleaded, it went on to consider plaintiffs’ arguments as to presumptive reliance, and found them all lacking. First, fraud-on-the-market was not viable because the bonds were purchased directly from investment banks in a Rule 144A private placement, which did not meet the requirement that a security must be "actively traded" in a "well-developed" market. Second, fraud-created-the-market theory was not available in the Ninth Circuit, but in any case did not apply. Despite the gravity of VW’s emissions fraud, it was almost inconceivable that, but for the fraud, the credit markets would have completely shut out one of the world’s largest automakers. In fact, the bond price fell only 3 percent after the fraud was revealed, suggesting robust marketability. Third, a theory of fraud-on-the-regulatory-process failed, because the bonds were exempt from registration and the alleged misrepresentations were not made directly to a regulatory agency such as the SEC.

The court also revisited the Affiliated Ute issue and found it a bit thorny as to whether the presumption applies to affirmative statements as well as omissions. Ultimately, the court found that this issue did not need to be resolved at this stage in the litigation, given that plaintiffs had adequately pleaded direct reliance.

CEO acted with scienter. Previously, the court found that plaintiffs had adequately pleaded that some defendants, but not others, had made misleading statements in the offering memorandum with scienter. In an attempt to cure the deficiencies, plaintiffs added new allegations as to Volkswagen’s U.S. subsidiary (VWGoA) and its former CEO, Michael Horn. Plaintiffs alleged that an engineer warned Horn in March 2014 that a study would be published that showed that VW’s "clean diesel" cars produced emissions up to nearly 40 times higher than allowed by regulations. Upon learning of the study, Horn allegedly requested reports and analyses. This established that Horn knew of the emissions issue seven weeks before plaintiffs finalized the bonds purchase.

The court rejected Horn’s argument that seven weeks was a reasonable amount of time to investigate potentially negative information before public disclosure, noting that he only disclosed the fraud one and a half years later, after Volkswagen was caught trying to conceal the emissions cheating. The court also rejected Volkswagen’s argument about the nature of the omission, observing that other information beyond the specific cheating mechanism was omitted from the offering memorandum. The court further found that control person claims were adequately pleaded as to Horn.

No insider trading for debt securities. Although the court allowed the amended complaint to proceed, it did not permit plaintiffs to add insider trading claims. Plaintiffs argued that defendants engaged in insider trading when they sold the bonds in the initial offerings because they did not disclose the emissions fraud. Plaintiffs noted that insider trading can be committed without affirmative statements, and asserted that Affiliated Ute’s presumption of reliance would apply under this "pure omissions" theory.

The court found that plaintiffs failed to establish that defendants had a duty to disclose material information to purchasers of corporate debt. The overwhelming majority of courts have held that corporations do not have a fiduciary relationship with their unsecured creditors—including debt security holders—because this relationship is contractual rather than fiduciary. Also, bondholders, as creditors, can protect themselves—or alternatively an indentured trustee can protect future bondholders—by negotiating the terms of the indenture agreements. Cases cited by plaintiffs were not on point, as they involved equity or convertible debt, or did not address the question at issue. Because the insider trading claims were not meritorious, it would be futile to allow them to be added, so the court denied leave to amend.

The case is No. MDL No. 2672 CRB (JSC).

Attorneys: Adam M. Stewart (Shapiro Haber & Urmy LLP) for Nadine Bonda. Amie Adelia Vague (Lightfoot, Franklin & White, LLC) and Matthew Henry Marmolejo (Mayer Brown) for Volkswagen Group of America, Inc., Audi AG, Volkswagen AG and Audi of America LLC.

Companies: Volkswagen Group of America, Inc.; Audi AG; Volkswagen AG; Audi of America LLC

MainStory: TopStory FraudManipulation PublicCompanyReportingDisclosure CaliforniaNews

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