The Petrobras Settlement: Critical Implications for Foreign Issuers and Securities Class

Tuesday, January 23rd, 2018 at 4:11 pm by Jeffrey Larocca

In early January 2018, Petroleo Brasilieiro SA (“Petrobras”), the Brazilian state-run oil company agreed to partially settle a class action lawsuit brought by purchasers of its debt and U.S. listed equity securities between January 2015 and July 2015 for $2.95 billion.  Should the district court judge approve the terms of the agreement, it would rank as the 5th largest securities class action settlement in U.S. history and the largest settlement ever paid by a foreign entity in the U.S. The suit arose out of a corporate scandal of epic proportions in which Petrobras manipulated the process by which outside contractors bid for work on its capital projects.  Essentially, members of Petrobras management were found to have colluded with contractors and materials suppliers to award contracts at unconscionably high prices. In exchange, the executives received kickback payments from the outside firms, believed to be in excess of $5 billion. The criminal probe by Brazilian authorities that uncovered the scheme, known as “Operation Car Wash,” resulted in the arrests and prosecution of dozens of high-level Petrobras executives, Brazilian businesspeople, and current and former Brazilian government officials. The scheme and its fallout resulted in Petrobras’s market capitalization tumbling from $310 billion in 2009 to $39 billion in early 2015, an erosion of approximately 87% of its value.[1]

The U.S. suit was filed in the Southern District of New York against Petrobras, several of its subsidiaries, certain officers and directors, its independent auditor, and the underwriters of its securities.[2] The debt and equity investors alleged violations by the defendants under both the Securities and Exchange Acts related to materially misleading financial statements, false representations by management regarding internal controls, and materially false registration statements and offering documents.[3]  Although the underlying case never advanced beyond the initial stages, it yielded crucial implications for future class certification attempts in securities cases and magnified a circuit split that could potentially make its way to the Supreme Court.  In early 2016, the district court certified two classes under FRCP 23(b)(3).[4]  The key issue on appeal of the certification to the 2nd Circuit was over whether Petrobras debtholders, who purchased their securities over-the-counter rather than on U.S. exchanges, were entitled to be members of the classes.[5]  Under Morrison v. National Australia Bank Ltd., in order to assert claims under the Securities and Exchange Acts, the debtholders were required to show that they acquired the securities in “domestic transactions.”[6] A transaction is considered domestic for the purposes of Morrison if either “[1] irrevocable liability is incurred or [2] title passes within the United States.”[7]

Petrobras argued on appeal that the classes failed to meet their burdens of satisfying the Rule 23(b)(3) implied requirement of ascertainability and the requirement of predominance due to the “difficulties inherent in assessing putative class members’ transaction records.”[8] Because of the difficulties, it asserted, each class member should be required to establish that the domestic transaction requirement was met on an “individual basis.”[9]  On the question of ascertainability of the classes, Petrobras argued that the court should apply heightened approach that the 3rd Circuit takes where it makes a decision at the time of certification as to whether determining class membership is an “administratively unfeasible” task.[10] The court declined to adopt this approach, stating that the only consideration a district court must make is “whether a proposed class is defined using objective criteria to establish a membership with definite boundaries.”[11] As long as there is a “clear sense of who is suing about what,” the ascertainability prong is satisfied with no requirement that a plaintiff prove “proof of membership.”[12]  The court held that the classes in this case had satisfied the ascertainability requirement because the parameters were defined by clearly objective criteria—anyone who acquired specific securities during a specific time period, as long as those acquisitions occurred in ‘domestic transactions.’”[13]

On the issue of predominance of questions of law or fact of the classes over those of individual members, the court ultimately vacated the class certification and remanded the case back to the district court.[14]  It found that the district court failed to “meaningfully address” the question of whether the determination of the domesticity of the transactions was a common question “susceptible to generalized class wide proof.”[15]  It noted that the answer to this question was not obvious, as there were a great deal of potential differences in how each class member might show domesticity, including the identity of the seller, the means by which the transaction was executed, and the type of documentation that could be presented.[16]  The court did not take a definitive position on the issue and left it to the district court to perform a proper analysis as to these individualized inquiries and whether more generalized class-wide evidence of domesticity existed.[17]

In November 2017, Petrobras filed a writ of certiorari with the Supreme Court seeking review of, among other things, the 2nd Circuit’s ruling on the question of ascertainability.  Since the 2nd and 9th Circuits find themselves at odds with the 3rd Circuit on the issue of administrative feasibility, it is very possible that the Supreme Court would take up the case to impose a uniform standard for future securities class action cases.  The objective criteria standard that the 2nd Circuit chose to adopt, according to Paul Weiss, “may make it more difficult for defendants to estimate their exposure and for absent potential class members to determine their membership.” After the settlement agreement was reached in January, the parties asked the Supreme Court to defer consideration of the writ until the district court made an approval decision.  The settlement is the largest of its kind, and could potentially lead to more plaintiffs’ firms seeking out foreign issuers to bring suit against in the U.S. court system. It also highlights the magnitude of exposure that a large-scale corruption scheme can place upon a company, once the cost of investigation, government fines, disgorgement, and settlements and judgments stemming from class action litigation are taken into account. This could incentivize multinational corporations to allocate more capital toward effective compliance programs.

[1] In re Petrobras Securities, 862 F.3d 250, 258 (2d Cir. 2017).

[2] Id. at 256.

[3] Id. at 259.

[4] Id.

[5] See Id. at 260.

[6] 561 U.S. 247, 267 (2010).

[7] Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60, 67 (2d Cir. 2012).

[8] Petrobras, 562 F.3d at 261.

[9] Id. at 260.

[10] Id. at 264-65.

[11] Id. at 269.

[12] Id.

[13] Id.

[14] Id. at 274.

[15] Id. at 271.

[16] Id. at 273.

[17] Id. at 274.