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Although we have been involved in many high profile appeals, none has generated the kind of public interest as the appeal over the settlement of Cameron and Tyler Winklevoss'1 suit against The Facebook Inc. and its CEO, Mark Zuckerberg. Everywhere we go, we are asked about this case. And with rare exceptions, what most people think they know about this case is wrong.

Most people seem to think that after agreeing to a $65 million settlement package, the Winklevosses decided they would like to renegotiate the settlement price, and went to court for that purpose. If that were an accurate summary, the appeal would have been a fool's errand, and we wouldn't have touched it with a pole of any length. The core of the case involved the duty of an issuer like Facebook to disclose material facts in connection with a transaction in its own securities. In its ruling, the Ninth Circuit assumed Facebook owed the Winklevosses a duty of disclosure.

Unfortunately, though, the court made some surprising rulings about the effect of a general release in the settlement and of a boilerplate mediation agreement, the net effect of which was to prevent the Winklevosses from invoking the securities laws to overturn the settlement. The Facebook Inc. v. Pacific Northwest Software Inc., 640 F.3d 1034 (9th Cir. 2011).

While our clients decided not to file a petition for certiorari for reasons unrelated to the merits, they authorized us to make public our draft so that others affected by the decision could see what we view as serious issues that affect all parties entering into settlement agreements in federal cases in general and also weaken the anti-waiver provisions of federal securities laws. You can read the draft yourself by going to www.howardrice.com/winklevoss. The following summary of the issues shows that the Ninth Circuit's decision has immunized fraudulent inducement of a mediated settlement in two very unexpected ways.

The settlement reached in the mediation called for the issuance of shares of Facebook common stock to the Winklevosses. In resisting enforcement of the settlement, the Winklevosses claimed that Facebook violated Rule 10b-5 by failing to make full disclosure of material facts bearing on the value of those Facebook shares.

The parties agreed in the mediation that the settlement consideration would be $20 million in cash and $45 million in Facebook stock. They agreed that the stock portion of the deal would consist of 1,253,000 shares. That works out to $35.90 per share. That sounded right because Facebook had recently publicly announced a large investment by Microsoft at the identical price per share.

Unknown to the Winklevosses and their prior lawyers, Facebook had also recently obtained an expert valuation of its stock (which was unlisted) at $8.88 per share, and used that valuation to set the exercise price of its stock options. Facebook did not disclose the existence of this valuation prior to or during the mediation.

Facebook's lawyers mentioned this prior valuation only after the mediation, when the parties were negotiating the definitive agreements to implement the settlement, and Facebook sought a credit for outstanding liabilities of the company the Winklevosses were to transfer to Facebook as part of the settlement. Facebook asked that, for purposes of calculating the credit in its favor, the shares be valued based on the previously undisclosed $8.88 valuation. The Winklevoss twins subsequently attempted to rescind because the failure to disclose constituted securities fraud under Rule 10b-5.

The Ninth Circuit gave two reasons for rejecting that claim for rescission. The first was that the general release in the settlement rendered the settlement agreement invulnerable against claims that it was procured by fraud. That ruling is contrary to – but makes no mention of – decisions of the Supreme Court and five other Circuits. Each of those courts has held that a settlement agreement containing a general release does not bar a claim that the settlement was itself induced by fraud.

Dice v. Akron, C. & Y.R.R., 342 U.S. 359, 362 (1952); Griffin v. Kraft Gen'l Foods Inc., 62 F.3d 368, 373 (11th Cir. 1995); Bennett v. Coors Brewing Co., 189 F.3d 1221, 1228 (10th Cir. 1999); Griffin v. Kraft Gen'l Foods Inc., 62 F.3d 368, 373 (11th Cir. 1995); Fisher Dev. Co. v. Boise Cascade Corp., 37 F.3d 104, 108 (3d Cir. 1994); Binker v. Commonwealth of Pennsylvania, 977 F.2d 738, 748 (3d Cir. 1992); Clarion Corp. v. American Home Prods. Corp., 494 F.2d 860, 864 (7th Cir. 1974); Irish v. Central Vermont Rwy., 164 F.2d 837, 839 (2d Cir. 1947); Plews v. Burrage, 274 F. 881, 886 (1st Cir. 1921).

If that were not the rule, dishonest parties could obtain settlements by (for example) falsely representing the limits of their insurance coverage. The Ninth Circuit's ruling applies to every settlement of federal claims within the circuit's jurisdiction, not just settlements that involve the transfer of securities.

The second ground given by the Ninth Circuit was based on a standard mediation confidentiality agreement the parties signed at the outset of the mediation – a kind of "what happens in Vegas stays in Vegas" deal. That agreement, the court said, "precludes the Winklevosses from introducing in support of their securities [fraud] claims any evidence of what Facebook said, or did not say, during the mediation." 640 F.3d at 1041.

The Winklevosses had argued that under Section 29(a) of the Securities Exchange Act of 1934, any agreement purporting to waive a securities law claim in advance is voidable. The mediation confidentiality agreement, as applied here, was just that: a prospective agreement that rendered it impossible to prove any fraud that took place during the mediation. The Ninth Circuit disagreed, construing Section 29 narrowly to apply only to "express" waivers and not to indirect waivers that accomplish the same end.

The opinion is contrary to – but makes no mention of – decisions of four other circuits holding that Section 29(a) and substantively identical federal securities statutes apply equally to direct and indirect waivers. See AES Corp. v. Dow Chem. Co., 325 F.3d 174, 180 (3d Cir. 2003); McMahan & Co. v. Wherehouse Entm't Inc., 65 F.3d 1044, 1051 (2d Cir. 1995); Rogen v. Ilikon, 361 F.2d 260, 265, 268 (1st Cir. 1966); Can-Am Petroleum Co. v. Beck, 331 F.2d 371, 373 (10th Cir. 1964).

The Ninth Circuit's opinion guts the Securities Act's anti-waiver provision. Your stockbroker cannot protect against securities fraud claims by having you sign an agreement agreeing that no such claims will be brought. But, under the Winklevoss decision's oddly formalistic logic, your broker can immunize himself against such claims by having you sign an agreement that all communications between your broker and you will be confidential and will not be revealed in any judicial proceeding or arbitration.

Fortunately for the Winklevosses, the stock they agreed to accept in the mediation has skyrocketed in value in the succeeding years. But that does not excuse or rectify Facebook's failure to make full disclosure. Had the $8.88 valuation been disclosed, undoubtedly the negotiations would have turned out differently. That equality of information is precisely what Rule 10b-5 commands and why it stands as a cornerstone of our securities market system. Yet it was swept aside here by a decision that is profoundly at odds with precedent and common sense.

Jerome Falk and Sean SeLegue are members in the San Francisco office of Howard Rice. They are certified appellate specialists, State Bar of California Board of Legal Specialization, who represented Tyler and Cameron Winklevoss, and Divya Narendra, in their appeal from the enforcement of a mediated settlement agreement.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, publisher of Law360. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

  1. For simplicity, the three plaintiffs, Tyler and Cameron Winklevoss and Divya Narendra, are referred to collectively here as "the Winklevosses."

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