The 10b-5 Daily

To what extent should courts rely upon market analysts in determining the meaning of corporate statements? In Boykin v. K12, Inc., 2022 WL 17097453 (4th Cir. Nov. 22, 2022), the U.S. Court of Appeals for the Fourth Circuit considered this question in a case alleging that K12, a provider of educational software and support, falsely told investors in 2020 that the Miami-Dade public school district had entered into a lucrative deal to purchase the company’s platform and content.

In August 2020, K12 confirmed that it was entering into a partnership with Miami-Dade where it would “provide customized services, including curriculum, assessment tools, teacher training and data management.” The CEO also stated that the company was seeing an increase in school districts who wanted to use the company’s content and curriculum, “with more of those contracts this year than we’ve ever had in any one year before,” and specifically mentioned Miami-Dade. Two financial analysts covering K12 “applauded the company, respectively, for having a ‘contract signed’ and a ‘contract win.'” A couple of weeks later, however, news reports came out suggesting that Miami-Dade was not going to enter into the contract due to issues it was experiencing with the platform. Ultimately, on September 10, 2020, Miami-Dade’s board voted to terminate the partnership.

On appeal from the district court’s dismissal of the complaint, the Fourth Circuit found that the company’s statements about the Miami-Dade deal “could well have factored into the run-up of K12 shares during the summer of 2020.” As to the falsity of the statements and the defendants’ scienter (i.e., fraudulent intent), however, the court was less convinced.

First, the falsity element is based on a reasonable investor’s view of the company’s statements, “not any individual investor’s reaction.” If the analysts believed that the CEO had confirmed the existence of a done deal, they were simply incorrect given that the CEO never “attested unambiguously to having a signed agreement.” And to the extent that the CEO “was gesturing to an extensive working relationship between K12 and Miami-Dade,” that was factually accurate at the time. Indeed, Miami-Dade’s superintendent even signed the completed contract in mid-August, but it was never returned to K12.

Second, the court held that “[j]ust as certain statements are such that, to show them false is normally to show scienter as well, the inverse is also true.” The timeline was consistent with the CEO’s “anticipation in mid-August of a consummated deal with Miami-Dade.” Moreover, if the CEO’s goal had been to inflate K12’s stock price, “he could have chosen far less ambiguous language than he did.” Nor did the plaintiffs provide any facts, such as insider trading, that would support a motive for fraud.

Holding: Dismissal affirmed.

What constitutes a “scheme” or “deceptive act” for purposes of liability under the antifraud provisions of the federal securities laws? Part of the difficulty in answering that question has been that Rule 10b-5 contains three separate subsections, which prohibit in connection with a securities transaction (a) the use of any “device, scheme, or artifice to defraud,” (b) the “mak[ing] of any untrue statement” or omission of material fact, and (c) any “act, practice, or course of business which operates or would operate as a fraud or deceit.” If these subsections are read separately, then a scheme or deceptive act would appear to be something different than simply making a false or misleading statement.

In 2017, however, the U.S. Supreme Court held in Lorenzo that the Rule 10b-5 subsections overlap, at least to the extent that an individual who disseminates false statements to investors (even if the statements were made by someone else) can be primarily liable for securities fraud under subsections (a) and (c). That ruling appeared to open up a new front for securities class actions: private plaintiffs could seek to hold defendants who merely participated in the making of false statements liable for securities fraud (whereas this type of claim previously had been barred by the absence of aiding and abetting liability in private actions brought under Section 10(b) and Rule 10b-5). Moreover, to the extent that a claim was framed as a “scheme liability” claim as opposed to a “misstatement” claim, it might be possible to circumvent the PSLRA’s heightened pleading standards (which technically apply to claims based on misstatements).

In the wake of Lorenzo, at least two circuit courts have found that claims based on misstatements also can be brought under Rule 10b-5(a) and (c) (Alphabet – 9th Cir.; Malouf – 10th Cir.). In July, however, the Second Circuit sought to limit the impact of the Lorenzo decision. In SEC v. Rio Tinto, the court held that “[u]ntil further guidance from the Supreme Court (or in banc consideration here) . . . misstatements and omissions can form part of a scheme liability claim, but an actionable scheme liability claim also requires something beyond misstatements and omissions, such as dissemination.” Although dissemination is clearly sufficient under Lorenzo, the court was vague about exactly what else could constitute the “something beyond misstatements and omissions.” Indeed, the court noted that it is “a matter that awaits further development.”

One prominent commentator has argued that the “show is over” when it comes to scheme liability after the Rio Tinto decision. But many in the defense bar have been more circumspect, including questioning whether the decision is as “clear as mud.” Meanwhile, arguably there now is a circuit split on the issue of whether “something beyond misstatements and omissions” is required for scheme liability. Will the plaintiffs bar become more aggressive in testing the boundaries of scheme liability in the wake of these decisions? Stay tuned.

Can allegations in a short seller report, even if the report’s issuance coincides with a stock price decline, form a basis for asserting loss causation?  In its 2020 decision in In re BofI Securities Lit., the U.S. Court of Appeals for the Ninth Circuit held that certain negative blog posts about the company could not support the existence of loss causation because they were written by short sellers and expressly disclaimed their own accuracy.

The Ninth Circuit recently had the opportunity to revisit the issue of short sellers and loss causation.  In In re Nektar Therapeutics Sec. Lit., 34 F. 4th 828 (9th Cir. 2022), the plaintiffs alleged that a report written by “anonymous short-sellers” examining Nektar’s clinical trial data was a “corrective disclosure” that led to a stock price decline.  The panel was not so sure.

The panel conceded that the report may have provided “new information to the market” by comparing statements made by Nektar at different conferences and cross-checking sources provided by the company.  Moreover, the report related directly to the false statements alleged in the complaint.  Citing the BofI decision, however, the panel concluded that the key issue was the fact that the report was written by short sellers with a financial incentive to convince others to sell and made no representations as to its accuracy.  Accordingly, “it is not plausible that the market would perceive [the report] as revealing false statements because the nature of the report means that investors would have taken its contents with a healthy grain of salt.”

Holding: Dismissal affirmed.

Securities class actions based on corporate financial disclosures, which used to form the backbone of securities litigation, have been declining.  Instead, in recent years the plaintiffs’ bar has turned its focus to “event-driven” securities litigation, bringing securities class actions based on external events that drive down a company’s stock price.  These external events have included data security breaches, sexual harassment allegations, commercial litigation, allegations that a product has caused injury, and regulatory investigations or enforcement actions.  The frequent challenge for the plaintiffs’ bar, however, is to find corporate statements that can be adequately alleged to have been rendered false or misleading by the external event.

In In re Marriott International, Inc., 2022 WL 1178526 (4th Cir. April 21, 2022), investors brought a securities class action based on a data breach that impacted approximately 500 million guest records in the Starwood guest reservation database.  The plaintiffs alleged that Marriott’s failure to disclose severe vulnerabilities in Starwood’s IT systems rendered various public statements false or misleading.  The district court dismissed the case, finding that the complaint failed to adequately allege falsity, scienter, and loss causation.

On appeal, the Fourth Circuit found that the challenged statements fell into three categories: “statements about the importance of protecting customer data; privacy statements on Marriott’s website; and cybersecurity-related risk disclosures.”

(1) As to the statements about the importance of data protection to Marriott’s business, the court held that “the investor’s whole theory of the case turns on those statements being true.”  In other words, data protection was important to Marriott and the fact that the company said this “basic truth is neither misleading nor creates the false impression the investor suggests.”  Moreover, Marriott also disclosed the “key risks that the investor alleges made Starwood’s systems vulnerable.”

(2) Marriott’s privacy statements on its website were inactionable for similar reasons.  The company stated that it seeks to protect personal data, but also noted that no data system “can be guaranteed to be 100% secure.”  The complaint conceded that “Marriott devoted resources and took steps to strengthen the security of Starwood’s systems.”  Therefore, the court held, the fact that Marriott suffered a security breach “does not demonstrate that the company did not place significant emphasis on maintaining a high level of security.”

(3) Finally, the court concluded that Marriott’s risk factors were accurate when issued.  The plaintiffs argued that “Marriott twice warned generally about cybersecurity breaches that could occur when it knew those events had in fact already occurred.”  The court found, however, that the first alleged cybersecurity breach was “not supported by the investor’s own allegations” and after the Starwood breach the company updated its risk disclosures to specifically state that it had “experienced cyber-attacks.”

Holding: Dismissal affirmed.

Quote of note: “Marriott certainly could have provided more information to the public about its experience with or vulnerability to cyberattacks, but the federal securities laws did not require it to do so.  Indeed, the SEC advises companies against ‘mak[ing] detailed disclosures that could compromise [their] cybersecurity efforts – for example by providing a ‘roadmap’ for those who seek to penetrate a company’s securities protections.’  Even as alleged here, Marriott provided sufficient information to ensure its statements were neither false nor misleading.”

Additional note: On the related issue of whether risk disclosures are material to investors, some courts (notably the Sixth Circuit in its Bondali decision) have held that investors do not rely upon risk disclosures because they are not meant to educate investors on what harms are currently affecting the company.   In Marriott, the Fourth Circuit drops a footnote stating that “risk disclosures generally also lack materiality” and favorably quotes the Bondali decision.

A key issue in securities fraud litigation is when, and under what circumstances, a company has a duty to tell investors about material corporate developments.

In Weston Family Partnership LLP v. Twitter, 2022 WL 853252 (9th Cir. March 23, 2022), the plaintiffs alleged that Twitter had misled investors about problems with its Mobile App Promotion (MAP) product.  In August 2019, Twitter announced that software bugs in the MAP product had caused the sharing of the cell phone location data of its users and that it had “fixed these issues.”  Several months later, the company disclosed that software bugs continued to exist and reported a $25 million revenue shortfall.

The district court dismissed the claims.  On appeal, the Ninth Circuit found that “fixed these issues” referred to no longer sharing the cell phone location data, not the software bugs.  Moreover, Twitter had no duty to update investors about the progress of its MAP product and the plaintiffs had not plausibly alleged that the software bugs had materialized and impacted revenue prior to August 2019.

Holding: Dismissal affirmed.

Quote of note: “While society may have become accustomed to being instantly in the loop about the latest news (thanks in part to Twitter), our securities laws do not impose a similar requirement. . . . Put another way, companies do not have an obligation to offer an instantaneous update of any internal developments, especially when it involves the oft-tortuous path of product development.  Indeed, to do so would inject instability into the securities markets, as stocks may wildly gyrate based on even fleeting developments.”

SEC Rule 10b5-1, put into place in 2000, establishes that a person’s purchase or sale of securities is not “on the basis of” material nonpublic information if, before becoming aware of the information, the person enters into a binding contract, instruction, or trading plan (as defined in the rule) covering the securities transaction at issue.  To take advantage of this potential affirmative defense, many executives have implemented trading plans for their sales of company stock.

Insider trading, of course, is often used by plaintiffs in securities class actions to create an inference of scienter (i.e., fraudulent intent).  The plaintiffs allege that the individual corporate defendants profited from the alleged fraud by selling their company stock at an artificially inflated price.  Even as the SEC is considering amendments to Rule 10b5-1, courts continue to grapple with when and how a stock trading plan can help shield corporate executives from securities fraud liability.

In KBC Asset Management NV v. DXC Technology Co., 19 F.4th 601 (4th Cir. 2021), the Fourth Circuit examined the various categories of scienter allegations made by the plaintiffs, including allegations that the company’s CEO and CFO sold shares during the nine-month class period.  The CEO sold 17% of his holdings, for proceeds of over $10 million, and the CFO sold 77% of his holdings, for proceeds of over $9.5 million.  The sales were concentrated in the time period shortly before the company revised its revenue projections downward (i.e., the alleged “corrective disclosure” at the end of the putative class period).

The Fourth Circuit held that despite the large amounts involved and the arguably suspicious timing, the sales could not support a strong inference of scienter.  First, the court found that the CEO’s sale of 17% of his holdings was similar to percentages that the court previously had held to be “nearly de minimus.”  Second, while the CFO’s sales were far more significant on a percentage basis, during the nine-month period prior to the class period the CFO had sold nearly $15 million worth of shares.  The court declined to “draw a strong inference of scienter from the fact that [the CFO] sold much less stock during the period in which he was allegedly defrauding investors than during the period in which he is not alleged to have done so.”

The defendants also argued that any inference of scienter should be negated by the fact that all of the trades were done pursuant to Rule 10b5-1 trading plans.  The Fourth Circuit concluded that it could not consider the impact of the trading plans because the record was “silent as to when [the CEO and CFO] entered their plans.”  If the plans had been entered into during the class period, they would not “mitigate a suggestion of motive for suspicious trading.”  Interestingly, the court also noted in a footnote that it was not clear whether it could consider the trading plans “as an affirmative defense at the motion-to-dismiss stage.”  Rule 10b5-1 trading plans, however, are an affirmative defense to a claim of insider trading, which is different than a claim of securities fraud based on material misrepresentations.  There does not appear to be any reason why a court could not consider the existence of trading plans in assessing whether trading by corporate insiders has raised an inference of scienter.

The SEC’s proposed amendments to Rule 10b5-1 place additional restrictions on how trading plans are structured and create extensive corporate disclosure requirements around the creation and use of trading plans.  If adopted, these amendments are likely to have a significant impact on the defense of securities class actions.  Stay tuned.

Holding: Dismissal affirmed.