The author of The 10b-5 Daily has a guest post on Forbes concerning the use of confidential witnesses in securities class actions. Please give it a read.
The Sixth Circuit continues to be a source of interesting opinions regarding corporate scienter. In 2014, the court held in its Omnicare decision that only a limited set of corporate officers (including officers who had either made or approved the alleged misstatements) could have their state of mind imputed to the company. But what about lower corporate officers who know about undisclosed problems and fail to report them?
In Doshi v. General Cable Corp., 2016 WL 2991006 (6th Cir. 2016), the court addressed a case arising out of General Cable’s financial restatement, which was the result of a “complex theft scheme in Brazil and, to a somewhat lesser extent, accounting errors, primarily in Brazil.” The plaintiffs alleged that the head of the company’s “Rest of World” (ROW) division, which included Brazil, knew about these issues but failed to report them to the executive management. Moreover, the plaintiffs argued, his knowledge could be imputed to General Cable because he “furnished information used in General Cable’s false public financial statements.”
The court found that even if the head of the ROW division had acted recklessly, in the absence of any allegations that he had “drafted, reviewed, or approved” the alleged misstatements, “only his knowledge of the theft and accounting errors – not his state of mind – imputes to General Cable.” The court then applied its normal “scienter factors” to determine whether the plaintiffs had adequately plead that the company, with that knowledge, had acted with a fraudulent intent. Ultimately, the court found that the more compelling inference was that “a theft scheme racked General Cable’s operations in Brazil where local managers overrode accounting procedures, which, when coupled with the legitimate freedom afforded ROW to report its financial data, led General Cable to issue materially false public financial statements.” Accordingly, the plaintiffs’ allegations failed “to create a strong inference that General Cable acted with scienter.”
Holding: Dismissal affirmed.
In Halliburton II, the U.S. Supreme Court held that defendants can rebut the fraud-on-the-market presumption of reliance at the class certification stage with evidence of a lack of stock price impact. In a typical case, where the plaintiff alleges that a misrepresentation artificially inflated the company’s stock price, the defendant can satisfy this requirement by providing evidence that there was no stock price increase as a result of the misrepresentation.
At least two circuit courts (Seventh and Eleventh), however, have recognized an alternative “price maintenance theory” of artificial inflation. Under the price maintenance theory, a misrepresentation can artificially inflate a stock’s price by improperly maintaining the existing price (e.g., by repeating prior falsehoods and preventing the stock’s price from falling to its true value). But how does a defendant provide evidence to establish a lack of stock price impact under these circumstances?
Perhaps because of the inherent tension between Halliburton II and the price maintenance theory, two recent circuit court decisions appear to question the theory’s use in securities class actions.
In IBEW Local 98 Pension Fund v. Best Buy Co., Inc., 2016 WL 1425807 (8th Cir. April 12, 2016), the court held that the district court had improperly certified a class based on statements made in an earnings call. According to experts for both sides, the statements were merely confirmatory and did not cause the company’s stock price to increase. While the plaintiffs argued that a price increase was not necessary under their price maintenance theory, the court found that the “theory provided no evidence that refuted defendants’ overwhelming evidence of no price impact.”
In In re Pfizer Inc. Sec. Litig., 2016 WL 1426211 (2nd Cir. April 12, 2016), the court addressed the issue more indirectly. The district court granted summary judgment for the defendants after excluding the plaintiffs’ loss causation and damages expert from testifying. On appeal, the court found that the plaintiffs were relying on a price maintenance theory and that the expert’s testimony would be helpful to the jury in that context. As to the theory itself, however, the court went out of its way to note that it was not deciding whether it was “either legally or factually sustainable” and that it “might be that Plaintiffs’ inflation-maintenance theory is deficient under Rule 10b-5.”
As noted by the dissent in the Best Buy case, “[n]either the Supreme Court nor any circuit court has however discussed the type of showing needed to rebut  a presumption of reliance in a price maintenance case.” Until that issue is addressed, the price maintenance theory appears to be on shaky ground.
Plaintiffs often establish the existence of loss causation by pointing to a “corrective disclosure” that allegedly revealed the fraud and led to a stock price decline. What a disclosure must contain to be deemed “corrective,” however, has been the subject of extensive debate.
In Rand-Heart of New York v. Dolan, 2016 WL 521075 (8th Cir. Feb. 10, 2016), the plaintiffs alleged that Dolan, a professional services company, had failed to adequately disclose that a major customer had stopped sending new work to the company in early 2013. It was not until November 2013 that Dolan told securities analysts about the problem. Although the company’s stock price declined based on that announcement, the plaintiffs argued that the fraud was not fully revealed until January 2014, when the company also announced that it had hired a new restructuring officer and the stock price declined again.
While the U.S. Court of Appeals for the Eighth Circuit was willing to allow claims based on the early 2013 to November 2013 time period to proceed, it found that the plaintiffs had inadequately plead loss causation as to any claims based on the November 2013 to January 2014 time period. The court agreed with the Fourth Circuit and Eleventh Circuit that a “corrective disclosure” must contain “new facts” about the alleged fraud to provide a basis for establishing loss causation. In contrast, “the appointment of a restructuring officer on January 2 does not correct a misrepresentation; it elaborates on the previously disclosed plan to restructure.”
Holding: Dismissal affirmed in part, reversed in part, and case remanded for further proceedings.
A number of years ago, the U. S. Court of Appeals for the Fourth Circuit addressed whether a company’s false statement about its CEO’s educational background was material. The court found that the statement was immaterial as a matter of law, even though the company’s stock price dropped significantly once the truth about the CEO’s lack of an undergraduate economics degree was revealed to the market. But is that true of any false statement in a corporate biography?
In Kelsey v. Textura Corp., 2016 WL 825236 (N.D. Illinois March 2, 2016), the court confronted a similar situation. As part of Textura’s initial public offering, the company issued a prospectus and registration statement containing its CEO’s biography. The biography provided a number of details about the CEO’s prior work history, but failed to disclose that the CEO previously had been the CEO of another company and, in that position, had been accused by an auditor of providing the auditor with false information. Indeed, the auditor later announced that it could no longer rely upon the CEO’s representations.
Textura argued that under the applicable SEC regulation, it was only required to provide investors with the last five years of the CEO’s business experience. During that period of time, the CEO had worked at Textura. The court found, however, that once Textura chose to speak about the CEO’s prior work history, it “had a duty to do so in a manner that was not misleading.” Indeed, the court concluded that the CEO’s prior work history clearly was material because Textura chose to include it even though it was not required to do so. The court therefore denied the defendants’ motion to dismiss as to the alleged omission in the CEO’s biography.
Holding: Denying in part and granting in part the motion to dismiss.
Quote of note: “The court rejects defendants’ argument that they did not ‘tout’ [the CEO’s] prior experience. Having convincingly argued that it was not required to include any of [the CEO’s] prior experience, there could be no other reason from them deciding to do so.”
An announcement that a company is the target of a government investigation is likely to lead to a stock price decline. The mere fact of an investigation, however, does not tell the market anything about the existence of prior corporate misstatements. Accordingly, some appellate courts have concluded that this type of announcement is not a “corrective disclosure” that can be used to establish loss causation. But what if the company later issues a corrective disclosure revealing that there were prior corporate misstatements related to the subject matter of the investigation? Given that factual scenario, those same appellate courts appear inclined to reverse field and find that the government investigation was a “partial corrective disclosure” that was later confirmed by the company.
In Lloyd v. CVB Financial Corp., 2016 WL384773 (9th Cir. Feb. 1, 2016), the court addressed what appears to be a paradigmatic fact pattern. In August 2010, CVB announced that it had received a SEC subpoena concerning its lending practices. Analysts speculated that the subpoena related specifically to loans made to a certain property company. Following the announcement, CVB’s stock price dropped by 22%. A month later, CVB announced that the property company was unable to pay its loans as scheduled and the bank took a large impairment charge related to the loans. The company’s stock price did not move significantly following this announcement, but at least one analyst speculated that this was because “further deterioration in credit quality and uncertainly surrounding the SEC investigation [were] already reflected in the share price.”
The Ninth Circuit concluded that the investigation announcement standing alone was insufficient to establish loss causation. Once CVB disclosed that it was charging off millions of dollars in loans, however, it was reasonable to conclude that the plaintiffs had plead a sufficient causal connection between the earlier stock price decline and the alleged fraud.
The problem with decisions based on paradigmatic fact patterns is that they leave room for interpretation if the facts are less clear. What if the market had not connected the SEC investigation to the particular loans at issue? What if the company’s decision to take a charge had been announced a year, rather than a month, after the disclosure of the SEC investigation? What if the company’s stock price had moved significantly after the company took its charge? All questions for another day.
Holding: Dismissal affirmed in part, reversed in part, and remanded.
Quote of note: “Under the facts of this case, loss causation is sufficiently pleaded. Indeed, any other rule would allow a defendant to escape liability by first announcing a government investigation and then waiting until the market reacted before revealing that prior representations under investigation were false.”
Yelp is an online networking platform that hosts user-generated reviews of local businesses. In a recent securities class action (Curry v. Yelp, Inc., 2015 WL 7454137 (N.D. Cal. Nov. 24, 2015)), the court considered claims that Yelp made misstatements about the authenticity of the reviews hosted on the company’s website and whether the company manipulated reviews in favor of businesses that advertised on the website.
In its original motion to dismiss order, the court held that the disclosure of the existence of FTC complaints in a WSJ article about Yelp could not demonstrate either materiality or loss causation. The company previously had disclosed the existence of media reports and lawsuits about review manipulation, leading the court to conclude that the article did not alter the total mix of information available to the market. Moreover, the article could not support the existence of loss causation because the FTC complaints merely alerted the market to the possibility that further investigations by the FTC could establish at some later time that the company had made false statements.
In their amended complaint, Plaintiffs responded to these holdings by including the results of an event study purporting to show that the decline in Yelp’s stock price on the day of the WSJ article “was statistically significant and the direct result of the new information contained within The Wall Street Journal’s article.” According to the court, however, a key problem with this event study was that the WSJ article had been published after the close of the market that day and itself stated that “Yelp was down 6% . . . in Wednesday afternoon trading in the wake of the [FTC] disclosure.” The WSJ article therefore could not have revealed material information or caused the stock price decline. Moreover, the amended complaint failed to specify when the FTC disclosure was made or whether it did anything other than disclose that the FTC had received a certain number of complaints about Yelp. Under these circumstances, the court also could not find that the FTC disclosure itself demonstrated either materiality or loss causation.
Holding: Motion to dismiss granted with prejudice.