Eight Circuit On Materiality/Loss Causation

The Eighth Circuit’s decision in the ConAgra case (Gebhardt v. ConAgra Foods, Inc., (8th Cir. June 30, 2003)) highlights how difficult it can be to establish the immateriality of alleged fraudulent statements at the motion to dismiss stage of a securities class action.

In ConAgra, plaintiffs alleged that the company had engaged in fraud by permitting its United Agri Products subsidiary to prematurely recognize revenue from sales where the delivery of the goods had not yet taken place. The Eighth Circuit found that “the problem was mostly one of having the money attributed to the wrong year, as opposed to not having ever made the money at all.” As a result, “ConAgra’s income, before taxes, was reduced by $111 million for the years 1998 through 2000, while its income for 2001 was increased by $127 million.” When the restatement was announced in May 2001, the stock price dropped from $20.61 to $20.07. It quickly recovered, however, and began to trend higher.

The district court dismissed the case on two bases. First, the lower court noted that the amount of earnings misrepresented was merely .4% of ConAgra’s total revenues during the years in question. The lower court concluded that “[a] reasonable investor with complete knowledge of the UAP accounting issues would have realized that ConAgra’s overall earnings were basically unaffected by any of those issues.” Second, the lower court held that the plaintiffs’ pleadings failed to allege loss causation. The alleged misrepresentations were immaterial and the company’s stock price was barely affected by the announcement of the restatement.

The Eighth Circuit disagreed with both conclusions. On the issue of materiality, the appellate court found that focusing on the percentage of total revenues misstated was insufficient. As a result of its revenue recognition problems, ConAgra overstated its net income for 1999 and 2000 by 8%. A discrepancy of that magnitude is not immaterial as a matter of law. The appellate court also found that it was inappropriate for the lower court to rely on the fact that ConAgra was eventually able to receive the revenues it prematurely recognized. The company “could not know for certain it would receive the profits it had booked.” Accordingly, a reasonable investor, at the time of the misrepresentation, may have found information about the premature revenue recognition to be material.

As for loss causation, the Eighth Circuit found that because the alleged misrepresentations were material, the plaintiffs can “invoke the fraud-on-the-market theory and assume that the misrepresentations inflated the stock’s price.” Even though the stock price did not decline when the restatement was announced, the appellate court declined “to attach dispositive significance to the stock’s price movements absent sufficient facts and expert testimony, which cannot be considered at this procedural juncture, to put this information in its proper context.”

The Eighth Circuit’s opinion leaves little room for a materiality argument to succeed on a motion to dismiss. Here, the amount of the restatement was relatively small (even for net income), the company’s overall finances were unaffected, and the stock market had virtually no reaction upon being told of the problem. Nevertheless, the appellate court goes out of its way to justify a finding that materiality and loss causation were adequately plead, including dismissing the lack of a negative stock market reaction by holding that “stockholders can be damaged in ways other than seeing their stocks decline. If a stock does not appreciate as it would have absent the fraudulent conduct, investors have suffered harm.” The allegations in the case, however, were that the company’s stock price was artificially inflated, not lowered, as a result of the misrepresentations.

Holding: Judgment of the district court reversed.

Quote of note: “A reasonable investor might be concerned about one of ConAgra’s subsidiaries reporting earnings not yet received, especially if this was done under orders from ConAgra’s senior management. The fraud-on-the-market theory then would allow the fact finder to presume that the stock’s price reflected the inflated earnings, and it makes sense to conclude that the plaintiffs were harmed when they paid more for the stock than it was worth.”

Addition: Note that the Eighth Circuit comes to virtually the opposite conclusion on materiality as the S.D.N.Y in the Allied Capital case. A discussion of Allied Capital can be found here.

Addition: Note also that other courts have expressly rejected the idea that the fraud on the market theory supports a presumption of loss causation. See, e.g., Robbins v. Koger Props, Inc., 116 F.3d 1441, 1448 (11th Cir. 1997).

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