Can the filing of a judicial complaint against a company constitute a revelation of the alleged fraud sufficient to establish loss causation? Courts have found that it can, but usually where there is some later, independent confirmation of the allegations in the complaint.
In Norfolk County Retirement Systems v. Community Health Systems (6th Cir. 2017), for example, the Sixth Circuit considered a case where the plaintiffs alleged that a healthcare company’s overcharging of Medicare was revealed by a rival company’s lawsuit. The court found that the stock price drop that occurred after the filing of the lawsuit could form the basis for loss causation, but specifically noted that the CEO of Community Health Systems had “promptly admitted the truth of one of the complaint’s core allegations.”
But what if no such admission ever occurs? In In re BofI Securities Lit., 2020 WL 5951150 (9th Cir. Oct. 8, 2020), the plaintiffs alleged that the defendant bank had made false or misleading statements about its loan underwriting standards, internal controls, and compliance infrastructure. The fraud supposedly was revealed by “a whistleblower lawsuit filed by a former company insider and a series of blog posts offering negative reports about the company’s operations.” The district court found that neither of these items were “corrective disclosures” because (a) the complaint contained only unsubstantiated allegations that had not been subsequently confirmed, and (b) the blog posts were based entirely on existing public information.
On appeal, the Ninth Circuit disagreed with the district court’s imposition of “bright line rules” in its decision.
(1) Whistleblower Complaint – The Ninth Circuit held (citing Norfolk County) that the relevant question for loss causation purposes is “whether the market reasonably perceived [the whistleblower’s] allegations as true and acted upon them accordingly.” It was not necessary for there to be any subsequent confirmation of the allegations so long as “the market treats allegations in a lawsuit as sufficiently credible to be acted upon as truth, and the inflation in the stock price attributable to the defendant’s misstatements is dissipated as a result.” Given that the whistleblower complaint was brought by an insider and the company’s stock price dropped significantly after it was filed, the court concluded that this standard was met.
(2) Blog Posts – The Ninth Circuit agreed with the district court that a corrective disclosure “must by definition reveal new information to the market that has not yet been incorporated into the price.” However, the court found that this new information could include an analysis of the company’s operations, based on existing public information, that the market had not yet seen. The court found that the blog posts “required extensive and tedious research involving the analysis of far-flung bits and pieces of data” and, as result, provided new information to the market. Because they were written by short sellers and expressly disclaimed their own accuracy, however, the court concluded that “it is not plausible that the market reasonably perceived these posts as revealing the falsity of BofI’s prior misstatements, thereby causing the drops in BofI’s stock price on the days the posts appeared.”
(3) Dissent – In a strongly-worded dissent, Judge Lee disagreed with the panel’s reasoning. Judge Lee noted that there have been multiple government investigations of BofI, but “so far, we have not seen any external evidence corroborating [the whistleblower’s] allegations.” The majority’s decision, in Judge Lee’s view, would have “the unintended effect of giving the greenlight for securities fraud lawsuits based on unsubstantiated assertions that may turn out to be nothing more than wisps of innuendo and speculation.” Nor does it help to say that the allegations in the judicial complaint must be plausible, because “the plausibility standard will likely stave off only lawsuits based on insider accounts that even Mulder and Scully would find unbelievable.” As to the blog posts, Judge Lee concluded that he would base the decision “on the grounds that the [blog posts] contain public information only, and that we should not credit anonymous posts on a website notorious for self-interested short-sellers trafficking in rumors for their own pecuniary gain.”
Holding: Reversing dismissal and remanding for further proceedings.
Quote of note (majority decision): “[The whistleblower] is a former insider of the company who had personal knowledge of the facts he alleged. Those facts revealed that a number of BofI’s alleged misstatements were false. If the market regarded his factual allegations as credible and acted upon them on the assumption that they were true, as the shareholders have plausibly alleged here, [the whistleblower’s] allegations established fire and not just smoke.”
Quote of note (dissent): “[The whistleblower’s] allegations are certainly ominous, and may in fact be true. But at this time, the drop in BofI’s share price can only be attributed to market speculation about whether fraud has occurred. And this type of speculation cannot form the basis of a viable loss causation theory. Before plaintiffs can establish loss causation based on an unsubstantiated whistleblower complaint, another shoe has to drop. It has not yet.”