The 10b-5 Daily

Is it necessary for the alleged false statements to have artificially inflated the company’s stock price to establish loss causation? The Eleventh Circuit recently considered this question in a case where the plaintiffs’ expert found that the company’s stock price was artificially inflated both before and during the class period by the same amount. The district court granted summary judgment for the defendants, concluding that because the stock price inflation predated the class period, the alleged false statements made during the class period could not have caused the inflation or any subsequent losses.

On appeal – FindWhat Investor Group v. FindWhat.com, 2011 WL 4506180 (11th Cir. Sept. 30, 2011) – the Eleventh Circuit disagreed. The court concluded that false statements “that prevent a stock price from falling can cause harm by prolonging the period during which the stock is traded at inflated prices.” Accordingly, “defendants can be liable for knowingly and intentionally causing a stock price to remain inflated by preventing preexisting inflation from dissipating from the stock price.”

Holding: Vacating dismissal of claims based on failure to establish loss causation (but affirming the dismissal of certain other claims)

Quote of note: “Defendants whose fraud prevents preexisting inflation in a stock price from dissipating are just as liable as defendants whose fraud introduces inflation into the stock price in the first instance. We decline to erect a per se rule that, once a market is already misinformed about a particular truth, corporations are free to knowingly and intentionally reinforce material misconceptions by repeating falsehoods with impunity.”

The scope of the Securities Litigation Uniform Standards Act (“SLUSA”), which precludes certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities, continues to be the subject of litigation. In Atkinson v. Morgan Asset Mgmt., Inc., 2011 WL 3926376 (6th Cir. Sept. 8, 2011), the court considered whether SLUSA preempted claims brought by the holders of mutual fund shares, who were entitled to redeem their shares at any time for their “proportionate share of the issuer’s current net assets.”

The plaintiffs argued that as the holders of mutual fund shares, their claims were covered by what is known as the “first Delaware carve-out” to SLUSA, which preserves state-law class actions that involve “the purchase or sale of securities by the issuer or an affiliate of the issuer exclusively from or to holders of equity securities of the issuer.” The first Delaware carve-out generally applies to cases challenging corporate transactions, such as tender offers and mergers, or share buybacks directed exclusively to existing shareholders. The plaintiffs claimed that it also should apply to the holders of mutual fund shares, because the “funds’ obligation to redeem Plaintiffs’ shares amounts to an ongoing contract to purchase them.”

The Sixth Circuit rejected the plaintiffs’ argument, holding that the redemption obligation did not convert the holders of mutual fund shares into continuous purchasers or sellers. Moreover, the U.S. Supreme Court, in its Dabit decision, has held that holder claims are precluded under SLUSA. Permitting the plaintiffs’ construction of the first Delaware carveout would create an impermissible exception for mutual fund shareholders. The court also held that for purposes of SLUSA preclusion it was sufficient that the plaintiffs’ claims included allegations of misrepresentations in connection with the buying and selling of securities; it was not necessary for fraud to be an element of the claims.

Holding: Dismissal affirmed.

Quote of note: “Plaintiffs’ construction of the carve-out invites us to pull the rug out from under Dabit‘s holding, creating an exemption for a large set of the very holder claims over which Dabit extended SLUSA’s bar. Indeed, Plaintiffs ask us to shield from PSLRA’s federal protections nearly every class action involving shareholders in open-end mutual funds. In the absence of clear language, precedent, or policy supporting this exemption, we decline to extend the carve-out so far.”

Are financial estimates like goodwill and loan loss reserves statements of fact or opinion? The answer is significant, especially for claims brought under Section 11 and Section 12 of the ’33 Act based on alleged misrepresentations in a registration statement. If these financial estimates are statements of fact, then a plaintiff is only required to establish that they were objectively false. If these financial estimates are statements of opinion, then a plaintiff must establish that they were objectively false and disbelieved by the defendant at the time they were made. In effect, it converts the cause of action from one based on strict liability (the company) or negligence (the individual defendants), to one based on knowing falsity.

In Fait v. Regions Financing Trust, No. 10-2311-cv (2d Cir. August 23, 2011), the plaintiffs alleged that despite adverse trends in the mortgage and housing markets, particularly in areas where the mortgage loans issued by a company previously acquired by Regions were concentrated, Regions failed to write down goodwill and to sufficiently increase its loan loss reserves. The lower court held that these financial estimates were matters of opinion and dismissed the Section 11 and Section 12 claims brought by purchasers of Region’s trust preferred securities.

On appeal, the Second Circuit affirmed the lower court’s ruling. Estimating goodwill “depend[s] on management’s determination of the ‘fair value’ of the assets acquired and liabilities assumed, which are not matters of objective fact.” Similarly, loss reserves “reflect management’s opinion or judgment about what, if any, portion of amounts due on the loans ultimately might not be collectible.” As a result, plaintiffs were required to plausibly allege that defendants did not believe their statements regarding goodwill and loan loss reserves at the time they made them. In the absence of these allegations, the plaintiffs’ claims were subject to dismissal.

Holding: Dismissal affirmed.