The Ninth Circuit Court of Appeals clarified an important question surrounding the “corrective disclosure” pleading requirement in Lloyd v. CVB Financial Corporation, 811 F.3d 1200 (9th Cir. 2016), finding that disclosure of an SEC investigation can constitute a partial corrective disclosure, but only if there is a follow-on disclosure that specifically corrects a prior misstatement.

The Lloyd loss causation holding, while clarifying the law to some degree, requires a fact-specific inquiry. In order to find loss causation in an analogous situation, courts would need to piece together several facts: (1) disclosure of a government investigation resulting in a stock drop; (2) market perception that the investigation related to a previous misstatement; (3) a follow-on disclosure confirming the previous misstatement; and (4) a minimal market reaction to the follow-on confirming disclosure.

Factual Background and Procedural History

The litigation arose from pre-recession loans that issuer defendant CVB Financial Corporation (“CVB”) made to the Garrett Group (“Garrett”), a commercial real estate company. In 2008, Garrett informed CVB that it would be laying off employees and reducing salaries, and that it could not make loan payments due to CVB. CVB agreed to restructure the loans, and loaned an additional $10 million to avoid a Garrett default. In 2009, CVB refinanced Garrett’s loans again, providing an additional $53 million and agreeing to other loan modifications. Despite these efforts, in 2010 Garrett again informed CVB that it was unable to fulfill its payment obligations and was then considering filing bankruptcy. Id. at 1203.

During this time, Garrett was CVB’s largest borrower and the loans in question were material to CVB’s balance sheet. Despite Garrett’s struggles and the materiality of the loans, CVB stated in its SEC filings that it was “not aware” of any “known credit problems of the borrower [that] would cause serious doubts” about Garrett’s ability to repay the loans. In July 2010, the SEC served CVB with a subpoena seeking information about its underwriting and loan loss methodologies. The next month, in its Form 10-Q, CVB disclosed the subpoena and that the SEC inquiry regarded CVB’s underwriting and allowance for credit and loan losses and related areas. The next day CVB’s stock fell 22%. Analysts following CVB noted that the subpoena was likely related to the Garrett loans. One month later, CVB finally wrote down $34 million in Garrett loans and reclassified the remaining $48 million of Garrett loans as non-performing. Following this disclosure, CVB’s stock price dropped only six cents to $6.99. Id. at 1204-05.

Plaintiffs brought a securities class action alleging Section 10(b) and Rule 10b-5 claims. The district court concluded that the challenged statements were not made with scienter and did not cause the plaintiffs’ alleged losses, and granted CVB’s motion to dismiss the complaint.

Ninth Circuit’s Ruling

The complaint alleged four types of CVB misstatements: (1) touting of loan underwriting and quality of loan portfolio; (2) a statement that the deteriorating real estate market “could” harm its borrowers’ ability to repay; (3) violations of GAAP in financial statements; and (4) assurances in SEC filings that it was “not aware of any other loans . . . for which known credit problems of the borrower would cause serious doubts as to the ability of such borrowers to comply with their loan repayment terms.” Id. at 1206.

The Ninth Circuit quickly concluded that the first three categories of alleged misstatements were not actionable, finding that the first category of statements were vague puffery, the second category was not misleading when placed in context, and the third category of GAAP failures, without more, did not establish scienter. Id. at 1206-07. However, with respect to the last category, the court concluded that some of these statements were false and made with knowledge or recklessness, and reversed the district court’s decision. The court found that the complaint had adequately alleged that CVB, prior to making those statements, had been alerted to facts that “would cause serious doubts” about Garrett’s ability to repay its loans.  Id. at 1207-09.

Finding one category of misstatements actionable, the court then moved to the question of loss causation, examining Supreme Court and Ninth Circuit law in this area. Under the Supreme Court’s decision in Halliburton, the “burden of pleading loss causation is typically satisfied by allegations that the defendant revealed the truth through ‘corrective disclosures’ which ‘caused the company’s stock price to drop and investors to lose money.’” Id. at 1209 (quoting Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014)). The court also revisited an open question from its recent decision in Loos v. Immersion Corporation, in which it held that “the announcement of an investigation, standing alone and without any subsequent disclosure of actual wrongdoing, does not reveal to the market the pertinent truth of anything, and therefore does not qualify as a corrective disclosure.” Id. at 1209-10 (quoting 762 F.3d 880, 890 n.3 (9th Cir. 2014)).

However, the court noted that the Loos court had reserved judgment on the question of whether the announcement of an investigation, such as CVB’s announcement of the SEC subpoena, could “form the basis for a viable loss causation theory” if the plaintiff also alleged a subsequent corrective disclosure. Lloyd, 811 F.3d at 1210. The Lloyd court then answered that question in the affirmative.

The disclosure of the SEC subpoena in July resulted in a 20% stock drop. Under Loos, the court found, that disclosure alone would not qualify as a corrective disclosure. However, just one month later, CVB disclosed that it had written off millions in Garrett’s loans. This second “bombshell” disclosure resulted in hardly any market reaction. However, the court concluded from this chain of events that investors correctly understood that the disclosure of the SEC subpoena was a partial corrective disclosure acknowledging the falsity of the prior “no serious doubts” statements. Id. at 1210-11. These two disclosures, when viewed together, constituted a sufficient corrective disclosure. The court reasoned: “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.” Id. at 1210. In making its ruling, the Court noted its holding was consistent with the Fifth Circuit’s decision in Public Employees’ Retirement System of Mississippi v. Amedisys, Inc., 769 F.3d 313 (5th Cir. 2014).