Securities Class Action

The Second Circuit, affirming the Southern District of New York’s dismissal of a ’33 Act securities class action, reaffirmed that the Circuit’s operative test for determining the materiality of omissions is the test set forth in DeMaria v. Andersen, 318 F.3d 170 (2d Cir. 2003), and explicitly rejected the First Circuit’s test in Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996).  In refusing to adopt Shaw’s standard—known as the “extreme departure” test—the court endorsed a test that it determined to be the “classic materiality standard in the omission context” and rejected the test that it found to “leave too many open questions” and to be “analytically counterproductive.”

Stadnick v. Vivint Solar, Inc. is a putative class action alleging violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 based on Vivint Solar’s alleged failure to disclose financial results for the quarter that ended the day before Vivint’s IPO, as well as Vivint’s alleged misstatements regarding the company’s expansion in Hawaii for failing to disclose the impact of the state’s evolving regulatory scheme.

The company’s unique business model and accounting methods are key to the case and the court’s analysis.  Vivint’s business model operates by leasing solar energy panels to its customers and maintaining ownership of the underlying panels.  This model allows Vivint to capitalize on the tax credits associated with solar energy.  Vivint finances its company through outside investors, who invest the capital necessary to purchase tranches of solar energy systems.  The outside investors then receive title to the system they financed and receive most of the monthly lease payments until the system is paid off.  At that time, Vivint then starts to receive most of the revenue.  Based on this set up, Vivint’s income is accordingly allocated between its public shareholders and its outside investors.  To properly calculate this income, Vivint employs an accounting method that allocates the income between the shareholders and outside investors.  Due to Vivint’s business model and this accounting method, Vivint shows significant income fluctuations from quarter to quarter.  Vivint experienced one such dramatic income swing in the quarter directly preceding its IPO.

Vivint issued its IPO on October 1, 2014.  In its registration statement, Vivint set forth the financial results from the previous quarters and warned investors that its business model and accounting practices could impact the allocation of income between shareholders and outside investors.  It also listed the “key operating metrics” for evaluating the company’s financial performance.

Vivint disclosed the financial results for the third quarter on November 10, 2014.  In that disclosure, Vivint revealed a significant decline in income to shareholders.  Specifically, the net income to shareholders was measured at negative $35.3 million, down from $5.5 million in the previous quarter.  However, the results showed that despite this loss, Vivint’s “key operating metrics,” which the company previously had set forth as its measure for evaluating the company’s financial success, were strong.  For example, the company’s installations were up 137 percent from the previous year and its market share increased from 9 percent to 16 percent in that quarter.

The plaintiff brought suit following the decline in stock as a result of the third-quarter earnings announcement.  The plaintiff raised two omissions as the basis for his suit: (1) Vivint’s failure to disclose the third-quarter financial information and (2) Vivint’s failure to disclose the adverse impact of the regulatory oversight in Hawaii.

The Second Circuit focused primarily on this first argument, and used this case as an opportunity to clarify the Second Circuit’s operative test for material omissions.  The plaintiff urged the court to adopt the First Circuit’s “extreme departure” test in Shaw v. Digital Equipment Corp.  In Shaw, the First Circuit held that an omission was actionable under Section 11 if there was “substantial likelihood” that the withheld information would represent an “extreme departure” from the previous financial performance.  Adopting this test would be its own extreme departure—pun intended—from the Second Circuit’s test in DeMaria v. Andersen, which looked instead to whether the information would “significantly alter[] the ‘total mix’ of information available.”  Vivint proved to be an ideal opportunity for the Second Circuit to re-exam its standards as it provides a situation in which the income swings were great enough to be reasonably seen as an “extreme departure,” but the company’s clear formula for evaluating its own performance makes clear that other factors more accurately reflect the company’s true financial health.

The court undertook an analysis of the “extreme departure” test, and affirmatively rejected that test.  The court noted that the DeMaria test used the “classic materiality standard in the omission context.”  Focusing on how the First Circuit test would allow a plaintiff to meet their burden based on two narrow metrics—which would not properly give the entire picture—the court had harsh words for the First Circuit’s test, calling it “analytically counterproductive” and “unsound[],” and noting that it “confuses the analysis.”  Once reaffirming that the Second Circuit would continue to rely on the DeMaria test, the court concluded that Vivint’s omission was not material because shareholder income and earnings-per-share are not the best indicators of Vivint’s financial performance.  The court also noted that the registration statement clearly set forth that Vivint’s unique business model meant that shareholder revenue and earnings would fluctuate.

Plaintiff’s second argument was rejected without much analysis—the court even noted this argument was “tack[ed] onto his complaint”—as the court concluded that the plaintiff failed to show that the regulatory changes adversely affected Vivint’s Hawaiian operations and that Vivint had sufficiently warned investors that such changes could impact their Hawaiian presence.

In a 5-4 decision split along traditional ideological lines, the U.S. Supreme Court held in CalPERS v. ANZ Securities, Inc., 582 U.S. ___ (2017), that the statute of repose in Section 13 of the Securities Act cannot be tolled under any circumstances. In particular, the Court held that the 3-year repose period—unlike the 2-year limitations period set forth in the same section of the Securities Act—is not tolled by the filing of a securities class action under the principles of American Pipe & Constr. Co. v. Utah, 414 U.S. 538 (1974).

Under American Pipe, the statute of limitations for a claim timely asserted in a putative class action is tolled for the period that the putative class claim is pending. Thus, if class certification is denied (or if a class member later decides to opt out of the class), individual putative class members can still pursue their separate claims, even if those claims would otherwise be untimely at the time they are filed. The question presented in CalPERS was whether that tolling principle likewise applied to Section 13’s 3-year statute of repose.

The CalPERS case arose out of the collapse of Lehman Brothers in 2008. Shortly after Lehman declared bankruptcy, a plaintiff filed a putative class action complaint alleging claims under Section 11 of the Securities Act against the underwriters of several of Lehman’s securities offerings from 2007 and early 2008. The complaint alleged that Lehman’s securities offered included material misstatements or omissions. CalPERS was not one of the named plaintiffs in that suit.

In 2011—more than three years after the last of those securities was first offered—CalPERS filed a separate complaint on its own behalf, alleging identical claims to those asserted in the putative class action. Shortly thereafter, the putative class action settled, and CalPERS opted out so it could continue to pursue its claims separately. However, the defendants then successfully moved to dismiss CalPERS’ separate lawsuit as untimely under Section 13, which provides, “In no event shall any [Section 11] action be brought…more than three years after the security was bona fide offered to the public….” The Second Circuit affirmed, and the Supreme Court granted certiorari.

Justice Kennedy delivered the opinion of the Court, joined by Chief Justice Roberts and Justices Thomas, Alito, and Gorsuch. The Court began by re-emphasizing the distinction between statutes of limitations and statutes of repose that the Court had described in CTS Corp. v. Waldburger, 134 S. Ct. 2175 (2014). Statutes of limitations are intended to encourage diligence on the part of plaintiffs, and are therefore typically triggered by the accrual of a cause of action. (Slip op. at 4-5.) Statutes of repose, by contrast, reflect “a legislative judgment that a defendant should be free from liability after the legislatively determined period of time[,]” and usually begin to run from the date of the defendant’s last culpable act. (Id. at 5 (quoting CTS Corp.).) The Court observed that Section 13 of the Securities Act has both types of time limits: a 2-year limitations period that runs from when the actionable untrue statement or omission was or should have been discovered, and a 3-year repose period that runs from the date the security was first offered. (Id. at 5-7.)

The Court explained that the distinction between the purposes of a statute of repose and a statute of limitations was decisive in the CalPERS case. Because the purpose of a statute of repose is to create an “absolute bar” to the defendant’s liability after a period of time, such statutes are generally not subject to tolling in the absence of some legislatively-enacted exception. (Slip op. at 7-8.) In particular, unlike statutes of limitations, statutes of repose are not subject to tolling based on equitable principles. (Id. at 8.) American Pipe tolling is based on just such equitable considerations: it was intended to serve judicial economy by obviating the need for protective motions to intervene by individual putative class members, while still serving the purpose of the statute of limitations by ensuring that the defendants were on notice of the substantive claims against them and the “generic identities” of the claimants. (Id. at 8-11 (quoting American Pipe).) Those considerations could not serve to toll a statute of repose, whose purpose “to grant complete peace to defendants….” (Id. at 11.) The Court found that “the text, purpose, structure, and history of the [Section 13] statute [of repose] all disclose the congressional purpose to offer defendants full and final security after three years.” (Id.)

The Court then quickly dispensed with the four counterarguments CalPERS had raised. First, the Court found that American Pipe was readily distinguishable based on the distinction between statutes of limitation and statutes of repose: while the first may be tolled based on equitable considerations, the second may not. (Slip op. at 11-12.) Second, the Court found that the fact that the class action put the defendant on notice of the putative class members’ claims missed the point—“the purpose of a statute of repose is to give the defendant full protection after a certain time.” (Id. at 12.) Moreover, while the defendant might be on notice of the claims generally, it would not be on notice of the “number and identity of individual suits, where they may be filed, and the litigation strategies they will use[,]” which could significantly affect a defendant’s “practical burdens” and “financial liability[.]” (Id. at 12-13.) Third, the Court found that a putative class member’s right to opt out, while important, could not override the “mandatory time limits set by statute.” (Id. at 13.) Fourth, the Court rejected the argument that its ruling would “create inefficiencies,” noting that the Court was not free to ignore the plain terms of the statute, and observing that, in any event, the Second Circuit had not seen any “recent influx of protective filings” since its rule was announced in 2013. (Id. at 13-14.)

Finally, the Court rejected CalPERS’ alternative argument that it had timely “brought” its “action” within the meaning of Section 13 because it was a member of the putative class on whose behalf the original lawsuit was brought, and that its separate action was merely part of that same “action.” The Court found that argument did violence to the term “action,” which generally refers to a particular “proceeding” or “suit.” (Id. at 14-15.) Moreover, the Court observed that the argument proved too much: if it were correct, there would be no need for American Pipe tolling at all, and even an action commenced “decades after the original securities offering” would be timely as long as a class action had been commenced within the applicable limitations and repose periods. (Id. at 15.)

Justice Ginsburg dissented, joined by Justice Breyer, Sotomayor, and Kagan. Justice Ginsburg accepted CalPERS’ alternative argument that its filing date should relate back to the filing of the original class action complaint, and that by filings its separate action, CalPERS “simply took control of the piece of the action that had always belonged to it.” (Slip op. at 2-3.) She asserted that the majority’s rule would render the right to opt out “illusory[,]” because most securities class actions reach their “critical stages” years after the initial complaint is filed. (Slip op. at 1-2, 4.) Moreover, Justice Ginsburg contended, the “harshest consequences” were likely to fall on the “least sophisticated” class members, who would be unaware of their need to file a protective claim within the repose period. (Id. at 4.) Finally, she stated that the majority’s ruling was likely to “gum up the works of class litigation” by encouraging defendants to engage in dilatory tactics and encouraging the filing of protective claims. (Id. at 4-5.)

The CalPERS decision is likely to have repercussions far beyond Section 11 securities cases. The Court’s logic would also apply to the 5-year statute of repose governing class action claims under Section 10 of the Exchange Act, which are much more common. Indeed, any federal statute of repose without an express legislative tolling provision will now be fully applicable in any class action asserting a claim governed by that statute. It will be interesting to see whether the inefficiencies predicted by Justice Ginsberg come to fruition.

Overruling (or, at least, creatively re-characterizing) its own precedent, the Ninth Circuit held in Resh v. China Agritech, Inc., — F.3d —, 2017 WL 2261024 (9th Cir. May 24, 2017), that the pendency of an earlier uncertified class action tolls the statute of limitations not only for later-filed individual claims, but for subsequent class actions as well. The Ninth Circuit’s decision opens the door to the possibility of serial, successive attempts to certify a class in securities (and other) cases, potentially exposing defendants to an almost never-ending series of class action lawsuits.

Under American Pipe & Construction Co. v. Utah, 414 U.S. 538 (1974), and Crown, Cork & Seal Co. v. Parker, 462 U.S. 345 (1983), the pendency of a putative class action tolls the statute of limitations applicable to the individual claims of the putative class members. Thus, if the putative class action is timely brought, but class certification is later denied after the statute of limitations would have otherwise expired, putative class members would still be able to bring individual claims on their own behalf. The question in Resh was whether American Pipe tolling should apply to subsequent class actions as well.

The facts of Resh are relatively straightforward. In February 2011, a market research company raised questions about the accuracy of China Agritech’s financial reporting. Its stock price fell substantially. A few days later, a China Agritech shareholder filed a putative securities fraud class action complaint against the company and several of its managers and directors in the Central District of California. The court denied class certification, finding that, because plaintiffs had failed to establish the fraud-on-the-market presumption of reliance, issues common to the proposed class did not predominate over individual issues. Five months after that denial, and one year and eight months after the initial adverse press report, another shareholder filed a second putative securities class action in the District of Delaware. The case was transferred to the same judge in the Central District of California, who again denied class certification, this time on grounds of typicality and adequacy of the named plaintiffs.

Nine months later — and more than three years after the initial adverse press report — plaintiff Michael Resh filed yet another putative class action complaint alleging securities fraud against China Agritech and several individual defendants. A claim for securities fraud under the Exchange Act is subject to a two-year statute of limitations. Thus, if American Pipe tolling applied, the putative class action would be timely — only about 14 months had passed since the initial press report during which a putative class action was not pending. But if American Pipe tolling did not apply, the class action complaint was plainly time-barred.

The Ninth Circuit began its analysis by discarding one of its prior precedents. In Robbin v. Fluor Corp., 835 F.2d 213 (9th Cir. 1987), the Ninth Circuit had held that American Pipe tolling did not apply to a subsequent class action following a definitive determination of the inappropriateness of class certification. The Ninth Circuit dismissed Robbin as “a short opinion published 30 years ago” that had been “modified” in Catholic Social Services, Inc. v. INS, 232 F.3d 1139 (9th Cir. 2000) (en banc). 2017 WL 2261024, at *6.

In Catholic Social Services, the district court had certified a class, but had lost subject matter jurisdiction due to an intervening change in the law. See id. The Ninth Circuit held that American Pipe tolling applied to a subsequent class action in those circumstances. See id. But it also stated, “If class action certification had been denied in [an earlier case], and if plaintiffs in this action were seeking to relitigate the correctness of that denial, we would not permit plaintiffs to bring a class action.” Id. (quoting Catholic Social Services, 232 F.3d at 1147).

The Resh court found that interpreting that statement as forbidding the application of American Pipe tolling to subsequent class actions when class certification had previously been denied would be a “misreading” of Catholic Social Services. Id. at *6-*7. The court explained that it was not talking about American Pipe tolling at all. What it was actually talking about was issue preclusion — all it meant was that, if the same plaintiffs sought to bring a subsequent class action after certification had previously been denied, issue preclusion would bar them from doing so. Id. at *7.

That is, to say the least, an odd reading of Catholic Social Services. Other than the reference to “relitigat[ion],” nothing in Catholic Social Services’ analysis suggests that the court was thinking of issue preclusion. In particular, nothing in the quoted sentence indicates that, to be barred from “relitigat[ing]” class certification, the plaintiffs in the subsequent class action had to be the same plaintiffs who unsuccessfully litigated the first class action — a critical requirement for issue preclusion. In fact, the court actually cited Robbin in support of its statement, which was plainly made in the context of a discussion of the applicability of American Pipe tolling to subsequent class actions. See Catholic Social Services, 232 F.3d at 1145-49. Indeed, the Ninth Circuit expressly dealt with issue preclusion on a different issue in a separate portion of its opinion. Id. at 1151-53.

In any event, having reinterpreted Catholic Social Services as applying American Pipe tolling to subsequent class actions — regardless of the reason for the dismissal of the earlier class action — the Ninth Circuit went on to find support for its position in three recent Supreme Court precedents:

  • In Shady Grove Orthopedic Associates, P.A. v. Allstate Insurance Co., 559 U.S. 393 (2010), the Supreme Court held that Rule 23 empowers a federal court to certify a class in any type of case, not only those “made eligible for class treatment by some otherId. at 399 (emphasis in original). The Ninth Circuit concluded that to deny American Pipe tolling to subsequent class actions would essentially import “certification criteria” into Rule 23 from “some other law,” which Shady Grove forbids. 2017 WL 2261024, at *7.
  • In Smith v. Beyer Corp., 564 U.S. 299 (2011), the Supreme Court held that, after denying class certification, a federal court could not enjoin a state court from certifying a class under the “relitigation exception” to the Anti-Injunction Act because the state court action had different named plaintiffs who were not subject to claim or issue preclusion. The Court acknowledged the risk of “serial relitigation of class certification,” but found that risk was mitigated by principles of stare decisis and comity, as well as the possibility of removal under the Class Action Fairness Act (for state court actions) or MDL consolidation (for other federal actions). Id. at 316-18. The Ninth Circuit found that those considerations similarly ameliorated the unfairness of serial class certification litigation due to American Pipe 2017 WL 2261024, at *9.
  • Finally, in Tyson Foods, Inc. v. Bouaphakeo, 126 S.Ct. 1036 (2016), the Supreme Court noted that “use of the class device cannot ‘abridge…any substantive right.’” Id. at 1046 (quoting 28 U.S.C. 2072(b)). While acknowledging that Tyson Foods did not directly control, given that “statutes of limitation occupy a no-man’s land between substance and procedure,” the Ninth Circuit found that it “nonetheless reinforces our conclusion that the statute of limitations does not bar a class action brought by plaintiffs whose individual actions are not barred.” 2017 WL 2261024, at *8.

Despite the court’s insistence to the contrary, Resh represents a sharp break from prior law in the Ninth Circuit. Given that the court radically reinterpreted the en banc decision in Catholic Social Services, it will be interesting to see whether the Ninth Circuit elects to reconsider the Resh decision en banc.

In the meantime, Resh increases the pressure on defendants in putative class actions pending in the Ninth Circuit to settle, lest they be saddled with the costs of serially re-litigating class certification even after prevailing. The Resh court’s suggestion that plaintiffs’ counsel, whose fees are usually contingent on the outcome of the case, “at some point will be unwilling to assume the financial risk in bringing successive suits,” id. at *9, is sure to be cold comfort to class action defendants, for whom the cost of litigation is frequently the driving factor in deciding to settle a case.

Some relief may be forthcoming soon from the Supreme Court, however. The Court is currently considering whether American Pipe tolling applies to statutes of repose, in addition to statutes of limitations. See California Pub. Employees’ Retirement Sys. v. ANZ Securities, Inc., 137 S.Ct. 811 (2017) (granting writ of certiorari). If the Supreme Court affirms that American Pipe tolling does not apply to statutes of repose, that would at least put a hard backstop on serial re-litigation of class certification. And given that there is a clear circuit split on whether American Pipe tolling applies to subsequent class actions, see, e.g., Korwek v. Hunt, 827 F.2d 874, 879 (1987), the Supreme Court may eventually take up that issue as well.

In a matter of first impression in the Ninth Circuit, the court applied the Supreme Court’s Omnicare standard for pleading the falsity of a statement of opinion to a Section 10(b) claim in City of Dearborn Heights Act 345 Police & Fire Retirement System v. Align Technology, Inc., — F.3d —, 2017 WL 1753276 (9th Cir. May 5, 2017).

The litigation arose from Align’s $187.6 million acquisition of Cadent Holdings, Inc. in April 2011, and Align’s alleged failures to properly assess and write off the goodwill associated with the acquisition. Align’s statements regarding the fair value of goodwill, of course, were quintessential statements of opinion, because they were inherently subjective. In Omincare, the Supreme Court set the standard for pleading the falsity of an opinion claim under Section 11. Many practitioners, including Lane Powell’s securities litigation team, had opined—and the Second Circuit and other courts had held—that the rationale of Omnicare should equally apply to Section 10(b) claims, since the falsity element is the same. In Align, the Ninth Circuit agreed, and partially overturned a previous Ninth Circuit case that permitted plaintiffs to plead falsity by alleging that “there is no reasonable basis” for the defendant’s opinion.

Align’s accounting for the acquisition resulted in $135.5 million of goodwill, $76.9 million of which was attributable to one of Cadent’s business units (the “SCCS unit”). The plaintiffs alleged that the purchase price, and thus the goodwill, was inflated due to Cadent’s channel stuffing practices prior to the acquisition, and that the defendants must have known as much after performing their due diligence. Following the acquisition, the SCCS unit’s financial results suffered due to numerous factors. Nevertheless, at the end of 2011, Align found no impairment of its recorded goodwill. Align did not perform any interim goodwill testing in the first or second quarters of 2012. Id. at *2-3.

On October 17, 2012, Align finally announced it would be conducting an interim goodwill impairment test for the SCCS unit, which it said was triggered by the unit’s poor financial performance in the third quarter of 2012 and the termination of a distribution deal in Europe. That announcement led to a 20% hit to Align’s stock price. On November 9, 2012, Align announced a goodwill impairment charge of $24.7 million, and it announced subsequent goodwill charges in the following two quarters. Id. at *3. The plaintiffs alleged that the defendants made seven false and misleading statements concerning the goodwill valuation between January 30, 2012 and August 2, 2012. The plaintiffs’ allegation was that defendants deliberately overvalued the SCCS goodwill, thereby injecting falsity into statements concerning the goodwill estimates and the related financial statements. The district court dismissed the complaint with prejudice for failing to adequately plead falsity and scienter. Id. at *4.

At issue in the Ninth Circuit was whether the plaintiffs had adequately pled that Align’s statements were false. The first question was what analytic framework applied. The plaintiffs did not dispute that five of the seven statements at issue were pure statements of opinion. However, with respect to two statements, the plaintiffs alleged the opinions contained “embedded statements of fact.” Those statements were that “there were no facts and circumstances that indicated that the fair value of the reporting units may be less than their current carrying amount,” and that “no impairment needed to be recorded as the fair value of our reporting units were significantly in excess of the carrying value.” The Court held that the former statement was an opinion with an embedded statement of fact, but that the latter was an opinion. Id. at *5.

The Court also addressed the proper pleading standard for falsity of opinion statements. The panel concluded that Omnicare established three different standards depending on a plaintiff’s theory:

  1. Material misrepresentation. Plaintiffs must allege both subjective and objective falsity, i.e., that the speaker both did not hold the belief she professed, and that the belief was objectively untrue.
  2. Materially misleading statement of fact embedded in an opinion statement. Plaintiffs must allege that the embedded fact is untrue.
  3. Misleading opinion due to an omission of fact. Plaintiffs must allege that facts forming the basis for the issuer’s opinion, the omission of which makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context.

Importantly, the Ninth Circuit extended this Omnicare holding from the Section 11 context to the Section 10(b) and Rule 10b-5 claims at issue in Align. Id. at *7. In doing so, the Ninth Circuit joined the Second Circuit in extending Omnicare in this regard. See Tongue v. Sanofi, 816 F.3d 199, 209-10 (2d Cir. 2016). Finally, the court overruled part of its previous holding in Miller v. Gammie, 335 F.3d 889, 900 (9th Cir. 2003) (en banc), which allowed for pleading falsity by alleging that there was “no reasonable basis for the belief” under a material misrepresentation theory. City of Dearborn Heights, 2017 WL 1753276, at *7.

Applying this pleading standard to the Align facts, the Ninth Circuit concluded that the plaintiffs had not met their pleading burden. Because the plaintiffs did not allege the actual assumptions the defendants relied upon in conducting their goodwill analysis, the court could not infer that the defendants intentionally disregarded the relevant events and circumstances. Accordingly, six of the seven statements that relied on the material misrepresentation theory failed to allege subjective falsity and were properly dismissed. Likewise, the failure to allege the actual assumptions used by the defendants prevented plaintiffs from pleading objective falsity as to the one statement of fact embedded in an opinion statement. Id. at *8-10.

After concluding that the plaintiffs failed to allege falsity, the Ninth Circuit went on to hold that plaintiffs had not alleged scienter against the defendants, providing a second ground for dismissing the complaint. At most, the plaintiffs alleged that the defendants violated generally accepted accounting principles, but such a failure does not establish scienter. Likewise, the stock sale allegations, core operations inference, the temporal proximity between the challenged statements and the goodwill write-downs, the CFO’s resignation, and the magnitude of the goodwill write-downs did not create an inference of scienter. Id. at *10-13.

Judge Kleinfeld concurred in the judgment. He would have upheld the district court’s dismissal based on scienter alone, leaving the weightier issue of falsity described above to a future case where such a decision was necessary. Id. at *13-14 (Kleinfeld, J., concurring in the judgment).

In Brennan v. Zafgen, Inc., — F.3d –, 2017 WL 1291194 (1st Cir., April 7, 2017), the First Circuit affirmed a District of Massachusetts decision dismissing claims against Zafgen, Inc., a biopharmaceutical developer, and its CEO, Dr. Thomas Hughes. Judge Stahl, writing for a panel that included retired Supreme Court Justice Souter (sitting by designation), concluded that plaintiffs’ complaint did not allege facts giving rise to the “cogent and compelling” inference of scienter required by the Reform Act. Id. at *1 (quoting Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007)).

Between August 2012 and May 2013, before Zafgen went public, the company conducted a Phase II trial of an anti-obesity drug called Beloranib. As the trial progressed, four patients in the trial who were receiving the drug suffered adverse “thrombotic”—i.e., blood-clotting—events of varying severity. Third-party clinical investigators classified two of these adverse thrombotic events as “superficial,” and the other two events as “serious.” In April 2014, as Zafgen was preparing for a June 2014 IPO, it disclosed the two serious events, but not the two superficial events, in its Form S-1 Registration Statement. Id. at *1-2.

In mid-October 2015, Zafgen’s share price began to decline, falling from $34.76 on October 12 to $15.75 at close of trading the next day. On October 15, Zafgen disclosed that a patient in its ongoing Phase III trial of Beloranib had died; and on October 16, the company confirmed that this patient had been treated with the drug (rather than a placebo), and that the FDA had placed Beloranib on a partial clinical hold. Also on October 16, 2015, Zafgen’s chief medical officer, Dr. Dennis Kim, disclosed for the first time the two superficial adverse events from the Phase II trial that was conducted in 2012-2013. By the end of trading on October 16, the price of Zafgen stock had dropped to $10.36. Id. at *2.

The plaintiffs in Brennan sued Zafgen and Dr. Hughes on behalf of a putative class consisting of all persons and entities who bought Zafgen stock between its IPO on June 19, 2014 and October 16, 2015, when the company announced the FDA’s partial clinical hold. Id. at *3. They argued that the company had made misleading statements about its Beloranib trial in ten different documents that were signed by Dr. Hughes, and they asserted claims under Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5. Specifically, the plaintiffs claimed that the challenged statements were misleading because they failed to mention the two superficial adverse events from the Phase II trial, which were disclosed for the first time by Dr. Kim on October 16, 2015. Id. at *1-3. (Despite alleging material omissions in Zafgen’s Registration Statement, plaintiffs did not assert Securities Act claims.)

The district court dismissed plaintiffs’ complaint on the ground that it failed to adequately plead a “strong inference” of scienter, as is required by the Reform Act. In doing so, the district court placed particular emphasis on the materiality of the two superficial adverse events, which it described as “marginal,” thereby weakening any inference of scienter. Id. at *4.

On appeal, the plaintiffs argued that they had, in fact, satisfied the Reform Act’s scienter requirement, because they had pled that defendants (1) knew, or were reckless in not knowing, about news and scientific articles purportedly showing a link between Beloranib and adverse thrombotic events; and (2) had a motive to commit securities fraud, as shown by Zafgen’s compensation structure, and by “heavy” insider sales before the patient death was announced. Id. at *5.

Regarding the news and scientific articles cited by plaintiffs, the First Circuit noted that “‘[t]he key question … is not whether defendants had knowledge of certain undisclosed facts, but rather whether [they] knew or should have known that their failure to disclose those facts’ risked misleading investors.” Id. (quoting City of Dearborn Heights Act 345 Police & Fire Ret. Sys. v. Waters Corp., 632 F.3d 751, 758 (1st Cir. 2012)). In this case, the cited articles “may [have] suggest[ed]” that the defendants were aware of a link between Beloranib and thrombotic events. But the articles did not demonstrate that the defendants “deliberately or recklessly risked misleading investors” by not disclosing the two superficial events from the Phase II trial until October 16, 2015. Id.

Turning to plaintiffs’ motive allegations relating to insider trading and Zafgen’s compensation structure, the First Circuit agreed with the district court that “the strength of the insider trading allegations drifts towards the marginal end of that spectrum because [CEO] Hughes and all other Zafgen insiders kept the vast majority of their Zafgen holdings.” Id. at *6 (observing that after accounting for vested options, Dr. Hughes retained at least 93 percent of his Zafgen stock, and every other insider identified in the complaint retained at least 85 percent). In light of this fact, the district court was correct in determining that the plaintiffs’ insider trading allegations “d[id] not alter the conclusion that the complaint as a whole fails to raise a strong inference of scienter.” Id.

As for the plaintiffs’ arguments regarding Zafgen’s compensation structure, the First Circuit found that the complaint’s allegations offered no basis for inferring fraudulent intent, but showed only “the usual concern by executives to improve financial results.” Id. (quoting In re Cabletron Sys., Inc., 311 F.3d 11, 39 (1st Cir. 2002)). An allegation that a defendant had motive and opportunity to commit fraud, or that a corporation “rewards [its executives for] the achievement of corporate goals,” does not satisfy the Reform Act “without something more.” Id.

The First Circuit also discussed several other considerations that “bolster[ed]” its conclusion that the complaint’s allegations did not give rise to a sufficiently strong inference of scienter. These included the fact that (1) the materiality of the two undisclosed superficial adverse events was “marginal,” which “tends to undercut the argument that the defendants acted with the requisite intent … in not disclosing [them],” id. at *7 (quoting In re Ariad Pharm. Sec. Litig., 842 F.3d 744, 751 (1st Cir. 2016)); and (2) Zafgen’s disclosures before and during the class period mentioned the two serious thrombotic events from the Phase II study, and also stated that the company would not disclose all adverse events as they occurred, which “weaken[ed] the complaint’s scienter showing,” id. at *8.

Having thus concluded that the plaintiffs’ allegations, considered as a whole, did not give rise to a “cogent and compelling” inference of scienter, the First Circuit affirmed the dismissal of plaintiffs’ Section 10(b) claim as well as their Section 20(a) claim against Dr. Hughes, which was derivative of the former. Id.

A senior officer’s violations of a corporation’s code of conduct do not give rise to a claim for violation of the federal securities laws—even where the corporation (including the officer himself) has touted the company’s high standards for compliance with its own ethical code.  That was the Ninth Circuit’s holding in a recent opinion affirming a district court’s dismissal of a putative class action filed against Hewlett-Packard and its former CEO and Chairman, Mark Hurd.  Retail Wholesale & Department Store Union Local 338 Retirement Fund v. Hewlett-Packard Co. and Mark A. Hurd, 845 F.3d 1268 (9th Cir. 2017).  The case arose out of Hurd’s departure from the company following revelations of Hurd’s relationship with an HP contractor and subsequent efforts to cover up the relationship.  Plaintiffs brought claims under Section 10 of the Securities Exchange Act of 1934 and Rule 10b-5, alleging that HP had materially misrepresented or alternatively made material omissions about its high ethical standards and compliance with its Standards of Business Conduct (“SBC”), where its Chairman and CEO was found to have violated the SBC.

HP touted its strict code of conduct prior to Hurd’s resignation for violating the code.

Several years earlier, under Hurd’s leadership, HP had revised and strengthened its SBC following a 2006 ethics scandal in which it was revealed that HP had hired detectives to spy on directors, employees and journalists.  While the then-Chairman and General Counsel faced criminal charges, Hurd (then-CEO) was found free of any wrongdoing in that scandal, and was promoted to Chairman in addition to his role as CEO.  As the Ninth Circuit noted, following the scandal “Hurd took many opportunities to proclaim HP’s integrity and its intention to enforce violations of the SBC.”

Four years later, in 2010, former HP contractor Jodie Fisher contacted HP’s Board of Directors through her attorney, alleging that Hurd had sexually harassed Fisher.  The Board launched an investigation, and Hurd initially lied to the Board about the nature of his relationship with Fisher before admitting to a “very close personal relationship” with her.  The investigation revealed that Hurd had also falsified expense reports to hide his relationship.  Hurd resigned following the investigation, and HP acknowledged in a press release that Hurd knowingly violated the SBC and acted unethically.  HP’s stock dropped immediately upon the announcement of Hurd’s resignation, resulting in a $10 billion loss in market cap.

Statements about a code of conduct must be both objectively false and material to be actionable.

Investors filed a putative class action claiming that the violations of the SBC amounted to securities fraud, either in the form of material misrepresentations because HP’s statements about its ethics were inconsistent with Hurd’s conduct, or in the form of material omissions regarding Hurd’s unethical behavior, which Plaintiffs claimed HP had a duty to disclose.  The district court rejected both theories and dismissed the complaint with prejudice.  A three-judge panel of the Ninth Circuit unanimously affirmed the dismissal.

In this issue of first impression before the Ninth Circuit, the court articulated a two-part test for determining whether a violation of a corporate code of ethics may give rise to a securities fraud claim.  First, it examined the objective falsity of the company’s statements regarding its code of ethics.  Second, it turned to the materiality of those statements.  The court found that Plaintiffs’ claims failed under both elements.

As to objective falsity, the Ninth Circuit held that HP and Hurd had made no “objectively verifiable” statements about its compliance with the SBC, and instead characterized the code of conduct and statements about it as “inherently aspirational.”  Plaintiffs pointed in particular to Hurd’s comments prefacing the SBC as revised following the 2006 scandal, in which Hurd urged employees to “commit together, as individuals and as a company, to build trust in everything we do . . .”  But the Court reasoned that such statements are not “capable of being objectively false,” and thus found no affirmative misrepresentation.

The Ninth Circuit further found that the challenged representations were not material.  It noted that companies are required by the SEC to publish their codes of conduct, and “it simply cannot be that a reasonable investor’s decision could conceivably have been affected by HP’s compliance with SEC regulations requiring publication of ethics standards.”  Moreover, while plaintiffs pointed to the stock drop as evidence of materiality, the court cited its decision in Police Ret. Syst. Of St. Louis v. Intuitive Surgical, Inc., 759 F.3d 1051, 1060 (9th Cir. 2014), for the proposition that the stock drop goes to reliance, not materiality.  Where, as here, there was no actionable misstatement, the court would not reach the reliance analysis.

The court also rejected plaintiffs’ alternative theory that HP failed to disclose material facts concerning Hurd’s noncompliance with the SJC.  The court found that HP’s “transparently aspirational” statements in and about the SBC did not amount to a suggestion that nobody at HP would ever violate the SBC.  Absent statements creating the impression that everyone at HP was in full compliance with the ethical standards, there was nothing that gave rise to a duty to disclose noncompliance.

The future is dim for securities claims based on violations of a company’s ethical code—and that’s good news for companies and their directors and officers who wish to adopt and tout strong codes of conduct.

Plaintiffs may complain that the Ninth Circuit’s opinion takes away a tool for enforcing compliance with codes of conduct, as (at least in the Ninth Circuit) securities class actions based on alleged noncompliance with SEC-mandated codes of conduct are unlikely to survive a motion to dismiss.  Indeed, defense counsel are already brandishing Hewlett-Packard to support the assertion that statements about ethics-policy compliance are not actionable under the securities laws—Goldman Sachs sent a letter to the Second Circuit recently citing the HP decision in support of Goldman’s bid to decertify a class of investors suing over its Abacus CDO.

But I think the better view is that the court’s ruling finding that “aspirational” statements will generally not support a finding of falsity or materiality under the securities laws should provide a level comfort to companies seeking to adopt robust ethical codes, and to speak freely both within the company and publicly about their values and compliance goals—with a few notes of caution.

First, it probably goes without saying that, even under the Ninth Circuit’s newly-articulated standard, companies should avoid unequivocal statements in or about their codes of conduct suggesting for example that there will be no violations of the ethical code.  Such statements will likely prove false over time, and probably demonstrably so.  But apart from those types of unequivocal statements, the Ninth Circuit’s ruling should be an encouraging sign for companies who adopt and publish strong codes of conduct, and for directors and officers who make statements about their efforts to abide by such codes.  As the court made clear, these “aspirational statements” about a company’s compliance with its own code of conduct—even where strongly stated or oft-repeated—will typically be neither objectively false nor material under the securities laws.  As the court noted, “A contrary interpretation—that statements such as, for example, the SBC’s ‘we make ethical decisions,’ or Hurd’s prefatory statements, can be measured for compliance—is simply untenable, as it could turn all corporate wrongdoing into securities fraud.”

The second caution is that the Ninth Circuit’s ruling did not go so far as to say that non-compliance with a code of conduct could never be actionable under federal securities laws.  The court imagined that “the analysis would likely be different if HP had continued the conduct that gave rise to the 2006 scandal while claiming that it had learned a valuable lesson in ethics.”  Accordingly, companies should continue to be particularly vigilant to avoid repeating (or continuing) prior ethical lapses, which the Ninth Circuit suggested could give rise to causes of action, particularly where the company indicated through public statements that such conduct had ceased.

The First Circuit affirmed the dismissal of nearly all securities class action claims against Ariad Pharmaceuticals, Inc. (Ariad) and four corporate officers, in In re Ariad Pharmaceuticals, Inc., Securities Litig., 842 F.3d 744 (1st Cir. 2016). The litigation focused on Ariad’s public statements about the potential for FDA approval of an experimental drug designed to treat a particular type of leukemia.  Ariad made robust public statements about the efficacy of the drug, until the FDA pulled the drug from clinical trials amid negative side effects. The First Circuit found that other than one statement, the allegations of misrepresentations were insufficient to support a strong inference of scienter. The court also held that the allegations of insider trading were not actionable.

Ariad is a pharmaceutical company employing R&D to develop new products. One such product showed promise in treating a chronic form of leukemia. After a series of clinical trials, Ariad sought FDA approval. The FDA initially rejected Ariad’s application, but eventually approved limited use, with the caveat that the packaging must indicate a significant risk of adverse cardiovascular events (a so-called “black-box” label). Black-box labels are the strictest warnings issued by the FDA and indicate that evidence of a serious hazard exists with the drug. Despite the concerns and the required label, Ariad projected public confidence about the drug’s effectiveness, which included a statement that management believed the drug would be approved “with a favorable label.” Within a year, however, clinical studies showed increased medical complications, ultimately resulting in the decision to suspend commercial distribution of the drug.  Ariad’s stock price went from $23/share to $2.20/share.

Plaintiffs brought claims under both the Exchange Act and the Securities Act. Plaintiffs identified two categories of alleged misstatements: (1) those statements made before the FDA approved the drug for limited use; and (2) those statements made post-approval. On either side of the FDA approval timeline, the crux of the alleged misstatements related to what Ariad knew and said (or failed to say) about the rate of cardiovascular events attributed to the drug’s use. To bolster their scienter allegations, plaintiffs alleged that certain executives sold shares during the class period.

On appeal, the First Circuit affirmed, in part, the district court’s dismissal. The court overwhelmingly rejected plaintiffs’ theory because, while the complaint was replete with conclusory allegations that the Ariad defendants knew about the rate of cardiovascular events, “plaintiffs’ theory of fraud suffer[ed] from a glaring omission”—plaintiffs failed to make concrete allegations of contemporaneous knowledge. The allegations, taken as a whole, did not establish when the adverse events occurred or, more importantly, when the defendants knew about those adverse events.  Instead, the complaint sought to impermissibly establish fraud by hindsight. As such, plaintiffs failed to create the required strong inference of scienter.

The court did find, however, that one statement did support a strong inference of scienter. After the FDA had informed Ariad that its limited approval would include a black-box label requirement, Ariad published a report indicating the drug would likely receive a favorable label. The court found this allegation sufficient.

The First Circuit also dispensed with the stock-sale allegations. Relying on its decision in Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999), the court analyzed the insider trading allegations under its holding that insider trades may be probative of scienter, but do not, on their own, establish scienter. The court found that the bulk of insider trades occurred well before the high point of Ariad’s stock price, an indication that the trades did not appear to be suspicious. Ariad’s CFO made trades closest to the stock’s high point, but, significantly, the court concluded a pharmaceutical company’s CFO is not likely to have access to nonpublic information obtained through clinical trials. As such, it was unlikely, in the court’s estimation, that the CFO’s trades indicated knowledge of negative information not yet available to the public. The upshot: none of the insider trading allegations bolstered the plaintiffs’ scienter allegations.

Finally, the First Circuit held that plaintiffs did not adequately plead that the purchase of their shares was traceable to the relevant offering. Based on the plaintiffs’ allegations, the court found it more plausible than not that they purchased shares that were issued prior to the date(s) of the alleged misstatements.

The 11th Circuit ignored the potential application of the Supreme Court’s 2015 decision in Omnicare, and instead reached back to its own precedent dating from 1979, in holding that plaintiffs are foreclosed from bringing a claim that a company misled shareholders about its real motivations for engaging in a stock repurchase program.

In its per curiam unpublished opinion in Henningsen v. ADT Corp. (“ADT”), 2016 WL 4660814 (11th Cir. 2016), the 11th Circuit affirmed the dismissal of Section 10(b) claims against ADT and its CEO, and against Corvex Management LP, and its founder, Keith Meister.

Plaintiffs alleged that Corvex had acquired more than five percent of ADT’s stock in 2012, and that after that point, Meister was outspoken in his criticism of the Company, alleging that its stock was undervalued and urging management to take on more debt so it could repurchase shares, with a goal of increasing ADT’s stock price.

The complaint alleged that Meister threatened to call a shareholder vote to replace the board if the directors did not offer him a board position and agree to take out loans for significant stock buybacks.  ADT announced a plan to repurchase $2 billion of its common stock over three years after an initial meeting with Meister.  Soon afterward, Meister was given a position on the ADT board, and the Company continued to borrow more money to repurchase more stock, ultimately causing credit rating agencies to downgrade ADT’s credit rating and ADT’s share price to drop.  After this downturn, the complaint alleges that Meister pushed for ADT to repurchase more shares on an even more accelerated timeframe, and that the directors acquiesced after Meister promised to leave the board if they agreed with his plan.

In November 2013, ADT announced that it was repurchasing Corvex’s shares and that Meister was resigning from the board.  ADT stock price dropped 6% on this news, and dropped another 30% in the following months.  Plaintiffs filed suit, claiming that ADT and Corvex had misrepresented various issues and problems at the Company, and that they had misled shareholders by concealing that they had engaged in aggressive share repurchases to appease Meister and Corvex, instead characterizing the repurchase plan as “thoughtful,” “effective,” and “optimal.” Id. at *5.

The district court dismissed most of the claims for failure to sufficiently plead falsity and scienter, and rejected the “motivation” claim because it was barred by 11th Circuit precedent, namely Alabama Farm Bureau Mutual Casualty Co. v. American Fidelity Life Insurance Co., 606 F.2d 602, 610 (5th Cir. 1979).  The 11th Circuit affirmed.

In Alabama Farm, the court held that a company does not engage in “deception” under the securities laws by failing to “disclose [its] motives in entering a transaction,” and that Section 10(b) does not require “the disclosure of an individuals’ motives or subjective beliefs.” ADT, 2016 WL 4660814, at *4 (quoting Alabama Farm, 606 F.2d at 610).

In ADT, 11th Circuit found that this precedent foreclosed plaintiffs’ claims that the “ADT Defendants misled investors by having one motive, while offering up another, for participating in an otherwise accurately-disclosed stock repurchase plan.”  The court reasoned that information about the Company’s motives was not material as long as the Company had accurately disclosed “material financial or other information concerning the nature, scope, or mechanics of the stock repurchase transaction.” Id. at *4.

The court rejected plaintiffs’ argument that such a bright-line test for materiality is no longer good law after the Supreme Court’s decisions in Basic Inc. v. Levinson, 485 U.S. 224 (1988) and Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011).  Even in light of these Supreme Court decisions expressing concern such bright-line tests might exclude information important to a reasonable shareholder, the court found that “no reasonable shareholder would have considered the alleged omissions” regarding ADT’s true motivations “significant to the decision about whether to trade ADT securities given the other disclosures regarding the stock repurchase program and ADT’s corporate financing.” Id.

Finally, the court declined to give meaningful consideration to plaintiffs’ claims that ADT and its CEO had misled its shareholders by calling the repurchase program “thoughtful,” “effective,” and “optimal,” among other descriptors.  The court did not consider the applicability to these claims of the Supreme Court’s decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), which sets forth the criteria for deciding whether a statement of opinion was false or misleading. Instead, the court relied on pre-Omnicare precedent to dismiss these statements as nonactionable “puffery,” thus sidestepping the question of whether plaintiffs might have adequately alleged that they were false statements of opinion under the Omnicare standard. Id. at *5.

The Third Circuit engaged in a searching analysis of plaintiffs’ falsity and scienter allegations and found them insufficient under the exacting standards of the Reform Act, upholding the district court’s dismissal of the complaint in OFI Asset Management v. Cooper Tire & Rubber, — F.3d —, 2016 WL 4434404 (3d Cir. 2016).

In its ruling, the Third Circuit also had some harsh words for plaintiffs’ “kitchen sink” pleading style, finding that it “has been a hindrance at every stage of these proceedings.”  Id. at *7.

The case is tied to Cooper’s failed merger with Apollo Tyres.  Cooper was valuable to Apollo largely due of its manufacturing facility in China (“CCT’), of which it owned 65%, with the remaining 35% owned by a Chinese company.  The merger fell through after workers at CCT went on strike, denied Cooper officials access to the facility, refused to provide Cooper with financial information, and stopped producing Cooper-branded tires.  At the same time, the merger announcement led to a labor dispute in Cooper’s U.S. manufacturing facilities, with a labor arbitrator eventually finding in favor of the union and barring Cooper from selling two of its U.S. plants to Apollo.

Plaintiffs alleged that Cooper made a number of false or misleading statements under Section 10(b) and 14(a) in connection with the failed merger, including in the merger agreement, the proxy statement, its financial statements, and two 8-Ks containing news about the merger.  The claim was dismissed by the district court in Delaware for failure to adequately allege falsity and scienter.

Prior to oral argument, the district court had ordered plaintiffs to submit a letter identifying the five most compelling examples of allegedly false statements, with three factual allegations demonstrating the falsity of each statement and three allegations supporting scienter as to each of the statements.  Upon appeal, plaintiffs’ first objection was as to the court’s process, arguing that the court abused its discretion by considering only five “artificially selected” allegedly false statements, and failing to rule on the whole of plaintiffs’ complaint.

The Third Circuit considered plaintiffs’ “umbrage. . . unfounded.” Far from harming OFI’s case, the court found that the district judge had tried to “give OFI an assist,” by offering it a chance to frame the issues in its complaint more clearly.  Asking OFI to bring some order and clarity to its 100-page, 245-paragraph complaint was well within the district judge’s discretion to manage complex disputes, and does not show that the judge failed to consider the allegations as a whole.  Id. at *6.

Held the Third Circuit: “As pled, the Complaint presents an extraordinary challenge for application of the highly particularized pleading standard demanded by the PSLRA. This is true not only due to the length of the Complaint, but also its lack of clarity. . . . Now that OFI has come to us with the same kind of broad averments that drove the District Court to demand specificity, we find ourselves more than sympathetic to the Court’s position.”  Id. at *6.

After holding that the district court had not abused its discretion in managing the case, the Third Circuit went on to explore in detail each of the allegedly false statements, finding that none of them were sufficient to maintain a claim.  In doing so, the court considered the context of each allegedly false or misleading statement, and examined whether the allegations of falsity as to each were sufficiently specific, rejecting those allegations that lacked the particularity required of the Reform Act or which failed to show how a statement was misleading rather than simply incomplete.

As to a number of forward-looking statements, the Third Circuit held that its allegations of falsity failed to account for the Reform Act’s Safe Harbor.  Because the statements had been accompanied by meaningful cautionary statements, the court held that the Safe Harbor immunized them from liability—and thus they were not actionable even if plaintiffs could show that they were false and made with scienter.  Id. at *15.

In regard to one isolated statement, the court also found that even if OFI had sufficiently pleaded technical falsity, it nevertheless failed to raise a strong inference of scienter, because the “plausible opposing inferences” were more likely, “including that the statement was simply imprecise or received little attention due to the context in which it was made[.]”  Id. at 12.

Wrote the court: “OFI’s post hoc scouring of countless pages of documents for a stray and inartfully phrased comment that can be argued to be technically false seems like just the sort of litigation maneuver the PSLRA was meant to eliminate. One purpose of the statute was to prevent disappointed investors from treating every imprecise statement during a transaction as an invitation to file a lawsuit.”  Id. at *13.

The Sixth Circuit has joined a majority of the other circuit courts in recognizing that loss causation can be shown through a “materialization of the risk” theory,” reversing the dismissal of a case against Freddie Mac stemming from the 2007 mortgage crisis.

In Ohio Public Employees Retirement Sys. v. Federal Home Loan Mortgage Corp. (“Freddie Mac”), — F.3d. —, 2016 WL 3916011 (6th Cir. 2016), the Sixth Circuit found that under “the clear weight of persuasive authority,” plaintiffs could adequately plead loss causation by alleging that a risk that had been fraudulently concealed caused harm to a company and a resultant stock drop — even if there was no corrective disclosure that revealed that the company’s statements had been false or misleading. Id. at *7.

Plaintiffs brought the action against Freddie Mac in January 2008, alleging that starting on August 1, 2006, the mortgage-holding giant had made false or misleading statements that concealed from purchasers of its stock its growing investment in loan portfolios comprised of risky mortgages, as well as the fact that it circumvented its traditional underwriting standards to purchase these portfolios.

Although Freddie Mac had given the market warnings about potential credit risk, plaintiffs alleged that it had made misleading statements highlighting its rigorous underwriting requirements and declaring that it had “basically no subprime exposure.” Id. at *7-8.

Plaintiffs allege that the market began to learn the truth behind these misrepresentations on November 20, 2007, when Freddie Mac released an earnings statement that revealed that more than a fourth of its loan portfolio was at high risk of substantial losses, and disclosed that it had incurred a record $2 billion in losses during the previous quarter. The company’s stock price dropped 29% on this news. However, it was not until 2008 that news articles and analyst reports suggested that Freddie Mac’s prior statements regarding its portfolio may have been false.

The complaint had previously withstood three motions to dismiss, but in 2013 the district judge in the Northern District of Ohio recused himself from the case and it was reassigned. The new district judge gave defendants leave to file a fourth motion to dismiss, which the court granted in 2014.

In finding the materialization of the risk theory sufficient to plead a Section 10(b) claim, the Sixth Circuit noted that it was an issue of first impression in the circuit, and referred to decisions from nine other circuit courts that recognize the theory.  It cited to the Second Circuit in holding that alternate theories of loss causation that do not include a corrective disclosure are sufficient if they allege that the stock drop was caused by events that were “within the zone of risk concealed by the misrepresentations and omissions.”  Id. at *6 (citing Lentell v. Merrill Lynch & Co., 396 F.3d 161, 172 (2d Cir. 2005)).

The court noted: “We are mindful of the dangerous incentive that is created when the success of any loss causation argument is made contingent upon a defendant’s acknowledgment that it misled investors. Our sister circuits are too and have recognized that defendants accused of securities fraud should not escape liability by simply avoiding a corrective disclosure.”  Id. at *7.

Emphasizing that allegations of loss causation do not need to meet heightened pleading under the Reform Act, the court found that plaintiffs had sufficiently alleged that their investment losses were caused when the allegedly concealed risky mortgages and compromised underwriting standards resulted in substantial defaults and record losses for the company. The court found that the disclosure of these losses on November 20, 2007 “well within the ‘zone of risk’ that Freddie Mac allegedly concealed,” and therefore were sufficient to support a “plausible claim” of loss causation under the standard of Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)). Id. at *8-9.