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.