The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In a February 10, 2010 opinion (here), the Second Circuit reversed the lower court’s dismissal of the securities class action lawsuit relating to The Blackstone Group’s June 2007 IPO. The decision, which represents a noteworthy victory for plaintiffs, contains an extensive analysis of "materiality" requirements and could prove significant in the many other pending cases alleging misrepresentations or omissions regarding the subprime meltdown and the ensuing deterioration of the financial marketplace.

Background

Blackstone, a leading asset manager and financial advisory firm, conducted an IPO in June 2007. As reflected here, in April 2008, investors who had purchased securities in the offering filed the first of several securities class action lawsuits against Blackstone and certain of its directors and officers, alleging that the company had made material misrepresentations and omissions in its IPO offering documents.

The investors alleged that at the time of the offering, Blackstone knew that two of its portfolio companies (FGIC Corporation, a monoline financial guarantor, and Freescale Semiconductor), as well as its real estate fund investments, were experiencing problems. The investors allege that the defendants knew that these problems could subject the company to a claw-back of performance fees or result in reduced performance fees. The defendants moved to dismiss.

In a September 22, 2009 order (here), Southern District of New York Judge Harold Baer, Jr. granted the defendants’ motions to dismiss, holding that the alleged misrepresentations or omissions regarding FGIC and Freescale were neither quantitatively nor qualitatively material, and further holding that the alleged misrepresentations regarding Blackstone’s real estate investments were insufficient because the plaintiffs’ allegations failed to specify how the residential mortgage woes would have a foreseeable material effect on Blackstone’s real estate investments. The plaintiffs appealed.

The February 10 Order

In an opinion written by Judge Chester J. Straub for a three judge panel, the Second Circuit reversed the district court, holding that the lower court had erred in dismissing the plaintiffs’ complaint.

The Second Circuit’s analysis focused on Blackstone’s obligation under Item 303 of Reg. S-K to disclose material risks, trends and uncertainties that could affect the firm’s financial results.

In holding that the complaint’s allegations regarding the offering documents’ omission in connection with Blackstone’s investments in FGIC and Freescale met both the quantitative and qualitative materiality requirements, the Court rejected Blackstone’s argument that a loss in one of its portfolio companies might be offers by a gain in another. "Blackstone," the Court said, "is not permitted, in assessing materiality, to aggregate the negative and positive effects on its performance fees in order to avoid disclosure of a particular negative event."

The Court added that "were we to hold otherwise, we would effectively sanction misstatements in a registration statement or prospectus related to particular portfolio companies so long as the net effect on revenues of a public private equity firm like Blackstone was immaterial." The question is not whether an investment’s loss in value will affect revenues but the firm "expects the impact to be material."

In concluding that the district court had erred in holding that the plaintiffs’ allegations did not satisfy the qualitative materiality requirements, the Court noted that the firm’s Corporate Private Equity division was the firm’s "flagship segment," adding that because the segment "plays such an important role in Blackstone’s business and provides value to all of its other asset management and financial advisory services," a reasonable investor "would almost certainly want to know information related to that segment that Blackstone reasonable expects will have a material adverse effect on its future revenues."

The Court added that it could not conclude that Freescale’s loss of an exclusive contract with it larges customer was immaterial in connection with one of the firm’s Corporate Private Equity firm’s largest investments. The Court noted that the failure to disclose the negative developments at FGIC and Freeescale "masked a reasonably likely change in earnings, as well as a trend, event or uncertainly that was likely to cause such a change."

With respect to Blackstone’s real estate investments, the Court held that the district court erred in concluding that the plaintiffs’ allegations were deficient because they failed to identify specific real estate investments that might have been at risk. The Court said:

This expectation …misses the very core of plaintiffs’ allegations, namely that Blackstone omitted material information it had a duty to report. In other words, plaintiffs’ precise, actionable allegation is that Blackstone failed to disclose material details of its real estate investments, and specifically that it failed to disclose the manner in which those unidentified, particular investments might be materially affected by the then-existing downward trend in housing prices, the increasing default rates for sub-prime mortgage loans, and the pending problems for complex mortgage securities.

The Second Circuit concluded that "plaintiffs provide significant factual detail about the general deterioration of the real estate market and specific facts , that drawing all reasonable inference in plaintiffs’ favor, directly contradict statements made by Blackstone in the Registration Statement."

Finally, the Court rejected the suggestion that the plaintiffs’ view of materiality would require investment firms like Blackstone to issue compilations of prospectuses of every portfolio company or real estate asset in with the firm has any interest. In order for omitted information to give rise to a claim under the ’33 Act, the reporting company would have to have an obligation (for example under Item 303 of Reg. S-K) to disclose the information and the omitted information would have to be "deemed material."

Discussion

The Second Circuit’s opinion in this case represents both a noteworthy victory for the plaintiffs and a development with potential significance for the many other subprime meltdown and credit crisis-related securities pending in Second Circuit.

It is not just that the district court’s dismissal was overturned, although that obviously is of most immediate significance for the parties involved. Rather, it is that the reversal was an act of the Second Circuit, to which all of the District Courts in the Southern District of New York – where so many cases are filed -- are answerable.

So many of the cases growing out of the subprime meltdown and the credit crisis were, like this case, filed in the Southern District of New York. As these cases have proceeded to the motion to dismiss stage, the courts have struggled with what is required to be alleged in order to survive the motion to dismiss. And although not all of the cases turn on questions of materiality, when materiality questions arise, the Second Circuit’s opinion in the Blackstone case could be important, particularly for plaintiffs in ’33 Act cases.

The Second Circuit emphasized that, in its view, materiality requirements may be satisfied relatively easily. The Court emphasized at the outset that a ’33 Act complaint "need only satisfy the basic notice pleading requirements" adding that "where the principal issue is materiality, an inherent fact-specific finding, the burden on plaintiffs to state a claim is even lower." With the Second Circuit specifying only minimal pleading requirements, the threshold standard, at least as far as materiality, should become less onerous for plaintiffs – at least in ’33 Act claims.

The significance of this is perhaps best seen with respect to the plaintiffs’ allegations concerning Blackstone’s real estate asset investments. Although the district court found that the allegations failed to link the general real estate downturn to Blackstone’s specific real estate investments, in essence the Second Circuit found the plaintiffs’ allegations about the general real estate downturn to be sufficient and required a relatively slight connection between these generalized allegations and Blackstone’s own circumstances.

Given that, at least in this case and under the circumstance alleged, allegations about the generalized real estate downturn were found to be sufficient could give heart to other plaintiffs in other subprime meltdown and credit crisis-related securities suits. The complaints in many of these other cases often contain extensive accounts of the generalized real estate downturn. These other plaintiffs will undoubtedly seek to rely on the Second Circuit’s opinion in the Blackstone case, at least in order to show that their allegations satisfy the materiality requirements.

All of that said, it should also be noted that a critical feature of this case is Blackstone's status as a publicly traded private equity firm. Both the district court and the Second Circuit were trying to deal with the threshold issues of what a firm like Blackstone has to disclose about its private equity portfolio investments. This aspect of the case arguably could limit the applicability of the Second Circuit's opinion. (I will say as an aside that the Second Circuit's supposedly reassuring words at the end of the Opinion that a firm like Blackstone would not have compile prospectuses of all of its portfolio companies are both unconvincing and unhelpful. The problem is that if materiality is as broad as the Second Circuit suggests, it is very difficult to find the outer edge of what a firm like Blackstone might have to disclose about its portfolio companies.)

The fact that the plaintiffs prevailed in their appeal in the Blackstone case may be noteworthy in and of itself. Up to this point, the plaintiffs’ appellate track record in securities suits related to the credit crisis was, well, not particularly encouraging for them. As reflected here, the plaintiffs had failed to overturn dismissals in the first three credit crisis securities appellate decisions, although just last month the plaintiffs in the Nomura Securities subprime-related securities suit did succeed in overturning one part of the dismissal of that case. Plaintiffs generally will take heart from the success in overturning the Blackstone lawsuit dismissal on appeal.

The Second Circuit’s reversal serves as a reminder that it may be dangerous to jump to too many conclusions about how plaintiffs are faring in the subprime and credit crisis related cases. There are still many more cases to be heard, and, as this case shows, there is always the possibility that further proceedings may alter or even undo prior results.

David Bario’s February 10, 2011 Am Law Litigation Daily article about the Blackstone decision can be found here. Peter Lattman's post on the Dealbook blog about the decision can be found here.

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There was a time when it was relatively rare for the Supreme Court to take up securities cases. Until recently, the Court basically went several years between cases filed under the securities laws. Those days are clearly over, as the Court has granted cert petitions in several securities cases in recent years, including the Merck and National Australia Bank cases this term.

The Court has now granted cert in a securities suit for next term as well. On June 14, 2010, the Supreme Court granted the petition for a writ of certiorari in the Matrixx Initiative case.

The question presented is whether plaintiffs must allege that adverse event information is "statistically significant" in order to establish that the defendants’ alleged failure to disclose the information was material. Though the issues involved appear narrow, the case potentially could address broader issues of securities claim pleading sufficiency.

Background

Matrixx Initiatives manufactured an internasal cold remedy called Zicam. In April 2004, plaintiff shareholders filed a securities class action lawsuit against Matrixx and three of its directors and officers, alleging that the defendants were aware that numerous Zicam users experienced loss of the sense of smell. The complaint alleges that the defendants were aware of these problems because of calls to the company’s customer service line; because of academic research, which was communicated to the company; and because of product liability lawsuits that had been filed against the company.

The district court granted the defendants’ motion to dismiss, finding that the complaint failed to adequately allege that the alleged omissions were material, because the complaint did not allege that the number of customer complaints was "statistically significant."

As discussed at greater length here, on October 28, 2009, the Ninth Circuit reversed the district court, holding that the district court "erred in relying on the statistical significance standard" in concluding that the complaint did not meet the materiality requirement. The Ninth Circuit said that a court "cannot determine as a matter of law whether such links [between Zicam and loss of smell] was statistically significant, because statistical significance is a matter of fact."

The Ninth Circuit said (citing Twombly and its progeny) that the appropriate test is whether the claim is "plausible on its face." The Ninth Circuit found that the complaint’s allegations of materiality were sufficient to "nudge" the plaintiffs’ claims from "conceivable to plausible."

On June 14, 2010, the U.S. Supreme Court granted the defendants’ petition for writ of certiorari, on the question whether the plaintiff can state a securities claim "based on a pharmaceutical company’s nondisclosure of adverse event reports even though the reports are not alleged to be statistically significant."

Discussion

When the U.S. Supreme Court grants cert, there is always the question "why"? On the theory that the Court wouldn’t take the case if it thought the Ninth Circuit got it right, one view might be that the Court took the case simply to overturn the Ninth Circuit. However, as we say in connection with the Supreme Court’s consideration of the Merck case (about which refer here), this assumption is not always borne out by the Court’s actions.

Perhaps the more neutral explanation is that as a result of the Ninth Circuit’s opinion, there is now a split in the circuits on the issue of the need to plead "statistical significance." Several other circuits (on which the district court relied in dismissing the Matrixx case) have held that plaintiff alleged that adverse events were "statistically significant," which the Ninth Circuit rejected that view and instead adapted a view that statistical significance cannot be resolved at the pleading stage and instead the court must consider facial plausibility.

Even if resolution of this narrow issue is all the Supreme Court accomplishes by taking up the Matrixx case, its review will still be significant. As the Morrison & Foerster law firm pointed out in its memo discussing the Supreme Court’s cert petition grant, companies regularly receive many customer complaints. These companies need to know when they have sufficient information about a product’s potential adverse effects that it must disclose that information.

Companies and defense attorneys would like a bright-line answer to this question, whereas, the MoFo memo suggests, plaintiffs "will push for an amorphous case-by-case determination."

There is a possibility that the Supreme Court’s consideration of this case could involve more than just this narrow issue, as important as it might be. Among other things, the 10b-5 Daily suggests that the Court could extend itself to a broader review of the issues of pleading materiality generally. Given what the Ninth Circuit said about what determinations are appropriate at the pleading stage, and what must be left to the trier of fact, this possibility seems substantial.

I also think it is critical to the Ninth Circuit’s rejection of the use of the "statistically significant" standard that its analysis was made in reliance on what it saw as required by the Twombly line of cases. Given the Ninth Circuit’s conclusion that its holding was required by Twombly, it seems unlikely that the Supreme Court could address the Ninth Circuit’s analysis without discussing what is required by Twombly and the larger issues of pleading sufficiency at the motion to dismiss stage.

There is the further possibility that the Supreme Court could range further and address other aspects of the Ninth Circuit’s decision, including even perhaps the Ninth Circuit’s conclusion that the plaintiff had adequately alleged scienter.

The Ninth Circuit’s conclusion that the scienter allegations were sufficient was based on plaintiffs allegations that the "high level executives …would know the company was being sued in a product liability action," and also based on the fact that the various academic research results and customer complaints were communicated to the company’s director of research – though there were no allegations that the other two individual defendants were aware of this information.

The Ninth Circuit put a great deal of emphasis on what the defendants’ "would have known" as higher level executives, without necessarily considering whether the plaintiffs had alleged that the defendants did know the supposedly omitted information.

This aspect of the case raises the question whether scienter may be sufficiently alleged based on an individual officers’ officer or position, even without supporting allegations about whether the defendants knew or what information they were provided access to.

Of course, there is no way of knowing whether the Supreme Court will reach these issues, or whether it will narrowly address the immediate questions presented. That is always one of the great uncertainties (and interesting possibilities) when the Court grants cert, you never know where the case might go. The broader possibilities here, while present, may also be conjectural best.

In any event, the next Supreme Court term will involve yet another consideration at the highest judicial level of questions involving securities lawsuit pleading questions. Perhaps this will be one of the first cases to be considered by Justice Kagan (assuming for the sake of argument that she does indeed join Justice Sotomayor and the other seven justices on the Supreme Court bench next term.

Readers may be interested to know that on June 16, 2009, the FDA warned consumers (here) to stop using three Zicam intranasal products because the products may cause a loss of smell. As reflected here, a second securities class action lawsuit was filed after the company’s share price plunged following this announcement.

Why Do They Call Them Wells Notices?:  If like me you have always wondered why a Wells Notice is called a Wells Notice, you will want to take a look at the recent post from the Compliance Building blog. Turns out there was, as we all suspected, someone named Wells – in fact, John W. Wells, an attorney who, in 1972 was appointed to chair a committee that made a number of recommendations, including the process now referred to as a Wells notice. Now we know.

My personal thanks to Doug Cornelius, the blog’s author, for answering a question I have always kind of wondered about.

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