In a February 10, 2011 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.
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."
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.