The plaintiffs alleged that when a real estate investment trust (REIT) disclosed that a financially troubled key tenant was making “partial monthly rent payments” — but omitted to mention that the tenant’s rent payments had been funded by an undisclosed loan from the REIT, not from the tenant’s own revenues — the REIT committed securities fraud. The district court dismissed the plaintiffs’ complaint, concluding that the plaintiffs had failed to plead a strong inference that the REIT had acted with the requisite scienter. However, in an interesting August 3, 2020 opinion (here), the Second Circuit reversed the district court, concluding that the plaintiffs’ allegations were sufficient to satisfy the scienter pleading requirements. The opinion includes an interesting analysis of the scienter pleading requirements in an omission case alleging recklessness.
Omega Healthcare Investors is a real estate investment trust that invests in healthcare facilities. Omega either owns the properties or leases them to the facility operators. In late 2016 and early 2017, Omega’s second-largest facilities operator, Orianna, was experiencing financial difficulties. In response to Orianna’s financial difficulties, Omega provided Orianna a $15 million working capital loan.
Orianna’s financial difficulties were sufficiently important to Omega that they were discussed in Omega’s quarterly conference call with analysts and also in Omega’s quarterly filings with the SEC. Among other things, Omega disclosed that Omega was delinquent on its rent payments. However, in its SEC filing, Omega stated that Orianna “is currently making partial rent payments.”
In their securities class action lawsuit, the plaintiffs alleged that the statements about Orianna’s rent payments were false and misleading because those statements implied that Omega had been making rent payments from its own operating income, when at least part of those rent payments were funded by the undisclosed loan Omega had extended to Orianna several months earlier. The plaintiffs alleged that Omega’s repeated failure to disclose the existence of the loan was part of a scheme to avoid disclosing to the market the gravity of Orianna’s financial woes and the likely impact on Omega’s financial results. The defendants moved to dismiss the plaintiffs’ complaint.
In a March25, 2019 opinion (here), Southern District of New York Judge Naomi Reice Buchwald granted the defendants’ motion to dismiss. Judge Buchwald held that although the non-disclosure of the loan amounted to a material omission, the plaintiffs had failed to plead a strong inference that Omega acted with the requisite scienter. The plaintiffs appealed.
The August 3, 2020 Opinion
In an August 3, 2020 opinion written by Judge Richard Wesley for unanimous three-judge panel, the Second Circuit reversed the district court’s dismissal ruling and remanded the case to the district court for further proceedings.
In reaching its decision, the appellate court first agreed with the plaintiffs that Omega was “duty-bound” to disclose the loan, and that the failure to do so rendered Omega’s various statements about Orianna’s financial condition “actionably misleading.” Specifically, Omega’s statements regarding Orianna’s rent payments “gave a false impression of the financial health of one of Omega’s largest assets” by suggesting that “Orianna could pay more than half of its rent from its earnings.” The omission “concealed the extent of Orianna’s solvency problems: Orianna could not pay rent without borrowing from its landlord.”
The appellate court then considered the plaintiffs’ scienter allegations. The plaintiffs attempted to meet the scienter allegations by proceeding on a “conscious recklessness” theory – that is, the appellate court said, a state of mind “approaching actual intent, and not merely a heightened of negligence.” To meet this standard, the appellate court said, the plaintiffs allegations must support the conclusion that Omega’s non-disclosure of the loan was “at least highly unreasonable and represented an extreme departure from the standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware.”
The appellate court conclude that the plaintiffs’ allegations were sufficient to establish that the defendants’ non-disclosure of the loan was a sufficiently extreme departure from the standards of ordinary care. Orianna’s performance “plainly impacted Omega’s overall health,” and Omega “had to know that revealing the full extent of Orianna’s performance problems would have been troubling news to investors.”
Omega’s reference to “partial monthly payments,” suggesting that Orianna was “on the road to recovery,” create “a compelling inference that Defendants made a conscious decision not to disclose the Loan in order to understate the extent of Orianna’s financial difficulties.” The inference that the Defendants sought to use Orianna’s “partial monthly payments” to “express optimism and underrepresent the extent of those very problems” is “at least as compelling as any opposing inference that one could draw from the facts alleged.”
The PSLRA’s heightened pleading standards requiring plaintiffs alleging violations of Section 10(b) of the ’34 Act and Rule 10b-5 thereunder are difficult to satisfy. Many 10b-5 actions are dismissed based on the plaintiffs’ failure to meet the heightened pleading standard, as was the case. The Second Circuit’s ruling here represents a rare instance where an appellate court has reversed a district court’s dismissal for failure to meet the heightened pleading standard.
What makes the appellate court’s reversal interesting and perhaps even important is the clarity of its analysis of how the scienter requirements are to be considered in an omission case. The appellate court concluded that the plaintiffs’ allegations were sufficient to create a “compelling inference” that the Defendants made a “conscious decision” not to disclose the Loan in order to “understate the extent of Orianna’s finance difficulties, allegations, the appellate court said, constituted “conscious misbehavior” or at least “highly unreasonable conduct that represents an extreme departure from the standards of ordinary care.” The mere recitation of the standards the plaintiffs were found to have met underscore just how demanding the scienter pleading standards are.
There is one rather unusual aspect to this case. Usually, the focus of a securities fraud complaint is the defendants’ alleged misrepresentations or omissions regarding the defendant company’s financial condition. The case presents the rather unusual circumstances where the misrepresentations and omissions pertain not directly to the defendant company itself, but rather to the financial condition of a third-party company. To be sure, the plaintiffs’ theory of the case is that the defendants misrepresented Orianna’s financial condition in order to mask how Orianna’s deterioration would affect Omega’s financial performance, but nevertheless the focus is on Omega’s misrepresentations and omissions about Orianna’s financial condition, rather than Omega’s statements about its own condition.
I will say that in reading this opinion, I was struck once again by the legal concept that has evolved (at least in certain of the federal Circuit Courts) of “conscious recklessness.” I have always that this is odd phrase, almost a contradiction in terms. I find it exactly to know where to put it on the state of mind spectrum running between negligence and intent. The “conscious” part of the phrase makes me wonder how it differs from intent. I suppose this is one of those philosophical topics suited best from a seminar room. Someday I would like to have serious conversation with several securities law practitioners, not only to see if they think they know what it means, but also to see if whether there is actually any shared understanding between them about what the phrase means.