In the following guest post, Nessim Mezrahi takes a look at the Second Circuit’s November 25, 2020 Summary Order in Lea v. TAL Education Group, in which the appellate court reversed the trial court’s dismissal of a securities class action complaint. Many of the plaintiff’s allegations in the complaint were based on matters first raised in a short seller report, a consideration about which Mezrahi has concerns, as discussed below. Mezrahi is co-founder and CEO of SAR, a securities class action data analytics and software company. I would like to thank Nessim for allowing me to publish his article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Nessim’s article.
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On September 25, 2019, District Judge Honorable Loretta A. Preska of the Southern District of New York dismissed the securities class action against the U.S.-listed Chinese company TAL Education Group because “there is no material misrepresentation here so there can be no scienter.”[1] On, November 25, 2020, the 2nd Circuit Court of Appeals reversed the district court’s ruling and remanded the case back for further proceedings.[2] According to the amended class action complaint, the alleged fraud hinges on a single alleged corrective disclosure from a third party disseminator – Muddy Waters Research – a well-established short-seller: “On June 13, 2018, during trading hours, analyst firm Muddy Waters published a report on TAL, which is attached as Exhibit 2 to this Complaint and incorporated herein by reference… On this news, the Company’s share price fell $4.54 per share, or approximately 9.95%, to close at $41.11 per share on June 13, 2018, on unusually heavy trading volume, damaging investors.”[3] According to the 2nd Circuit Appellate Court’s Summary Order, “the stock value loss following the disclosure of such information in the Muddy Waters report is sufficient at this stage to plead loss causation as to each of the claims.”[4]
The decision by the 2nd Circuit Appellate Court emphasizes Plaintiffs’ argument that “much of the information in the [short-seller] report, including numerous interviews of former employees of TAL, Changing Edu, and Shunshun, was not public information, and much of the information, including SAIC filings of multiple entities in a different language and Chinese court judgements, was not readily accessible to investors.”[5] The Court’s description of the allegedly corrective information is at odds with what Muddy Waters Research disclosed in the June 13, 2018 report, which states that the published information is “based on generally available information, field research, inferences and deductions through the applicable Muddy Waters Entity’s due diligence and analytical process… [and] all information contained herein is accurate and reliable, and has been obtained from public sources.”[6]
Basically, the Court ruled that investors may rely on a short-seller report to initiate and substantiate alleged violations of the Exchange Act and Rule 10b-5 if they can prove that the allegedly related information was not previously disclosed and accessible to all investors, even if the short-seller discloses that such information was attained via “generally available information”.
The Second Circuit’s ruling contrasts the Ninth Circuit decision In Re BofI Holding, which rejected to accept short-seller blog postings as alleged corrective disclosures, primarily because the related information was publicly available. Honorable Kenneth K. Lee agreed with the appellate majority primarily because the information disseminated via the short-seller blog posts of Seeking Alpha only contained public information. Furthermore, Hon. Lee stated, “that we should not credit anonymous posts on a website notorious for self-interested short-sellers trafficking in rumors for their own pecuniary gain.”[7]
The ruling in the Second Circuit raises a vexing legal question: can information that is published as “generally available”, but is considered to be non-public and inaccessible to all investors by the Court, and is disseminated by activist short-sellers, be used as valid evidence to constitute an alleged corrective disclosure to plead loss causation? According to the ruling, the answer is yes.
This legal development is troubling for directors and officers of U.S. listed corporations and their insurers, because it keeps the door open for Plaintiffs to file costly securities class actions based on biased research from self-interested, non-independent parties. The analysis of the 2nd Circuit Appellate Court prioritized the accessibility and availability of potentially material and corrective information disseminated by profit-taking short-sellers, over the independent validity of such information.
The June 13, 2018 Muddy Waters Research Report specifically states: “You should assume that, as of the publication date of a Muddy Waters report, Muddy Waters Related Persons (possibly along with or through its members, partners, affiliates, employees, and/or consultants), Muddy Waters Related Persons clients and/or investors and/or their clients and/or investors have a short position in one or more of the securities of a Covered Issuer (and/or options, swaps, and other derivatives related to one or more of these securities), and therefore stand to realize significant gains in the event that the prices of either equity or debt securities of a Covered Issuer decline or appreciate.”[8] Harry Markopolos, the fraud investigator that uncovered Madoff’s shenanigans, failed in claiming that the General Electric Company manifested a decades long fraud after disclosing that he stood to gain on the decline of certain GE securities based on the publication of his own research.[9]
A short-seller’s singular incentive is to attain above market returns by issuing biased research that triggers a decline in stock price of the covered company. By allowing plaintiff lawyers to introduce biased information as evidence to substantiate allegations of corporate fraud, the Court is enabling a systemic conflict of interest between securities class action plaintiff attorneys and well-known activist short-sellers. Afterall, both benefit from the same material declines in stock price.
According to Joshua Mitts, an associate professor at Columbia Law School: “The intersection of these two trends has led to cases like BofI, in which short sellers and plaintiffs’ firms enjoy a kind of de facto symbiosis. A share price crash accompanied by an allegation of fraud is mutually profitable for both: the former, because they have a short position in the stock; and the latter, because they can bring a class action claiming that the report revealed the truth to the market.”[10]
The Second Circuit ruling in Lea v. TAL Education Group disincentivizes plaintiff securities class action lawyers from performing their own independent investigatory work of corporate malfeasance. Instead, the ruling encourages unwarranted reliance on biased research published by short-sellers that stand to monetize handsomely from a sell-off. It is economical for securities class action attorneys to informally outsource their investigatory work to short-sellers and focus their efforts on proving that, at least, some of the published information was not “readily accessible to investors” to corroborate an alleged corrective disclosure and fulfill the loss causation pleading requirements of an Exchange Act claim. Unchecked reliance on activist short-seller reports affects the just pursuit of justice in securities class action litigation by allowing plaintiff lawyers to piggyback on the work of short-sellers that benefit from the decline in shareholder value.
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Nessim Mezrahi is co-founder and CEO of SAR LLC, a securities class action data analytics software company.
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[1] Opinion and Order, In re Lea v. TAL Education Group et al, Case No. 1:18-cv-05480
[2] Summary Order, In re Lea v. TAL Education Group et al, Case No. 19-3549
[3] Amended Class Action Complaint, In re Lea v. TAL Education Group et al, Case No. 1:18-cv-05480
[4] Summary Order, In re Lea v. TAL Education Group et al, Case No. 19-3549
[5] Id.
[6] “TAL Education: A real Business with Fake Financials,” Muddy Waters Research, June 18, 2018.
[7] Opinion, In re BofI Holding, Inc. Securities Litigation, WL 5951150
[8] “TAL Education: A real Business with Fake Financials,” Muddy Waters Research, June 18, 2018.
[10] “Short Sellers and Plaintiffs’ Firms: A Symbiotic Ecosystem,” by Joshua Mitts, October 14, 2020, The CLS Blue Sky Blog. https://clsbluesky.law.columbia.edu/2020/10/14/short-sellers-and-plaintiffs-firms-a-symbiotic-ecosystem/