A while back, I posted about a new split between the Second and Ninth Circuits regarding the ability of plaintiffs to bring a Section 10(b) action based on a failure to disclose required information, even in the absence of allegations that the omitted information rendered the remaining statements misleading. The Second Circuit is for; the Ninth is against.
At the time, the split was not well-developed; the Second Circuit allowed for the possibility of such claims, but also held that the case before it failed to allege scienter. And the last time the Second Circuit had allowed similar claims to go forward was in In re Scholastic Corp. Sec. Litig., 252 F.3d 63 (2d Cir. 2001).
So it wasn’t clear whether the split would have much practical effect.
Well, the Second Circuit now found a case where scienter was properly alleged – and it reversed a district court’s dismissal of the complaint. The opinion is a veritable goldmine of interesting nuggets.
[More under the jump]
In Indiana Public Retirement System v. SAIC, handed down on March 29, the plaintiffs allege that SAIC kept its profits up by falsely billing the City of New York on a contract. Eventually, the city caught wise and began a criminal investigation into SAIC’s conduct. SAIC was aware of both the investigation and the scheme that had inspired it. Yet when it issued its 2010 10-K, it failed to make any disclosures in the MD&A.
Shortly thereafter, SAIC publicly announced that it would likely have to repay the City over $600 million, and that it was entering into a deferred prosecution agreement. A class of investors filed a securities fraud complaint, and by the time the case came before the Second Circuit, the central issue was whether SAIC had violated Section 10(b) by failing to disclose the investigation in its 10-K.
The Second Circuit agreed with the plaintiffs that the false billing scheme and the resulting fallout constituted a “trend, event, or uncertainty [that] might reasonably be expected to materially impact SAIC’s future revenues” under Item 303, and that the omission could form the basis of a Section 10(b) claim. It also agreed that omission was so obvious that scienter could be inferred, and remanded the case to the district court.
The holding is significant because it solidifies the split with the Ninth, and demonstrates that the disagreement between the circuits has bite. I’d even say it was certiorari bait, but the plaintiffs’ alternative claim – also interesting, and also upheld – makes it less of a clean grant. And not for nothing, but if I were a defense attorney taking the long view, this is not exactly the fact pattern I’d want to bring to the Court. (I further note for the record that way back in the Pleistocene era (i.e., pre-PSLRA), the First Circuit also permitted an Item 303 omission claim to proceed under Section 10(b). See Shaw v. Digital Equip. Corp., 82 F.3d 1194 (1st Cir. 1996).)
Anyhoo, the plaintiffs’ alternative argument – which the Second Circuit accepted – was that under the relevant accounting rules, SAIC was required to disclose a loss contingency due to its potential liability to the City; its failure to do so rendered its financial statements out of compliance with GAAP and thus misleading.
The reason I find this fascinating is that there is a long history of plaintiffs claiming that financial statements are misleading for failure to disclose the illegal conduct that generated the revenues. Most of the time, courts have resisted this argument so long as the actual reported numbers are truthful, see, e.g., In re Advanta Corp. Securities Litigation, 180 F.3d 525 (3d Cir.1999); FindWhat Investor Group v. FindWhat.com, 658 F.3d 1282 (11th Cir. 2011); Boca Raton Firefighters’ & Police Pension Fund v. DeVry Inc., 2012 U.S. Dist. LEXIS 41305 (N.D. Ill. Mar. 27, 2012); In re Merck & Co., 2012 U.S. Dist. LEXIS 123800 (D.N.J. Aug. 29, 2012); In re Marsh & McLennan Co. Sec. Litig., 2006 U.S. Dist. LEXIS 49525 (S.D.N.Y. July 19, 2006), and I think that’s more due to policy reasons than anything else. I.e., as I’ve discussed before, the requirement that plaintiffs identify a false statement is the thin fig leaf that courts use to distinguish claims based on poor governance from claims for fraud; for that reason, courts have implicitly recognized that if they hold that financial statements are false whenever there is undisclosed misconduct, they will have obliterated the distinction between fraud and mismanagement. At the same time, however, courts have allowed claims to proceed if the defendant falsely attributes its financial success to factors other than the misconduct. See, e.g., In re Syncor Int’l Corp. Sec. Litig., 239 Fed. Appx. 318 (9th Cir. 2007); In re ATI Techs., Inc., Sec. Litig., 216 F. Supp. 2d 418 (E.D. Pa. 2002). It’s a fine line to draw, and ultimately perhaps a meaningless one, but in general (and with some exceptions, see In re Providian Fin. Corp. Secs. Litig., 152 F. Supp. 2d 814 (E.D. Pa. 2001)), courts have refused to hold that the numbers themselves carry any implication of the quality of the conduct that generated them. But not now, apparently – because the Second Circuit agrees that financial figures are misleading when the issuer fails to disclose potential legal liability.
Now, I don’t want to overstate the significance here. First of all, this case involved straight up false billing – and it’s hard to find a distinction between false billing and simply making up numbers, which would certainly be actionable as a financial misstatement. But see Steiner v. MedQuist, Inc., 2006 WL 2827740 (D.N.J. Sept. 29, 2006) (financial statements not rendered false by fraudulent billing scheme). Second, the Second Circuit highlighted the fact that in this case, the criminal investigation was well underway, and made it clear that it would be harder – though not impossible – for plaintiffs to make similar allegations if the undisclosed misconduct was not yet the subject of a government probe. Still, this holding – like the Item 303 holding – represent further cracks in the wall built by Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977) to separate fraud from mismanagement.
Which brings me to the final holding. The plaintiffs claimed that SAIC lied to the public by touting its high ethical standards. The Second Circuit rejected these claims on the ground that they constituted inactionable puffery. Notably, however, the Second Circuit threw the plaintiffs’ bar a bone: it allowed that similar statements might be actionable in a future case if the company emphasized its ethical reputation as “central to its financial condition” or to “distinguish the company from other specified companies in the same industry.” Here, I can’t help but feel that the panel was writing with an awareness of the pending appeal of the class cert grant in In re Goldman Sachs Group, Inc. Securities Litigation, which also involves statements that the defendants claim are mere puffery. Is the Second Circuit offering those plaintiffs a hint as to how to frame their arguments? Time will tell.
That said, the most ironic aspect of the SAIC opinion comes not in the legal reasoning, but in the statement of facts. Highlighting SAIC’s perfidy, the Second Circuit wrote:
Notwithstanding the audit team’s findings [of misconduct], SAIC’s Form 10-K … did not disclose SAIC’s potential liability …. To the contrary, in a separate Annual Report to shareholders that same month, SAIC touted its commitment to high standards of “ethical performance and integrity.”
So apparently, in the Second Circuit’s view, SAIC’s claims of “integrity” were striking enough to be worth contrasting with its nondisclosure of the criminal investigation, but not so striking that a reasonable investor might “take such statements seriously.” Hmm.