The 10b-5 Daily

The U.S. Supreme Court has issued a decision in Macquarie Infrastructure Corp. v. Moab Partners, L.P. holding that the failure to disclose information required by Item 303 of Regulation S-K can support a Rule 10b-5(b) claim only if the omission renders affirmative statements misleading.  It is a unanimous decision authored by Justice Sotomayor.

Item 303 of Regulation S-K requires companies to describe “known trends or uncertainties” that may have a material impact on the company’s operations.  There has been a circuit split over whether a company’s failure to meet its Item 303 disclosure requirement can support a private claim under Section 10(b) and Rule 10b-5(b) in the absence of an otherwise-misleading statement.  The Second Circuit has held that a private claim can be brought based on this omission, while other circuits – notably the Ninth Circuit and Third Circuit – have disagreed.

In Macquarie, the Court had little trouble concluding that the Second Circuit had gone too far in expanding the scope of potential securities fraud liability.  The Court clarified that “Rule 10b-5(b) does not proscribe pure omissions.”  Instead, it prohibits only affirmative misstatements and the omission of materials facts necessary to ensure that statements are not misleading (i.e., “half-truths”).  The failure to provide required information under Item 303 is not a half-truth, but instead is a pure omission of information.  Had Congress or the SEC wanted to make pure omissions a basis for liability under Section 10(b) or Rule 10b-5, the Court noted, they knew how to do so because that type of liability exists under Section 11 of the Securities Act for misstatements in registration statements.

Holding: Judgment vacated and case remanded for further proceedings consistent with opinion.

Quote of note:  “[T]he difference between an omission and a half-truth is the difference between a child not telling his parents he ate a whole cake and telling them he had dessert.  Rule 10b-5(b) does not proscribe pure omissions. . . . Put differently, it requires disclosure of information necessary to ensure that that statements already made are clear and complete (i.e., that the dessert was, in fact, a whole cake.)”

Disclosure:  The author of The 10b-5 Daily participated in an amicus brief in support of Macquarie filed by the Washington Legal Foundation.

To what extent can plaintiffs commission an expert report based on public information and rely on it in their complaint to adequately plead securities fraud?  The Ninth Circuit recently addressed this issue in E. Ohman J:or Fonder AB v. NVIDIA Corp., 2023 WL 5496507 (9th Cir. Aug. 25, 2023).  A majority of the panel (Judge Fletcher and Judge Wallace) found that the expert report was credible and could be relied upon, even though it did not reference any internal corporate data or witness statements.

In NVIDIA, the plaintiffs alleged that NVIDIA failed to disclose the impact of crypto-related sales of its gaming products on the company’s financial performance so as to conceal the extent to which its revenue growth depended on the volatile demand for cryptocurrency.  Accordingly, the key question in the case was whether and when NVIDIA became aware that crypto-related sales were a significant driver of its revenues.

To answer that question, the plaintiffs primarily relied upon two analyses conducted by outside entities after NVIDIA missed revenue projections in November 2018 (the end of the putative class period).  First, RBC Capital Markets published an investigative report concluding that NVIDIA had significantly understated the amount of its crypto-related sales.  Second, the plaintiffs hired an economic consulting firm, the Prysm Group, that issued a report coming to the same conclusion.

On appeal from the dismissal of the complaint, the Ninth Circuit concluded that based on the RBC and Prysm reports, statements from confidential witnesses discussing bulk purchases of the company’s gaming products for cryptocurrency mining, and the fact that NVIDIA’s earnings collapsed when cryptocurrency prices collapsed, “there is a sufficient likelihood that a very substantial part of NVIDIA’s revenues during the Class Period came from sales . . . for cryptocurrency mining.”  Moreover, the court found, the plaintiffs had adequately plead a strong inference of scienter (i.e., fraudulent intent) as to NVIDIA’s CEO based on confidential witness statements alleging that the CEO received detailed sales reports, closely monitored them, and these reports would have shown the portion of sales used for cryptocurrency mining.

The majority opinion was the subject of a strong dissent from Judge Sanchez (and there is a significant amount of back-and-forth between the judges in their opinions).  The dissent argued that the majority “essentially concluded that Plaintiffs have adequately alleged falsity merely by showing that Defendants’ statements concerning cryptocurrency-related revenues diverged from Prysm’s post hoc revenue estimates.”  The problem with that approach, according to Judge Sanchez, is that the Ninth Circuit has “never before allowed an outside expert to serve as the primary source of falsity allegations under the PSLRA where the expert relies almost exclusively on generic market research and without any personal knowledge of the facts on which their opinion is based.”  As to the scienter of NVIDIA’s CEO, the dissent carefully went through the confidential witness statements and concluded that none of them demonstrated that the CEO reviewed internal information that conflicted with the company’s public statements.

Holding:  Affirmed in part, reversed in part, and remanded.

Quote of note (majority opinion): “Prysm and RBC performed rigorous market analyses to reach their independent but nearly identical conclusions.  Contrary to our colleague’s contention, the PSLRA nowhere requires experts to rely on internal data and witness statements to prove falsity.  It merely requires that ‘the complaint state [] with particularity all facts on which [the] belief [underlying an allegation of falsity] is formed.’  Prysm did exactly that.  To categorically hold that, to be credible, an expert opinion must rely on internal data and witness statements would place an onerous and undue pre-discovery burden on plaintiffs in securities fraud cases.”

It would appear that the third time’s the charm, at least for Goldman Sachs in its long-running securities class action related to certain collateralized debt obligation (CDO) transactions.  For the past several years, the key issue in the case has been whether Goldman’s alleged misrepresentations about its business principles and potential conflicts of interest had any stock price impact, and therefore could support the presumption of reliance necessary to certify a class.  The question has been the subject of two Second Circuit appeals and a Supreme Court decision.  Late last week, as part of the third appeal to the Second Circuit, that court finally decided to deny the certification of the class.

As way of background, to certify a class on behalf of all investors who purchased shares during a class period, plaintiffs usually invoke a presumption of reliance created by the Supreme Court in the Basic case.  Under the Basic presumption, plaintiffs can establish class-wide reliance by showing (1) that the alleged misrepresentations were publicly known, (2) that they were material, (3) that the stock traded in an efficient market, and (4) that the plaintiff traded the stock between the time that the misrepresentations were made and when the truth was revealed.  These requirements are based on the efficient market hypothesis, which, as relevant here, posits that in an efficient market any material statements will impact a stock’s price.  If all four elements are met, any investor trading in such a market can be presumed to have relied upon the stock’s price and all material statements (or misstatements) about the stock.  Accordingly, the Court has held that the Basic requirements are merely an “indirect proxy for price impact,” which is the true underpinning of the presumption of reliance.

Without the Basic presumption, individualized issues of reliance would normally prevent any attempt to certify a class in a securities fraud class action.  Defendants have the ability to rebut the Basic presumption, and defeat class certification, by demonstrating that the alleged misrepresentations did not have a price impact.

Picking up the story at the Supreme Court, in Goldman the Court considered whether defendants can, at least in part, demonstrate a lack of price impact by pointing to the generic nature of the alleged misrepresentations.  The Court held that “a court cannot conclude that Rule 23’s requirements are satisfied without considering all evidence relevant to price impact.”  That is the true even if the evidence – like the generic nature of the alleged misrepresentations – “is also relevant to a merits question like materiality.”  Moreover, the Court noted that an inference of price impact “break[s] down” when “there is a mismatch between the contents of the misrepresentation and the corrective disclosure,” especially where “the earlier misrepresentation is generic . . . and the later corrective disclosure is specific.”  This inquiry into the nature of the alleged misrepresentations especially is relevant in cases like Goldman where plaintiffs, invoking the “inflation maintenance theory,” argue that the misrepresentations did not increase the company’s stock price, but instead merely prevented it from falling.  The Court concluded that it had some “doubt” as to whether the Second Circuit had “properly considered the generic nature of Goldman’s alleged misrepresentations” and remanded with instructions for the lower court to “take into account all record evidence relevant to price impact.”

Back at the district court level, the court once again found that Goldman had failed to demonstrate that the alleged misrepresentations did not have a stock price impact.  In particular, the district court concluded that the Supreme Court’s “mismatch” test was satisfied because the alleged corrective disclosures at issue “implicated” the same subject matter as the misrepresentations.  Goldman again appealed the district court’s decision to certify the class.

In Arkansas Teacher Retirement System v. Goldman Sachs Group, 2023 WL 5112157 (2nd Cir. August 10, 2023), the Second Circuit considered whether the district court had adequately applied the Supreme Court’s analytical framework in assessing the evidence of price impact.  In a long, and at times convoluted, opinion, the court concluded that Goldman had sufficiently severed the link between the alleged misrepresentations and any price impact.  In particular, the court found that the district court’s opinion misapplied the Supreme Court’s framework to the plaintiffs’ inflation-maintenance theory.  Having “acknowledged a considerable gap in specificity between the corrective disclosures and alleged misrepresentations,” the district court “should have asked what would have happened if the company has spoken truthfully at an equally generic level.”  Instead, the district court determined that the alleged misrepresentations had not been consciously relied upon by investors when they were made, but found that they would have been relied upon had Goldman disclosed the details and severity of its misconduct.  The Second Circuit concluded that the district court had “concoct[ed] a highly specific truthful substitute” for the alleged misrepresentations that “look[ed] nothing like the original,” thereby violating the Supreme Court’s guidance that an inference of price impact “breaks down” where the misrepresentations are more generic than the corrective disclosures.

Going forward, the Second Circuit noted that “a searching price impact analysis must be conducted where (1) there is a considerable gap in front-end-back-end genericness . . ., (2) the corrective disclosure does not directly refer . . . to the alleged misstatement, and (3) the plaintiff claims . . . that a company’s generic risk-disclosure was misleading by omission.”  The key question is “whether a truthful – but equally generic – substitute for the alleged misrepresentation would have impacted the price.”  As to the Goldman case, the Second Circuit concluded that the expert evidence put forward by the parties did not support that conclusion.

Holding: Case remanded with instructions to decertify the class.

Quote of note: “In cases based on the theory plaintiffs press here, a plaintiff cannot (a) identify a specific back-end, price-dropping event, (b) find a front-end disclosure bearing on the same subject, and then (c) assert securities fraud, unless the front-end disclosure is sufficiently detailed in the first place.  The central focus, in other words, is ensuring that the front-end disclosure and back-end event stand on equal footing; a mismatch in specificity between the two undercuts a plaintiffs’ theory that investors would have expected more from the front-end disclosure.”

Disclosure:  The author of The 10b-5 Daily participated in an amicus brief in support of Goldman filed by the Washington Legal Foundation.

When the U.S. Supreme Court issues a securities litigation opinion, it rarely is having the last word on the subject.  Lower courts still have to interpret and apply the Court’s holding.  Last month, a decision from the U.S. Court of Appeals for the Third Circuit – City of Warren Police and Fire Retirement System v. Prudential Financial, Inc., 2023 WL 3961128 (3rd Cir. June 13, 2023) –  addressed two questions about how to apply Court precedent in this area.

Opinion Falsity – In its Omnicare decision, the Supreme Court considered when an opinion statement may be false or misleading under Section 11 of the Securities Act (liability for misstatements in registration statements).  The Court found that if the speaker actually did not hold the stated belief, or the opinion omitted material facts about the stated inquiry into, or knowledge concerning, the opinion, it can be actionable as a false statement.  But does this analytical framework also apply to securities fraud claims under Section 10(b) and Rule 10b-5?

The Third Circuit held that it does.  In particular, the Prudential decision noted that Section 11 and Rule 10b-5 “use almost identical language in prohibiting misrepresentations and omissions” and “share the same standard for materiality for misleading statements.”  Under these circumstances, the Third Circuit joined every other federal circuit court to consider the issue (1st, 2d, 4th, 9th, 10th, and 11th) and found that the “more developed” Omincare standard applies to both Section 11 and Rule 10b-5 claims based on opinion statements.

Maker of False Statement – In its Janus decision, the Supreme Court held that for a person or entity to have “made” a false statement that can lead to Rule 10b-5 liability, that person or entity must have “ultimate authority over the statement, including its content and whether and how to communicate it.”  The attribution of a statement “is strong evidence that a statement was made by – and only by – the party to whom it is attributed.”  But how does this analytical framework apply to a paraphrased statement from a corporate officer contained in an analyst report?

The Third Circuit held, contrary to the district court’s decision, that the corporate officer could still be deemed a “maker” of the statement.  Even though the statement was indirect (paraphrased) and contained in a non-corporate document (analyst report), the court found that “because the report attributed the statement to the [corporate officer] and the context of the statement indicates that he exercised control over its content and the decision to communicate it to the [analyst], the statement cannot, at least at the pleading stage, be considered to have been ‘made’ by [the analyst] for purposes of Rule 10b-5.”  In other words, the corporate officer had “ultimate authority” to speak about the topic on behalf of the company, so he was still the “maker” of the statement even though it was republished by the analyst.

Holding: Dismissal affirmed in part and vacated in part.