Today, we wade into recent appellate conflicts on the requirements for asserting private actions under section 11 of the Securities Act of 1933 (“1933 Act”) for allegedly inaccurate disclosures in public offerings. The private action provided in section 11 of the 1933 Act is the most powerful weapon in the arsenal of securities plaintiffs’ litigators. Securities actions under section 10(b) of the Securities Exchange Act of 1934 must satisfy the significant requirement of proving intentional fraudulent conduct, which has been a major obstacle to successful claims and therefore serves as serious constraint on settlement value of a case. Section 11 claims, however, have no such requirement. They can be asserted only for losses incurred in transactions that are part of public offerings pursuant to a Registration Statement which contains disclosures intended to describe the investment to investors. The securities laws provide special investor protections to assure that the disclosures in Registration Statements are accurate, and one of those protections is that the company issuing the securities is liable for material factual inaccuracies in the Registration Statement regardless of whether they were, or even could have been, known to be inaccurate at the time they were made.
Section 11 is the only provision in the federal securities laws that makes a public company a guarantor against losses incurred by investors as a result of inaccurate factual statements. If the Registration Statement is materially inaccurate and the stock price drops as a result, section 11 provides a powerful weapon which often provides considerably higher settlement value than a companion section 10(b) claim, even though the section 10(b) claim covers all investors, not just those who bought in a public offering. That makes the scope of permitted claims under section 11 an extremely important issue in securities class action litigation.
There is a substantial disagreement about the scope of section 11 claims that will be before the Supreme Court next term. Several appellate courts have taken varying positions on the allegations needed to support claims for allegedly false statements in registration statements that involve so-called “soft information” rather than hard ascertainable facts – i.e., statements involving judgments, expectations, evaluations, predictions, and the like, rather than verifiable historic events or performance. The Supreme Court granted a writ of certiorari in one of these cases, Indiana State District Council v. Omnicare, Inc., 719 F.3d 498 (6th Cir. 2013) (“Omnicare II”). That case is now pending in the Supreme Court under the caption Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, No. 13-435.
In Omnicare II, the Sixth Circuit ruled that plaintiffs could state a section 11 claim by identifying statements of opinion or belief in a registration statement that were inaccurate even if they were not believed to be incorrect at the time they were made. Several other appellate courts, including a decision handed down by the Tenth Circuit on August 1, 2014, held or suggested otherwise: that disclosures in a registration statement that are in the nature of judgments, opinions, or predictions that turned out to be incorrect are not actionable under section 11 unless a plaintiff can credibly allege that they were not only incorrect, but also were not believed to be correct at the time they were made. See, e.g., MHC Mutual Conversion Fund, L.P. v. Sandler O’Neill & Partners, L.P., No. 13-1016 (10th Cir. Aug. 1, 2014) (which can be seen here: MHC Mutual Conversion Fund v. Sandler O’Neill); Fait v. Regions Fin. Corp., 655 F.3d 105 (2d Cir. 2011); Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156 (9th Cir. 2009).
The importance of this disagreement may not be obvious, but it is indeed significant. Many required disclosures in a registration statement by their nature involve uncertainties. Although much of what is disclosed – e.g., how many widgets were sold in certain periods; how much money is in the bank at a certain time; how sales, revenues, and profits have changed from period to period – involves backward looking facts that are ascertainable under specified rules for making the calculations, other required disclosures involve judgments or evaluations that do not allow for certainty. For example, Registration Statements require disclosures that involve predicting future events or the impact of future events on company business affairs or assets. Different people can reach different conclusions based on varying views about future company-specific events, or even industry-wide, nationwide, or worldwide events. If companies become guarantors of the accuracy of those uncertain disclosures whenever they make public securities offerings, the costs and risks of capital generation become much greater, and the cumulative economic consequences could be significant.
What Does Section 11 Say?
Let’s start with what the statute says. Section 11(a) provides a private action to persons acquiring securities pursuant to a registration statement “[i]n case any part of the registration statement … contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading.” Under section 11(e), the precise amount of damages is complicated by variations relating to when the security is sold, but in essence the plaintiff can recover the difference between the amount paid and the value received on sale or when the action is commenced, less any portion of that loss that a defendant proves did not result from the misleading statements or omissions.
Only specified people are liable for section 11 claims: the issuer of securities pursuant to the Registration Statement, those signing the Registration Statement, directors of the issuer, accountants or experts who made inaccurate statements included in the Registration Statement, and the underwriters for the offering. Apart from the issuer, other defendants can avoid liability by proving they acted with due diligence and reasonably believed the Registration Statement was accurate. The issuer, however, has no good faith or due diligence defense. It has strict liability for losses caused by inaccurate factual statements.
The key statutory points for purposes of these cases are: (1) a section 11 action must be for untrue statements or misleading omissions of a “material fact”; and (2) the issuer is liable without fault. There is no requirement of intent, knowledge, negligence, or any state of mind or breach of duty of care.
What Is the Circuit Split About?
Section 11 cases often are plainly about inaccurate factual statements. The issuer said its revenues were “x” when they were not. Or the issuer said it owned a gold mine, but it did not. Or the issuer said it had a long-term contractual right to purchase or sell a product, but it did not. Things of that nature. In those cases, the only real issues are whether the inaccuracy was material; if so, how much investors lost as a result; and does the issuer have sufficient assets to pay the losses. What is not at issue is whether the Registration Statement included an inaccurate fact. And, as described above, the issuer has no defense based on whether it knew, or should have known, or could have known, about the inaccuracy.
The types of cases we are discussing here are different. In these cases, the nature of the challenged statement, or the alleged omission, involves not an ascertainable fact, but a judgment or subjective evaluation about future events. In securities parlance, these opinions are called “soft information,” because they do not convey “hard facts,” but rather predictions, judgments, or evaluations about which reasonable people may differ. The requirements regarding disclosure of “soft information” take account of the uncertainty attached to such evaluative disclosures, which a reasonable investor reading these materials is expected to understand. A reasonable investor would not treat these kinds of statements as “facts.”
For example, Omnicare involves the description of contracts and business practices of Omnicare – a provider of pharmaceutical care services to residents of long-term care facilities – with pharmaceutical manufacturers. Plaintiffs challenge the statement in the Registration Statement that the company’s contracts with drug companies were “legally and economically valid arrangements,” alleging that these contracts were in fact part of illegal kickback arrangements and submissions of false Medicare and Medicaid claims. In an earlier ruling in the same case affirming dismissal of section 10(b) claims in an earlier version of the complaint, the Sixth Circuit noted that the materiality of statements about the “legality” of the company’s conduct “derives solely from predictions regarding the actions of third parties, particularly whether fines or other sanctions would be brought based on findings of regulatory violations.” This made “the information ‘soft,’ and no disclosure is required despite the generalized claim of ‘legal compliance.’” See Indiana State Dist. Council of Laborers & Hod Carriers Pension & Welfare Fund v. Omnicare, Inc., 583 F.3d 935, 947 (6th Cir. 2009) (“Omnicare I”).
The Second Circuit Fait case involved a challenge to the accuracy of disclosures of goodwill and loan loss reserves on the financial statements of a bank in a Registration Statement. It is generally accepted that these accounting determinations are highly judgmental, not hard facts.
The Ninth Circuit Rubke case involved allegedly false “fairness opinions,” which address the fairness of compensation offered to acquire securities in a merger or acquisition, which on their face are opinions, not facts.
The recent Tenth Circuit MHC Mutual case involved an evaluation of expected losses a bank would incur on investments in mortgage-backed securities following the 2008 financial crisis. This was stated as an estimate based on expectations for the future, not a current or historic fact.
What Is Different About “Soft Information”?
The treatment of so-called “soft information” has been a nettlesome issue in the securities laws for quite some time. Because this information involves evaluations of facts or expectations of future events, and not “hard facts,” distinct rules have developed over the circumstances when such statements can form the basis for liability if they turn out to be inaccurate. There are also “safe harbors” adopted by Congress and the SEC to encourage public companies to provide forward-looking statements in disclosures to investors. (See SEC Rule 175; section 27A of the 1933 Act; section 21E of the 1934 Act.)
In considering whether there is liability for such statements, it is essential to analyze them in relation to four distinct aspects of securities law liability: (1) is there “falsity,” that is, is the statement factually inaccurate (by itself or in light of omissions required to be disclosed that render it inaccurate)?; (2) is the inaccuracy “material”?; (3) was the statement (or omission) made with knowledge that it was false, or in reckless disregard of whether it was true or false (i.e., was there scienter)?; and (4) does a safe harbor apply?
The Supreme Court considered some aspects of liability for opinions or beliefs stated by company officials in Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991). That case involved a claim under the proxy disclosure provisions in section 14(a) of the Securities Exchange Act of 1934. Plaintiff sought damages arising out of allegedly false statements to shareholders in a proxy solicitation that a proposed merger offered a “fair” price for the stock, and provided “an opportunity for the Bank’s public shareholders to achieve a high value for their shares.” Id. at 1088, 1109. The plaintiff claimed that the Board did not actually believe the price was fair or the value high but recommended approval only to maintain their Board positions. Id. at 1088-89. A jury found for plaintiff.
The Supreme Court addressed “the actionability per se of statements of reasons, opinion or belief.” Id. at 1090. The Court assumed the jury found that “the directors’ statements of belief and opinion were made with knowledge that the directors did not hold the beliefs or opinions expressed.” Id. It also found that materiality of the Board’s opinion and its underlying reasoning was not a matter of serious dispute because there was no doubt that shareholders would treat the views of the Board on this issue as important. Id. at 1090-91. It then turned to the issue “whether statements of reasons, opinions, or beliefs are statements ‘with respect to … material fact[s].’” Id. at 1091. It noted that the directors’ statement of their beliefs, and the reasons for their beliefs, “are factual in two senses: as statements that the directors do act for the reasons given or hold the belief stated and as statements about the subject matter of the reason or belief expressed.” Id. at 1092. The Court found that a challenge to the correctness of stated beliefs did not allege a “false or misleading … fact” that could create liability under section 14(a): “A statement of belief may be open to objection … solely as a misstatement of the psychological fact of the speaker’s belief in what he says,” but not because it “mislead[s] about the stated subject matter (e.g., the value of the shares).” Id. at 1095. However, in order to state a claim for damages, a plaintiff must additionally show that the subject matter of the statement was objectively false. Id. at 1095-96. In other words, there can be damage liability for a statement of opinion as a false statement only if the statement (i) was objectively wrong, and (ii) was not in fact believed by the speaker. See id. at 1108-09 (Justice Scalia, concurring).
Following Virginia Bankshares, the Ninth Circuit decided in Rubke that fairness opinions in a registration statement that a transaction was “financially fair” to minority shareholders are “not statements of fact,” and therefore, under the reasoning in Virginia Bankshares, “they can give rise to a claim under section 11 only if the complaint alleges with particularity that the statements were both objectively and subjectively false or misleading.” 551 F.3d at 1162 (citing 501 U.S. at 1095-96). Because the complaint failed adequately to allege a basis for inferring “subjective falsity,” that aspect of the claim was properly dismissed. Id.
Two years later, the Second Circuit took the same approach in Fait. The court noted that “[a]lthough [section 11] refer[s] to misrepresentations and omissions of material fact, matters of belief and opinion are not beyond the purview of those provisions.” 655 F.3d at 110. Citing Virginia Bankshares (501 U.S. at 1095-96), the court said that for a claim under section 11 “based upon a belief or opinion alleged to have been communicated by a defendant, liability lies only to the extent that the statement was both objectively false and disbelieved by the defendant at the time it was expressed.” Id. The court explained that because goodwill disclosures involve an opinion by management of the “fair value” of assets acquired and liabilities assumed, they “are not matters of objective fact.” Id. at 110. Because the complaint did not “plausibly allege that defendants did not believe the statements regarding goodwill at the time they made them,” the section 11 claim was properly dismissed by the district court. Id. at 112.
Most recently, in MHC Mutual, the Tenth Circuit agreed that Virginia Bankshares mandated that both subjective falsity and objective falsity were required to pursue a section 11 claim.
How Did the Sixth Circuit Get It Wrong in Omnicare II?
The Sixth Circuit’s ruling in Omnicare II is flawed for two reasons.
First, the court apparently completely ignored the issue of materiality the second time around. Section 11 claims do not require proof of scienter, but they do require that inaccuracies in the registration statement be material (“In case any part of a registration statement … contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading ….”). In Omnicare I, the same court held that allegedly “false assurances of legal compliance” in company press releases did not support liability under section 10(b) for two reasons. The first reason was that the complaint failed adequately to allege that the defendants “knew their statements of ‘legal compliance’ were false when made.” 583 F.3d at 946. The factual allegations did not support the general assertion in the complaint that defendants’ assurance of legal compliance “was made with knowledge of its falsity.” 583 F.3d at 945-46.
The second reason for affirming dismissal of the section 10(b) claim based on this allegation was for lack of materiality: “[T]he materiality of the alleged omission derives solely from predictions regarding the actions of third parties, particularly whether fines or other sanctions would be brought based on findings of regulatory violations. This information is ‘soft.’ And no disclosure is required despite the generalized claim of ‘legal compliance.’” Id. at 947. Yet, in Omnicare II, the court failed to consider the implications of its earlier materiality ruling. Instead, it focused single-mindedly on its view that because “§ 11 is a strict liability statute,” “once a false statement has been made, a defendant’s knowledge is not relevant.” Id. at 505. The court noted that section 11 liability requires “an untrue statement of a material fact” (id.), but then simply ignored the materiality issue the court itself found in Omnicare I.
Second, the Omnicare II court lost sight of the fact that the issue whether Omnicare officials believed the company’s business activities were lawful was part and parcel of showing the required element of falsity, and not just showing scienter. As noted above, the court reversed the district court’s dismissal of the amended complaint’s section 11 claim because section 11 “provides for strict liability when a registration statement ‘contain[s] an untrue statement of a material fact.’ … No matter the framing, once a false statement has been made, a defendant’s knowledge is not relevant to a strict liability claim.” 719 F.3d at 505. It is correct that no allegation was needed to support a state of mind element for the section 11 claim because there is no such element, but it is not correct that allegations of knowledge were not necessary to support a claim that the statements were false. As the court itself noted, section 11 does require proof of “an untrue statement of material fact.” But the court then failed to examine whether the allegations showed that the statements regarding legality of conduct were both (i) objectively false, and (ii) made by the defendants when they did not believe them to be true.
The Omnicare II court’s confusion on this point is reflected in its difficult to parse discussion of Fait and Rubke, and the back of the hand it gives to the Supreme Court’s discussion in Virginia Bankshares of the requirements for falsity of statements of opinions or belief . The Omnicare II court dismissed Rubke and Fait as improperly extending the rationale of Virginia Bankshares to section 11 cases, and then essentially ignored the painstaking discussion of this issue in Virginia Bankshares as irrelevant dicta because, in its view, that Court had no good reason to discuss the issue and rendered a series of unnecessary majority and concurring opinions. The gist of the Omnicare II opinion on this point is that the Supreme Court had no reason to discuss whether an opinion or belief could be “false” even if it was genuinely held, because the Court assumed the jury decided the defendants did not believe the statements they made in the proxy and deferred to that finding. See 719 F.3d at 506-07 (“The Virginia Bankshares Court was not faced with and did not address whether a plaintiff must additional plead knowledge of falsity in order to state a claim” because “it assumed the jury in the case had already found knowledge of falsity”).
But there can be no doubt from the opinion that the Supreme Court held that such a jury finding was essential to find a violation of section 14(a)’s mandate that no proxy solicitation shall “contain any statement which, at the time it is made, is false or misleading with respect to any material fact….” The majority opinion described the statement at issue as one “which misstate[s] the speaker’s reasons and also mislead[s] about the stated subject matter,” and stated unequivocally that such “[a] statement of belief may be open to objection only in the former respect, however, solely as a misstatement of the psychological fact of the speaker’s belief.” 501 U.S. at 1095 (emphasis added). That could not be more clear, but Justice Scalia’s concurring opinion provided the exclamation point: the statement “‘this is a high value for the shares’ would produce liability if in fact it was not a high value and the directors knew that. It would not produce liability if in fact it was not a high value but the directors honestly believed otherwise.” 501 U.S. at 1108-09.
In fact, there is no doubt from the Virginia Bankshares opinion that because the statement at issue was a purported belief, in the Court’s view, the only “false or misleading … fact” in what the directors said was that they believed something they did not in fact believe – i.e. subjective falsity. The entire discussion of the additional requirement of objective falsity addresses a different issue: whether a private action for damages could proceed if there is only subjective falsity “standing alone.” Id. at 1095-96. The Court ruled that it could not, on the grounds that allowing such claims “would threaten just the sort of strike suits and attrition by discovery that Blue Chip Stamps sought to discourage.” Id. at 1096. Thus, it is subjective falsity that makes an purported opinion a “false … fact”; objective falsity is also required, but only to avoid an avalanche of paralyzing securities litigation over “the ‘impurities’ of a director’s ‘unclean heart.’” Id.
The Virginia Bankshares Court made it clear that as to expressions of opinions or beliefs, the only factual aspect that could be challenged as “false or misleading” is whether the beliefs were genuine, not whether they “mislead about the stated subject matter.” Id. at 1095. The “subject matter” in Omnicare was whether the company conducted its business legally. Per Virginia Bankshares, that was not a challengeable “fact.” Because the complaint challenged that statement in the section 11 claim, and failed to allege facts showing the defendants did not believe that statement when they made it, there was no “untrue statement of a material fact” alleged in the complaint (as required under section 11(a)) and the claim was properly dismissed by the district court. If the Omnicare II court bothered to parse Virginia Bankshares a bit more carefully, rather than jettisoning it as extensive dicta, it could not have allowed the claim to proceed. Since it seems highly unlikely that the Supreme Court is going to expand the scope of statements actionable as “facts” under section 11, Omnicare II seems headed for reversal.
September 19, 2014
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