This article has been republished in the Harvard Law School Forum on Corporate Governance.
On October 8, 2020, a new Ninth Circuit ruling deepened a circuit split over whether allegations in another civil lawsuit could constitute a corrective disclosure in a securities fraud class action. [1] The Ninth Circuit joins the Sixth Circuit in declining to adhere to a categorical rule that allegations in a civil suit can never constitute corrective disclosures. [2] The Eleventh Circuit remains at the other end of the spectrum, holding that, as a matter of law, allegations from civil suits cannot constitute corrective disclosures, even partial. [3] As a reminder, a corrective disclosure occurs when “information correcting the misstatement or omission that is the basis for the action is disseminated to the market.” [4]
As Judge Kenneth K. Lee suggests in his dissent, BofI may portend an uptick in securities fraud suits predicated on allegations made in related whistleblower suits. Moreover, companies may be more likely to settle earlier and for larger sums even when loss causation is predicated on meritless allegations in a parallel civil action. The best approach for defendants in securities fraud actions in the Ninth Circuit will be to distinguish the facts of their related civil litigation from that in BofI, undermining the plausibility of the allegations.
Ninth Circuit: BofI and its “case-by-case basis” standard
District Court. Plaintiffs alleged that BofI Holding, Inc. (“BofI”) and several of its officers and directors falsely assured shareholders that the company was conservative in its loan underwriting standards and had effective internal controls and a robust compliance structure. [5] The district court found that plaintiffs adequately pled every element of a securities fraud claim except for loss causation—a relatively rare occurrence. In particular, the court found that accusations levied against the company in a related whistleblower suit did not rise to the level of corrective disclosures. [6] The court held that whistleblower accusations may serve as a partial disclosure if “a later disclosure occurred that confirmed the risk identified by [the] complaint,” [7] but alone they were “at most unconfirmed accusations of fraud.” [8]
Ninth Circuit. On appeal, the Court reviewed only the dispositive issue of loss causation. As for the accusations in the whistleblower complaint, the Court parted with the district court completely: it found “[t]he allegations of egregious wrongdoing in the [whistleblower] lawsuit, if accepted as true, unquestionably revealed to the market that at least some of [defendants’] alleged misstatements were false.” [9] According to the Court, plaintiffs did not need to “establish the allegations in the lawsuit [we]re in fact true.” [10] Rather, they only had to show that “the market reasonably perceived [them] as true.” [11] Applying this standard, the Court found the whistleblower’s accusations “detailed and specific” and “based on firsthand knowledge.”[12] Moreover, the significant post-complaint stock drop “would not be expected in response to whistleblower allegations perceived as unworthy of belief.” [13]
The Court found that its holding did not depart from two key Ninth Circuit precedents. The two-judge majority found that Loos v. Immersion Corp. was distinguishable because the alleged corrective disclosure in Loos was the announcement of an internal investigation, which unlike the whistleblower lawsuit, did “not reveal to the market any facts[;] all the market could react to was ‘speculation’ about ‘what the investigation w[ould] ultimately reveal.’” [14] Nor was Curry v. Yelp Inc. in opposition, wrote the majority. In Yelp, plaintiffs alleged that a Federal Trade Commission’s disclosure revealing several thousand complaints alleged that Yelp manipulated reviews was a corrective disclosure: “Critically . . . the customers who filed complaints in Curry were outsiders who lacked any firsthand knowledge of Yelp’s practices,” whereas the whistleblower referenced in BofI was an employee. [15]
The Ninth Circuit noted that its decision joins with the Sixth Circuit in declining to categorically find accusations in a civil suit unsuitable as corrective disclosures. [16] The Sixth Circuit has rejected the proposition that “complaints can reveal only allegations rather than truth,” [17] holding that allegations could serve as corrective disclosures in conjunction with facts “separate from the complaint,” including the company’s own admissions and expert analysis referenced in the complaint. [18]
Eleventh Circuit’s bright line rule
The Ninth Circuit now stands in direct opposition to precedent in the Eleventh Circuit. In Meyer v. Greene, the Eleventh Circuit held that disclosure of an SEC informal inquiry and subsequent announcement that that the SEC had ordered a private investigation of the subject matter at issue in the securities fraud suit were “insufficient as a matter of law to constitute disclosures.” [19] While the investigations could be “indicators of risk because they reveal the potential existence of future corrective information,” further corroborative disclosures were necessary for them to count as disclosures. [20]
Two years later, the Eleventh Circuit decided Sapssov v. Health Mgmt. Assocs., in which, like BofI, the securities complaint relied on allegations made in a wrongful termination suit. In Sapssov, the whistleblower bringing the suit was a former FBI investigator and the company’s former compliance officer. [21] (Arguably, such allegations would have held even more credibility than a former mid-level employee in the eyes of the Ninth Circuit.) The Eleventh Circuit held that a report summarizing the facts of the wrongful termination suit could not be a corrective disclosure because it merely restated information that had been publicly available in a court docket for several months. [22] Echoing its holding from Meyer, the Eleventh Circuit also added that the whistleblower’s case “was not proof of fraud, because a civil suit is not proof of liability.” [23] In short, in the Eleventh Circuit, allegations made in related civil litigation cannot serve as stand-alone corrective disclosures. [24]
Takeaways
The Eleventh Circuit’s bright line rule provides a bulwark against frivolous securities fraud class actions. By its recent decision, the Ninth Circuit seems to favor an approach in which judges reviewing pleadings in securities class actions must also play the role of jury for parallel civil actions and weigh the facts alleged in those complaints in order to determine the credibility of the parallel allegations.
The Ninth Circuit’s decision in BofI offers several takeaways:
- As Judge Lee described in his dissent, the Ninth Circuit’s ruling could prove to be a slippery slope: “An insider account will almost always have a patina of plausibility because it will likely be based on some non-public allegation that cannot be easily disputed or rebutted at the pleading stage.” [25] In the case of BofI, the whistleblower might even lose his suit, but the damage to the company would have already been done if it had to defend against the suit longer or settle for a larger amount of money than warranted by the merits of the suit. [26]
- The Ninth Circuit’s holding is hard to reconcile with precedent because, as described in Judge Lee’s dissent, a stock drop after the announcement of a lawsuit does “not necessarily [mean that the lawsuit’s] allegations revealed the ‘truth’ and acted as a corrective disclosure. Rather, it is better construed as a disclosure of an ‘added risk of future corrective action.'" [27] In other words, a stock drop in response to a lawsuit is the market adjusting for the potential risk that the allegations may ultimately be correct. Such market adjustments cannot be corrective disclosures, as they do not “reveal” any prior misstatement. The Ninth Circuit had previously recognized this principle in Loos. Although BofI discussed and distinguished Loos on its facts, it did not address this broader principle.
- The Ninth Circuit credited the BofI whistleblower because of his “detailed and specific” allegations and “firsthand knowledge.”[28] This suggests that the Ninth Circuit implicitly applied a test similar to that for evaluating statements from confidential witnesses. [29] Thus, defense counsel should consider challenging allegations from related civil litigation using arguments like those from the confidential witness context. Specifically, defense counsel should consider: (1) pointing to facts showing that the complainant’s rank and position within the company would not qualify her to credibly speak to the facts alleged; and (2) highlighting a lack of descriptions of specific instances of wrongdoing. The whistleblower in the civil litigation related to BofI detailed specific instances of egregious wrongdoing and alleged specific members of management to whom he had tried to report these alleged infractions. [30] Although not mentioned in the opinion, the Court may have also been swayed by the fact that the parallel whistleblower suit in BofI advanced beyond the pleading stage. [31]
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[1] In re BofI Holding, Inc. Sec. Litig., 2020 U.S. App. LEXIS 31938 (9th Cir. Oct. 8, 2020). (the panel was comprised of Judges Paul J. Watford, Market J. Bennett, and Kenneth K. Lee. Lee concurred in part and dissented in part.)
[2] BofI, 2020 U.S. App. LEXIS 31938, at *20 (citing Norfolk Cty. Ret. Sys. v. Cmty. Health Sys., 877 F.3d 687, 696 (6th Cir. 2017)).
[3] Sapssov v. Health Mgmt. Assocs., 608 F. App’x 855, 863 (11th Cir. 2015) (noting that “a civil suit is not proof of liability”).
[4] 15 U.S.C. § 78u-4(e)(1).
[5] BofI, 2020 U.S. App. LEXIS 31938 at *5.
[6] In Re BofI Holding, Inc. Securities Litigation, 302 F. Supp. 3d 1128, *1140 (S.D. Cal. 2018). The other corrective disclosures alleged were a series of blog posts written by anonymous authors on Seeking Alpha. The court found that the blog posts only restated information already publicly available, and therefore could not be corrective disclosures. Id. at *1142. The Ninth Circuit agreed with the district court that the blog posts at issue here were not corrective disclosures, but stated that disclosures based on publicly available information could sometimes constitute corrective disclosures. BofI, 2020 U.S. App. LEXIS 31938 at *27-28.
[7] In re BofI Holding, Inc. Securities Litigation, 302 F. Supp. 3d at *1140.
[8] Id. at *1139 (likening them to the announcement of an SEC investigation in Meyer v. Greene, 710 F.3d 1189 (11th Cir. 2013)).
[9] BofI, 2020 U.S. App. LEXIS 31938 at *17.
[10] Id. at *18.
[11] Id. at *19 (citing Norfolk Cty. Ret. Sys., 877 F.3d at 696).
[12] BofI, 2020 U.S. App. LEXIS 31938 at *19-20.
[13] Id. at *20.
[14] Id. at *20 (quoting Loos v. Immersion Corp., 762 F.3d 880 (9th Cir. 2014)) (emphasis in original).
[15] BofI, 2020 U.S. App. LEXIS 31938 at *22-23 (distinguishing Curry v. Yelp Inc., 875 F.3d 1219 (9th Cir. 2017)).
[16] BofI, 2020 U.S. App. LEXIS 31938 at *20.
[17] Norfolk Cty. Ret. Sys., 877 F.3d at 696.
[18] Id. at 696-97.
[19] 710 F.3d 1189, 1202 (11th Cir. 2013) (emphasis added).
[20] Id. at 1201 (internal quotation marks omitted).
[21] Sapssov, 608 F. App’x 855, 857-58.
[22] Id. at 863.
[23] Id. (emphasis added).
[24] Id. (citing Meyer, 710 F.3d at 1198 n.9, approvingly).
[25] BofI, 2020 U.S. App. LEXIS 31938, at *39-40 (Lee, J., dissenting).
[26] Id. at *39 (Lee, J. dissenting).
[27] Id. at *41 (Lee, J., dissenting) (quoting Meyer, 710 F.3d at 1201).
[28] Id. at *19-20.
[29] See Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 995 (9th Cir. 2009) (considering the “corroborative nature of the facts alleged (including from other sources), the coherence and plausibility of the allegations, the number of sources, and the reliability of the sources”)
[30] BofI, 2020 U.S. App. LEXIS 31938, at *17.
[31] Erhart v. Bofi Holding, Inc.., 269 F. Supp. 3d 1059 (S.D. Cal. 2017) (denying motion to dismiss).
