Saturday, February 29, 2020

Three Times Federal Courts Got Materiality Wrong, and One Time They Didn’t

I often skim through recent opinions issued in private securities class actions, just to see what the latest issues are and how courts are addressing them.  So this week, I’ll talk about a few that caught my eye.  As the subject line indicates, most of this discussion concerns materiality, but there are some extra issues tossed in.

And yes, this is a very long one, so behind a cut it goes:

First up, we have In re Philip Morris Int'l Sec Litig, 2020 WL 550769 (S.D.N.Y. Feb. 4, 2020).  Plaintiffs claimed that Philip Morris lied about the clinical evidence of health benefits from its smokeless cigarette alternatives.  The court concluded that any omissions from Philip Morris’s public statements were immaterial, with the following reasoning:

Much like this case, Tongue v. Sanofi, 816 F.3d 199 (2d. Cir. 2016), involved a company’s alleged misstatements regarding the methodology it used in clinical trials, the results of those trials, and the likelihood of obtaining FDA approval of the company’s product—in that case, a multiple sclerosis drug. The Second Circuit held that the company “need not have disclosed” the FDA’s critique of its clinical trial methodology “merely because it tended to cut against their projections” of FDA approval, as “Plaintiffs were not entitled to so much information as might have been desired to make their own determination about the likelihood of FDA approval.” Id. at 212. With respect to the defendants’ claims about clinical trial results, the Second Circuit held that the “Defendants’ statements about the effectiveness of [the drug] cannot be misleading merely because the FDA disagreed with the conclusion—so long as Defendants conducted a ‘meaningful’ inquiry and in fact held that view, the statements did not mislead in a manner that is actionable.” Id. at 214. In so doing, the court determined that the plaintiffs’ claim that the defendants misled investors by making positive statements about the results of the trials amounted to “little more than a dispute about the proper interpretation of data.” Id. It further noted that “no sophisticated investor familiar with standard FDA practice would expect that every view of the data taken by Defendants was shared by the FDA.” Id.

The Court agrees with Defendants that Plaintiffs have failed to allege any omission that would make Defendants’ opinion statements about its clinical studies misleading to a reasonable investor under the standards set forth in Sanofi. …Defendants’ statements about the results of its clinical studies were not misleading “merely because the [Tobacco Products Scientific Advisory Committee] disagreed with the conclusion,” as “no sophisticated investor familiar with standard FDA practice would expect that every view of the data taken by Defendants was shared by the FDA.” Sanofi, 816 F.3d at 214. … Accordingly, like in Sanofi, Plaintiffs’ argument amounts to “little more than a dispute about the proper interpretation of data.”

Now, the question of materiality to a reasonable investor is an unsettled one in securities law.  Joan Heminway has documented some interpretations of the “reasonable investor” concept here but most judicial rhetoric implies that the reasonable investor is something like a relatively savvy, but nonexpert, retail investor.  Cf. Virginia Bankshares v. Sanford, 501 U.S. 1083 (1991) (“not every mixture with the true will neutralize the deceptive. If it would take a financial analyst to spot the tension between the one and the other, whatever is misleading will remain materially so, and liability should follow”).

In some specific contexts, though, courts have departed from that view. For example, Margaret Sachs has shown how in schemes targeting vulnerable investors (like seniors), courts automatically adjust their expectations. Margaret V. Sachs, Materiality and Social Change: The Case for Replacing “the Reasonable Investor” with “the Least Sophisticated Investor” in Inefficient Markets, 81 TuL. L. Rev. 473 (2006). Similarly, for investments targeted solely to sophisticated institutions, courts have gauged materiality by reference to what targeted investors would have considered important. See, e.g., Flannery v. SEC, 810 F.3d 1 (1st Cir. 2015); U.S. v. Litvak, 808 F.3d 160 (2d Cir. 2015).

And that’s what the court did in Sanofi.  There, the plaintiffs were purchasers of a contingent value right, whom the Second Circuit deemed to be highly sophisticated and “accustomed to the customs and practices of the relevant industry.”  In that context, the court concluded that these investors particularly would have known that any optimism expressed by the defendants about FDA approval of their drug did not necessarily mean that the FDA had not internally expressed reservations about their clinical methodology.

In Philip Morris, however, the class included all securities purchasers – not necessarily a highly sophisticated bunch. But, without explanation, the court relied on Sanofi to conclude that the omitted information was immaterial. Now, to be fair, I don’t know that the reliance on Sanofi, specifically, made much of a difference in the outcome, but the court’s automatic assumption of investor sophistication worries me, because it’s just the kind of thing that will be used in future cases to raise the materiality bar.

That said, the case highlights ongoing tensions in this area of law.  First, obviously, investors come in all stripes, and defining a single “reasonable investor” is an impossible task.  Second, it’s not obvious how the notion of a “reasonable investor” interacts with the fraud-on-the-market context in which most securities class actions appear; after all, the investors who drive market pricing might be more sophisticated than your average bear. See Asher v. Baxter, 377 F.3d 727, 731 (7th Cir. 2004); Wielgos v. Commonwealth Edison Co., 892 F.2d 509, 515 (7th Cir. 1989).  And then there’s the point made by Geoffrey Rapp in Rewiring the DNA of Securities Fraud Litigation: Amgen’s Missed Opportunity, 44 Loy. U. Chi. L.J. 1475 (2013), which is that no reasonable retail investors should ever care about random public facts about individual stocks; at most, theyshould only care about facts that matter to their overall portfolio. 

But there’s more to talk about in this case, because in a prior post, I pointed out that courts are increasingly free with their dismissals on puffery grounds, essentially using the doctrine as a mechanism for distinguishing what they think should be governance-type fiduciary duty claims from fraud claims.  Philip Morris presents a nice example of the genre:

Philip Morris’s statements that it was “conducting extensive and rigorous scientific studies,” “conduct[ing] rigorous scientific assessment[s],” “draw[ing] upon a team of world-class scientists,” following a “thorough and systematic approach to smoke-free product development and assessment,” “following a rigorous scientific assessment program,” “draw[ing] upon a team of expert scientists,” and conducting “research [that] meets rigorous standards” are mere puffery. …“[T]hese statements did not, and could not, amount to a guarantee” regarding the quality of Philip Morris’s studies or the likelihood of FDA approval…. Instead, these statements were “too general to cause a reasonable investor to rely upon them.”

Again, puffery isn’t – or isn’t supposed to be – about whether someone is guaranteeing an outcome, but about whether the statement is one that an investor would take seriously.  And that doesn’t require that the statement be exact; even inexact statements may still suggest that the true facts fall within a limited range of possibilities, and investors may rely upon that range.  After all, the Supreme Court acknowledged way back in Basic v. Levinson, 485 U.S. 224 (1988), that even contingent/uncertain information may be valuable to investors.  Still, courts, increasingly skeptical of 10(b) claims about the quality of corporate governance, treat a broad swath of statements describing internal processes as “puffery.”

Next up, we have In re Sinclair Broadcast Group Sec Litig., 2020 WL 571724 (D. Md. Feb. 4, 2020)The basic allegation was that Sinclair agreed to a merger with Tribune and then falsely represented how diligently it would work with DoJ to satisfy antitrust concerns.  The plaintiffs alleged that Sinclair claimed to be shedding assets when in fact it was engaging in sham sales that would allow it to retain control.

In securities actions, the Supreme Court has drawn a distinction between statements of opinion and statements of fact.  The theory is that when someone says “XXX is true,” that’s a representation about the state of the world that can be falsified if the state of the world is other than XXX.  But the statement “It is my opinion that XXX is true” is a representation about one’s own belief, and is only false if one does not in fact believe XXX, or – at the very least – if the statement implies that one’s belief is rooted in a more rigorous factual investigation than is actually the case. 

The distinction was laid out in Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 575 U.S. 175 (2015), where the Court held that “A statement of fact expresses certainty about a thing, whereas a statement of opinion conveys only an uncertain view as to that thing.”  As a result, the statement “We believe our contract arrangements … are in compliance with applicable federal and state laws” was held to be merely an opinion.

Now, I personally believe this is an absurd distinction; defendants should not be able to change a factual statement into a representation of opinion merely by inserting the phrase “I believe” in front.  After all, of course everything anyone represents to be true is their belief, what else could it be?  Cf. In re Oxford Health Plans, Inc. Sec. Litig., 187 F.R.D. 133, 141 (S.D.N.Y. 1999) (“It is disingenuous to suggest that factual assertions are puffery and opinion … simply because Oxford claims only to have stated that it believes in their truth.”); SEC v. Okin, 137 F.2d 862, 864-65 (2d Cir. 1943) (inserting “in my opinion” in fact statement does not fundamentally alter statement).

But that’s what the Supreme Court held, and that’s where we are.  Still, it seems even that Maginot line is shifting. In Sinclair, the plaintiff alleged that the following were false:

Sinclair’s statement that “[t]he Divestiture Trust Applications comply with the National Cap Rule,” and they were filing a Divestiture Trust Application for WPIX “in order to facilitate the Transaction’s compliance with the National Cap Rule.”

Sinclair’s statement that it had “executed asset purchase agreements with third parties” to divest WGN and WPIX to those third parties “in order to come into compliance with the National Cap Rule.”

Sinclair’s statement that “Sinclair will divest stations ... to comply with the National Cap Rule. Upon divestiture of these stations ... [Sinclair] will be in compliance with the National Cap Rule,” and that “an agreement to sell WGN to a third party has been executed.”

No representation of belief, no caveat that it’s only an opinion, right?

Wrong.  Per the court:

Here, the challenged statements regarding Sinclair’s compliance with FCC regulations were made to the FCC in connection with divestiture proposals. A reasonable investor would have understood that, notwithstanding Sinclair’s own position, the final arbiter of FCC compliance is the FCC, not Sinclair. “Statements of opinion are generally actionable only if the plaintiff establishes that the statement was objectively false and the issuer lacked a rational belief in the veracity of the statement at the time it was made.”

So apparently, we've gone from Omnicare’s “We believe we are in compliance” is a statement of opinion to flat out “We are in compliance” is also a statement of opinion.   And again, I’m just going to highlight that this is of a piece with the puffery developments, namely, statements about corporate compliance just feel like governance rather than fraud, and so courts find a way to treat them as insufficient to anchor a Section 10(b) claim.

Which also explains why Sinclair followed what is rapidly becoming something of a general rule, namely, that codes of ethics are almost per se puffery.  Without giving much thought to the matter, the court held:

Finally, [plaintiff] claims that, [in] light of Sinclair’s attempts to deceive the FCC, it was materially false and misleading for Sinclair to state, in its Code of Business Conduct and Ethics, that it “aim[ed] to succeed through fair and honest competition” and “never through unethical or illegal business practices.” … Statements in corporate codes of conduct can be characterized as inactionable “puffery”: statements of a company’s ideals rather than representations of past or present fact. Accordingly, the court will dismiss claims against all defendants arising from statements made in Sinclair’s code of conduct.

There’s something perverse about taking information that is required to be disclosed under federal law, 17 C.F.R. § 229.406 (“Disclose whether the registrant has adopted a code of ethics that applies to the registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. If the registrant has not adopted such a code of ethics, explain why it has not done so.”), and declaring it per se immaterial, but here we are.  Courts believe they have to draw that governance/fraud distinction somehow.

I’ve also talked about how courts are often quick to assume that public markets are able to absorb even the most obscure bits of nominally-public information in order justify concluding that a defendant’s false representation was not “material” in light of the “total mix of information made available.”  This kind of move is usually part of a market efficiency analysis – the court assumes that an efficient market has near-mystical powers to absorb any fact, no matter how inaccessible – but Sinclair takes it a step further.  In that case, the question was whether Sinclair misled the public when it said it had sold assets to “an unrelated party,” when in fact, the assets were sold to Michael Anderson, who had extensive ties to Sinclair’s founder.  The court concluded not, because, well:

[W]hen Sinclair stated on March 1, 2018, in the 2017 Form 10-K, that the voting stock of Cunningham had been sold to an unidentified “unrelated party,” the details of that transaction—including Anderson’s identity and details of his relationship to the Smith family—were already in the public domain.

In a public notice issued on December 7, 2017, the FCC disclosed its approval of a “Voluntary Transfer of Control” between Michael Anderson, as trustee of the Carolyn C. Smith Cunningham Trust, and Michael Anderson, in his personal capacity. (12/7/17 FCC Public Notice, Mot. Ex. 15, ECF 49-14). The filing number listed in the public notice corresponds to a publicly-filed application that details the terms of the transaction and Anderson’s status as the sole trustee of a trust associated with the estate of the defendant Smith’s late mother. (Anderson Transfer App., Mot. Ex. 1, ECF 49-3). The court notes that the details of the transaction were not included in the 2017 Form 10-K, and that a reasonable investor would have needed to conduct further research to discover the nature of Sinclair’s relationship to Anderson. Nevertheless, this information was in the public domain…

Notice the court doesn’t even pretend that the all-seeing “market” would have absorbed this information; it was public, and therefore no one was misled, QED.  The phrase “It was on display in the bottom of a locked filing cabinet stuck in a disused lavatory with a sign on the door saying ‘Beware of the Leopard’” comes to mind.

One final point of note in the Sinclair opinion has to do with the issue of corporate scienter.  Determining how to ascribe intent to a corporation is always a challenge; most courts hold that you must ascribe intent to a particular corporate agent who was, in some way, responsible for the misstatement, though they vary as to how specific the plaintiff must be in identifying that agent at the pleading stage.  See, e.g., Smallen v. Western Union Co., 2020 WL 893826 (10th Cir. Feb. 25, 2020).

(Sidebar: That’s what courts say they are doing; in practice, they generally require a showing that a top officer/director knew of the fraud, which is a point I make in my Slouching Towards Monell paper.)

But it’s rare you see something like this:

[Despite failing to show scienter as to any individual defendant, t]he court finds, however, that [plaintiff] has adequately alleged scienter as to corporate defendant Sinclair. The [confidential witness] statements describe a widespread understanding among Sinclair and Cunningham employees that, despite Cunningham’s “technical” independence; Sinclair was in charge. These allegations are sufficient to satisfy the scienter requirement.

It remains to be seen whether, at later stages, the court will treat this widespread knowledge as corporate scienter per se, such that Sinclair had scienter independent of any individual actor, or whether it will be used as evidence that specific agents – whose scienter could be attributed to the company – must have known the truth.

And that brings me to my final case, In re TransDigm Group Sec. Litig., 2020 WL 820823 (N.D. Ohio Feb. 19, 2020).  There, the plaintiff alleged that a defense contractor engaged in a variety of illegal practices to overcharge the government, and losses were incurred when the scheme was exposed. Once again, the plaintiff claimed that the defendants lied when they issued a Code of Business Conduct and Ethics, which represented that it was “the Company’s policy to comply with all applicable local, national, and international laws, rules, and regulations.” And once again, the court held:

The Court finds the above statements are not material. As the Sixth Circuit has explained, “a code of conduct is not a guarantee that a corporation will adhere to everything set forth in its code of conduct” and, instead, is simply a “declaration of corporate aspirations.” Bondali v. YumA Brands, Inc., 620 Fed. Appx. 483, 490 (6th Cir. 2015). Thus, the Court finds that a reasonable investor would not rely on the above statements in TransDigm’s Codes of Conduct and Ethics as a guarantee that TransDigm would at all times remain in compliance with all applicable laws, rules and regulations. Instead, these statements merely set forth standards in general terms that TransDigm hoped it and its senior executives would adhere to…

Well, yeah, a Code isn’t a guarantee of anything, and it’s not even a promise that the company will be completely free of any legal violations whatsoever.  But it is a statement of policy, and “[a]t some point, statements by a defendant that it ‘generally’ adheres to a particular policy become misleading when in fact there is no such policy or the policy is something else altogether.” In re Dynex Capital, Inc., 2009 WL 3380621, at *8 (S.D.N.Y. Oct. 19, 2009).

To be fair, at this point, I guess I would agree that no investor takes an ethics policy statement seriously, but that’s not because there’s anything inherent about the statements themselves that renders them unreliable – it’s because courts have made clear that there are no consequences for lying about them.  Which means they are immaterial – now

And this is the argument I make in my article, Reviving Reliance: You can’t expect institutional investors to take on stewardship roles and police the quality of corporate governance and then simultaneously tell them they can’t rely on anything a company says about the quality of its governance.

But … there’s more. 

In TransDigm, the plaintiff also alleged that TransDigm misrepresented its business practices by attributing its success to, inter alia, “constant focus on [its] value-based operating strategy,” its “‘unique in the industry’ business model with ‘its consistency and its ability to sustain and create intrinsic shareholder value,’” its “value-based operating strategy, based on our three value driver concept,” and its “core value-driven operating strateg[y]” of “obtaining profitable new business” and “providing highly engineered value-added products to customers.”

I mean.

Where do you even start with this?

Obviously, I’m pretty skeptical of the puffery concept, because I think courts are using it as a way to police what they think should be the distinction between a fraud claim and a governance claim.  But if a company’s best explanation for its profits is “we provide value and value drivers and value-added products”?  That’s almost a red flag that something must be wrong.  And in an investor-stewardship-world, you want to say that these kinds of disclosures should place investors on notice of potential illegal behavior, and confer upon them a duty to inquire further.  At minimum, this is the point where reimbursement for losses is inconsistent with the notion that investors should bear the costs of illegal conduct, in order to incentivize them to select better managers.  Yes, there’s the old saw that the securities laws were intended to “substitute a philosophy of full disclosure for the philosophy of caveat emptor…,” Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972), but in a world of institutional investors, we also increasingly expect shareholders to do some of the work.  And if investors heard those statements and bought the stock anyway?  It does kinda seems like they were all in.

So on this one, I’m giving it to the court when it held that these statements “are not tethered to any kind of objective standard and are so lacking in specificity that no reasonable investor could have found them important in the ‘total mix’ of information available to investors.”  Motion to dismiss (properly) granted.

Ann Lipton | Permalink


You know that I love this post. I am assigning it to my students, many of whom--like you and me--like to nerd out over materiality analyses. But your post does cover more and should be very useful to our discussions of securities fraud litigation generally.

I especially like the points you make about Phillip Morris/Sanofi. The contextualization of the reasonable investor--focusing in on an investor in a specific kind of offering and a specific type of securities--changes a purely objective standard to a partially subjective one. If that's what courts should be doing, it should be done consistently.

And I agree that the analyses of fact/opinion and puffery have gotten a bit out of control in a number of cases. We have gotten away from using the puffery doctrine to excuse generalized glowing statements about products, services, and circumstances. (I refer to this in class as the type of language a stereotypical used car salesman might employ in trying to make a sale.) What bothers me in many of these cases is the overuse of adjectives and adverbs in SEC documents and public statements in substitution for factual information. I would love to write about that sometime. It bugs me.

I could go on, but I will leave it here. Thanks for the great post. I hope that others will also chime in with some of their views on these issues. They are critically important to securities fraud doctrine and claims.

Posted by: joanheminway | Feb 29, 2020 5:54:50 AM

I'm so glad you liked the post- thank you! And yeah, I am not sure what to do about the issue of contextualization, whether it should be put in the reliance box, whether maybe we should think differently for public and private offerings, or efficient vs inefficient markets, but right now it's all very ad hoc, and that's a problem.

Posted by: Ann Lipton | Feb 29, 2020 6:06:36 AM

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