Rumpelstiltskin and the Securities Laws

I’m finding the district court’s decision in Marcu v. Cheetah Mobile, 2020 WL 4016645 (S.D.N.Y. July 16, 2020) fascinating, not because it’s wrong on the law – it isn’t, in my view, at least with respect to its falsity determination – but because it illustrates the artificiality of a lot of securities fraud litigation.

Cheetah Mobile is a Chinese company that develops apps that used to be downloadable from Google Play.  It went public on the NYSE in 2014, and quickly developed a reputation for poor quality products that used intrusive advertisements and interfered with the functioning of users’ phones.  In 2017, a short-seller accused it of fabricating revenue and clicks, and in 2018, Buzzfeed exposed that 7 of its 18 apps were engaged in a type of clickfraud scheme that improperly credited Cheetah Mobile with referrals to other apps.  Google removed the offending apps, and earlier this year, apparently fed up with Cheetah’s behavior, booted it from its platform entirely.

A putative class of Cheetah investors brought Section 10(b) claims shortly after the Buzzfeed expose, alleging that Cheetah misled investors about its business practices.  The district court dismissed the case in large part because the plaintiff could not identify any false statements.  The company accurately described its revenues – even if some portion of those revenues were generated through the clickfraud scheme – and accurately described its users’ experiences with its products.  As the court put it:

Nor do Plaintiffs plausibly allege that the challenged statements regarding revenue and profit derived from the apps are misleading. “[A] violation of federal securities laws cannot be premised upon a company’s disclosure of accurate historical data.” In re Sanofi Sec. Litig., 155 F. Supp. 3d 386, 404 (S.D.N.Y. 2016). …That said, a statement may be misleading if it describes the factors that influence the reported figures but omits the fact that one such factor is the alleged misconduct.  For example, in In re VEON Ltd. Securities Litigation, No. 15-CV-8672 (ALC), 2017 WL 4162342 (S.D.N.Y. Sept. 19, 2017), the plaintiffs alleged securities fraud on the ground that the defendant had concealed that it had paid bribes to receive favorable treatment in Uzbekistan. Notably, the court held that “references to sales and subscriber numbers in Uzbekistan” were not, in themselves, misleading. Id. at *6. By contrast, assertions that growth in the Uzbekistani market was due to “the improving macroeconomic situation, product quality and efficient sales and marketing efforts” were misleading because the “growth also was due to bribe[ry].” Id.; see also In re Braskem S.A. Sec. Litig., 246 F. Supp. 3d 731, 758-61 (S.D.N.Y. 2017) (holding that a list of reasons for the low price the defendant had paid for a good was plausibly misleading because it omitted a “key factor, the bribery-affected side deal” with the supplier and therefore amounted to “a classic half-truth”)…

…[Cheetah’s] disclosures did “not put the source of [Cheetah Mobile’s] success at issue.” In re KBR, Inc. Sec. Litig., No. CV H-17-1375, 2018 WL 4208681, at *5 (S.D. Tex. Aug. 31, 2018) (emphasis added). That is, they did not “put the circumstances surrounding” the means by which Cheetah Mobile’s apps generated revenue “‘in play’ — by, for instance, touting some legitimate competitive advantage or specifically denying wrongdoing — but instead merely report[ed] the facts that some of the reported revenue and income came from ‘increased progress,’ or ‘increased activity’ . . . and the like — reports that Plaintiffs do not contend were false.” Id.

Plaintiffs come closer to the mark with respect to Defendants’ disclosures explaining the drivers of revenues and profits from mobile apps, but here too they ultimately fall short.  Specifically, Plaintiffs take issue with Cheetah Mobile’s representations that it “generate[d] online marketing revenues primarily by referring user traffic and selling advertisements on our mobile and PC platforms.” SAC ¶ 49 (emphasis omitted). Cheetah Mobile also articulated its “belie[f] that the most significant factors affecting revenues from online marketing include[d],” inter alia, “a large, loyal and engaged user base,” which “results in more user impressions, clicks, sales or other actions that generate more fees for performance-based marketing,” and “the fee rate [Cheetah Mobile] receive[d] per click or per sale.” Id.; see also id. ¶¶ 63, 72, 79 .… At first glance, these statements appear akin to those found actionable in In re VEON Ltd. … But there is a critical difference: The disclosures here did not, explicitly or implicitly, rule out other factors playing a role in generating revenue. To the contrary, by using words such as “primarily” and “most significant,” Defendants overtly acknowledged that other factors might play a role. To be sure, the statements did unmistakably imply that any unstated factors played a minor role relative to the stated factors. But Plaintiffs allege no facts suggesting, let alone showing, that implication to be false. 

2020 WL 4016645, at *5 (some quotations omitted).

The court here is correctly summarizing existing caselaw: Accurate reporting of past financial results – even if those results were achieved by illegal or improper means – is not misleading, but it becomes misleading if those results are falsely attributed to legitimate factors.  Here, Cheetah hedged just enough to make its disclosures technically truthful; Cheetah did not rule out clickfraud, it just, you know, emphasized everything else.

Except.

That is insane.

Does anyone seriously think that investors were any less misled because Cheetah only said its loyal user base was mostly responsible for its revenues?  Are we to believe that there is such a big difference between mostly responsible and just, responsible, full stop, that it would have made a difference to a single trader?

I call this kind of thing a Rumpelstiltskin game; it only counts if the exact magic words are used; if not, case dismissed.  Like the Supreme Court’s decision in Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 575 U.S. 175 (2015) – which invited issuers to couch every statement with the phrase “I believe” in order to have it treated legally as a matter of opinion rather than a representation of fact – these decisions allow defendants to escape liability with a slight rephrase that, in context, is unlikely to have much substantive impact on the listener.

That said, Cheetah is an example of a broader issue I frequently revisit here, which is the doctrinal distortion caused by courts’ continued attempts to distinguish between fraud claims – covered by federal law – and governance claims, which are supposed to be the purview of state law.  Companies are allowed to engage in bad behavior under the federal securities laws; they’re just not permitted to lie about it.  By contrast, poor management is policed by state fiduciary standards.  The line between the two is often very difficult to parse, especially when a fairly anodyne statement conceals pervasive corporate dysfunction.

So in Cheetah’s case, the problem for the court was, yes, there’s little difference between statements like “our success is mainly attributable to our loyal user base” and “our success is attributable to our loyal user base,” but in reality, it’s not clear that investors would care about either statement.  It’s an app company; of course it makes money from users.  Investors are looking at the revenue stream, and if they’re fooled, it’s because they’re making certain assumptions about business regularity.  As I wrote in my article, Reviving Reliance, in these cases, “it is not so much the company’s statements, but its business model that acts as a fraud on shareholders; its mere existence on the market in the guise of a legitimate investment” is the fraud. 

And yeah, we have a concept for that: “Fraud-created-the-market.” But most courts have rejected that theory, so plaintiffs are stuck hunting for isolated misstatements.

But – and here’s the rub – consider Cheetah Mobile in another light.  If we’re going to be honest about it, do we think that any investor really assumed a Chinese mobile app developer distributing programs like “Battery Doctor” and “Speed Booster” operated regularly?  Just how fooled were they likely to be?  Yes, Google kicked them off the platform, but there’s a good argument that this was less because Google suddenly discovered problems than because Google changed, especially in an altered political environment.  We might say that anyone who invests in a skeevy mobile app company notorious for crapware pretty much knows what they’re getting. Which is, in a sense, exactly why the fraud-created-the-market theory proved unmanageable, and we’re stuck playing Rumpelstiltskin.