Loss Causation and Disclosures of Investigations
ATTORNEY: J. ALEXANDER HOOD II
POMERANTZ MONITOR MARCH/APRIL 2016
In many instances, the first indication of securities fraud is an announcement that a company is under investigation by some government authority—for example, the SEC, the Department of Justice, a U.S. Attorney’s office, or a state attorney general, to name a few. Frequently these announcements are immediately followed by significant stock drops, as the market reacts to the fact of the investigation, even before the investigation’s findings are disclosed. Because the market has already reacted to the bad news, it sometimes fails to react to subsequent news of the investigation’s findings or to disclosure of false statements by the company that the government was investigating. This non-reaction often reflects the fact that investors assumed the worst when the investigation was first announced, and thus do not react a second time to what is, in some sense, the same news, when the fraud at issue is subsequently confirmed.
For plaintiffs in securities fraud lawsuits, however, the market’s failure to react to news confirming the fraud can be a problem. To survive a defendant’s motion to dismiss, the complaint must show that the investor’s economic loss was caused by the revelation of the defendant’s fraud. Thus, when a company’s stock price plummets in reaction to news of an investigation and then barely moves when the fraud is subsequently confirmed, the company may argue that the only loss was caused by the announcement of an investigation, which the company would characterize as an intervening event, and that no losses were directly traceable to disclosure of news of the fraud itself.
Addressing these issues in Jacksonville Pension Fund v. CVB Financial Corporation, the Ninth Circuit Court of Appeals presented a sensible, context-specific view ofloss causation, holding that the announcement of an SEC investigation related to an alleged misrepresentation, coupled with a subsequent revelation of the inaccuracy of that representation, can serve as a corrective disclosure for the purposes of loss causation—in other words, that under such circumstances, the losses caused by the announcement of the investigation are recoverable, even if the stock fails to react to the subsequent confirmation of the fraud.
In 2008, CVB Financial Corporation was informed by the Garrett Group, a commercial real estate company that was CVB’s largest borrower, that Garrett would be unable to make payments on its loans from CVB. After the loans were restructured, Garrett again informed CVB in 2010 that it could not make the required payments and was contemplating bankruptcy. Nonetheless, in 2009 and 2010 SEC filings, CVB represented that there was no basis for “serious doubt” about Garrett’s ability to repay its borrowings.
In 2010, the SEC served a subpoena on CVB, seeking information about the company’s loan underwriting methodology and allowance for credit losses. The day after CVB announced receipt of the SEC subpoena, the company’s stock dropped 22%, from $10.30 to $8.0 0per share, a loss of $245 million in market capitalization.
Analysts noted the probable relationship between the subpoena and CVB’s loans to Garrett. A month later, CVB announced that Garrett was unable to pay its loans as scheduled, wrote down $34 million in loans to Garrett, and placed the remaining $48 million in its non-performing category. On this news, however, the market barely reacted, and CVB’s stock price did not significantly fall.
As lead plaintiff in a consolidated action on behalf of CVB investors, Jacksonville Police & Fire Pension Fund filed a complaint in U.S. District Court for the Central District of California, alleging securities fraud by CVB and certain of its officers. However, the district court granted CVB’s motion to dismiss, holding that Jacksonville had failed to plausibly allege that the statements caused a loss to shareholders, given the market’s failure to react to CVB’s announcement that Garrett would be unable to pay its loans as scheduled.
On appeal, the Ninth Circuit reversed the district court’s decision on the loss causation issue. It agreed with the district court that the only significant fall in CVB’s share price occurred after the announcement of the SEC subpoena, and not after the disclosure that Garrett had failed to repay its loan. It noted that “the announcement of an investigation, standing alone and without any subsequent disclosure of actual wrongdoing, does not reveal to the market the pertinent truth of anything, and therefore does not qualify as a corrective disclosure.” However, the court held that in the case against CVB, the announcement of the SEC investigation did not stand alone; rather, the announcement was followed a month later by the company’s announcement that it was charging off millions in its Garrett loans. The market did not react to the subsequent news about the Garrett loans because the announcement of the SEC investigation foreshadowed the ultimate result. Commenting on the practical effects of its ruling, the Ninth Circuit observed that “any other rule would allow a defendant to escape liability by first announcing a government investigation and then waiting until the market reacted before revealing that prior representations under investigation were false.”
In short, the CVB Financial Corporation decision is a welcome and sensible development that removes a significant potential pleading obstacle to securities class actions in the Ninth Circuit.