Securities Regulation Daily Categorical rule that lawsuit allegations cannot be corrective disclosures rejected
Tuesday, October 13, 2020

Categorical rule that lawsuit allegations cannot be corrective disclosures rejected

By Rodney F. Tonkovic, J.D.

Can allegations in a whistleblower lawsuit, with no additional confirmation, serve as a corrective disclosure? The Ninth Circuit says, "yes."

A Ninth Circuit panel held that allegations in a whistleblower lawsuit served as a corrective disclosure. With this holding, the court joined with the Sixth Circuit in rejecting any categorical rule that allegations in a lawsuit, standing alone, can never qualify as a corrective disclosure. For loss causation purposes, the market must perceive the allegations as credible and act upon them on the assumption that they are true. The panel accordingly reversed the district court's dismissal of the action and remanded for proceedings consistent with this opinion (In re BofI Holding, Inc. Securities Litigation, October 8, 2020, Watford, P.).

BofI Holding. BofI Holding Inc. is a holding company for a federally chartered savings association. The company had reporting strong earnings for several years but experienced an almost 50 percent stock price drop between August 2015 and February 2016. Multiple fraud suits were filed and later consolidated into this action, which alleges that BofI executives falsely portrayed the company as a safer investment than it was. Specifically, the complaint alleged that BofI touted its conservative loan underwriting standards, effective internal controls, and robust compliance infrastructure.

Dismissed by district court. At issue on appeal was the district court's dismissal with prejudice of the third amended complaint for failing to adequately plead loss causation. The district court had found, and the panel agreed, that falsity and scienter were adequately pleaded. The complaint relied on two corrective disclosures to establish loss causation, arguing that they revealed the falsity of BofI's statements. First, a whistleblower lawsuit filed in 2015 alleged the existence of serious compliance issues. A second disclosure consisted of anonymous blog posts on Seeking Alpha alleging evidence of potential regulatory violations and risky loan origination partnerships. The district court reasoned that the whistleblower lawsuit contained only unconfirmed accusations and was thus not a corrective disclosure. The blog posts, the court said, relied on publicly available information and, as a result, could not have revealed anything to the market.

What is a corrective disclosure? In this case, the shareholders invoked the "fraud-on-the-market" presumption of loss causation, meaning that, the panel explained, at some point the truth was revealed, causing the fraud-induced inflation in the stock's price to be reduced. The truth is commonly revealed via a corrective disclosure that disseminates to the market information correcting the misstatement or omission, the panel said, and this disclosure must be linked to a decline in the company's stock price.

Whistleblower allegations are corrective. The panel first concluded that the allegations in the whistleblower lawsuit constituted a corrective disclosure. The allegations in the suit "unquestionably" revealed that at least some of BofI's alleged misstatements were false, and the company's share price dropped by over 30 percent immediately after the market learned of the allegations via an article in the New York Times. To plead loss causation, the panel said, the shareholders were not required to establish that the allegations were true—falsity and loss causation are separate elements—just that the market perceived them as credible and acted accordingly. In this case, the allegations were highly detailed and based on firsthand knowledge. Plus, the fact that the stock price dropped by a large amount on extremely high trading volume bolstered the inference that the market viewed the allegations as credible.

Here, the Ninth Circuit joined with the Sixth in rejecting any categorical rule stating that allegations in a lawsuit, standing alone, can never qualify as a corrective disclosure. Short of an admission or formal finding of fraud, which are not required, the panel said, any corrective disclosure takes the form of contestable allegations of wrongdoing. For loss causation purposes, what matters is that the market treats the allegations as credible and acts upon them as truth and that the inflation in the stock price attributable to the misrepresentation is dissipated as a result, the panel said.

Blog posts. On the other hand, the panel agreed that the Seeking Alpha blog posts were not corrective disclosures but disagreed with the district court's reasoning. The fact that the blog posts relied on public information, the panel said, did not by itself preclude them from qualifying as corrective disclosures, since the information can be "new" if the market has not yet understood its significance. For pleading purposes, the panel held that a shareholder relying on a corrective disclosure based on publicly available information must allege facts plausibly suggesting that other market participants had not—not, as the district court interpreted the requirement, could nothave—done the same analysis and reached the same conclusions. The blog posts in this case, however, failed to meet this standard because they were written by anonymous short-sellers with a financial incentive to convince others to sell, meaning that a reasonable investor would take them "with a healthy grain of salt."

Dissent. A member of the panel took issue with the holding on the whistleblower allegations, dissenting on that portion of the judgment while concurring with the rest. The judge based the dissent on the potential for lawsuits based on unsubstantiated assertions that turn out to be "wisps of innuendo and speculation." This judge would accordingly prefer a bright-line rule requiring additional external confirmation of fraud allegations before they are counted as a corrective disclosure. In this case, to date there has been no external evidence from, for example, BofI or resulting from government investigations, corroborating the whistleblower's allegations. The allegations were "ominous," the judge said, but the subsequent drop in share price was attributable to market speculation that fraud may have occurred.

The case is No. 18-55415.

Attorneys: Katherine C. Lubin (Lieff Cabraser Heimann & Bernstein, LLP) for Houston Municipal Employees Pension System. Alejandro Emmanuel Moreno (Sheppard, Mullin, Richter & Hampton LLP) for BofI Holding, Inc.

Companies: Houston Municipal Employees Pension System; BofI Holding, Inc.

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