Securities Regulation Daily Shareholder plausibly alleges fraud against Zillow, officers
Monday, April 22, 2019

Shareholder plausibly alleges fraud against Zillow, officers

By Rebecca Kahn, J.D.

Second amended complaint alleged more particularized facts that Zillow designed its co-marketing program to allow, and even encourage agents and lenders to violate RESPA. This cured deficiencies that resulted in a prior dismissal

After reviewing Zillow shareholders’ second amended complaint, the district court in Seattle found that it plausibly alleged that Zillow officers made material misstatements or omissions about a Consumer Financial Protection Bureau inquiry into the company’s potential RESPA violations. The court also found revised pleadings of loss causation and scienter sufficient to withstand a motion to dismiss In re Zillow Group, Inc. Securities Litigation (April 19, 2019, Coughenour, J.).

Shareholders filed this putative class action against Zillow Group, Inc. alleging violations of Exchange Act Sections 10(b) and 20(a) and Rule 10b–5. The plaintiffs also named as defendants Zillow’s CEO and CFO/Chief Legal Officer ("officer defendants"). The plaintiffs’ claimed that Zillow’s "co-marketing program" was designed to allow participating real estate agents to refer mortgage business to participating lenders in violation of Section 8(a) of the Real Estate Settlement Procedures Act ("RESPA"). RESPA prohibits kickbacks or other referral fees where a federally related mortgage loan is involved, but a safe harbor provision permits payment for goods or services actually furnished or performed.

The plaintiffs asserted that the defendants made a series of misleading statements regarding Zillow’s legal compliance by failing to disclose the co-marketing program’s illegality, particularly after the Consumer Financial Protection Bureau ("CFPB") launched an investigation into the program in April 2015. The plaintiffs alleged that the defendants’ misrepresentations about Zillow’s legal compliance caused them to purchase the company’s stock at artificially inflated prices.

Dismissal. In October of 2018, the court dismissed the case for failing to allege with particularity that co-marketing agents were actually providing unlawful referrals to lenders. The court rejected the plaintiffs’ theory that the co-marketing program violated RESPA by allowing lenders to pay more than fair market value for advertising services. The complaint also failed to plead with particularity any false statements or omissions on the part of Zillow management.

In its dismissal order, the court instructed the plaintiffs that an amended complaint must assert particularized facts demonstrating that Zillow designed the co-marketing program to violate RESPA, and that Zillow was instructing and encouraging third-parties to commit such violations. In addition, it must allege with particularity that the defendants made material false or misleading statements regarding the co-marketing program’s compliance with RESPA, that the defendants’ statements evinced a strong inference of scienter, and that such statements caused the alleged loss.

Second amended complaint. In their second amended complaint ("SAC"), the plaintiffs alleged that the co-marketing program was designed to violate RESPA and that the defendants made false statements regarding Zillow’s legal compliance. The SAC also alleged, for the first time, that the defendants violated the Consumer Financial Protection Act ("CFPA"), by providing "substantial assistance" to co-marketing participants who were violating RESPA. The defendants moved to dismiss.

Anonymous witnesses. The SAC asserted that the purpose of the co-marketing program was "to enable lenders to obtain referrals in exchange for payments to [Zillow]" and that "Zillow designed the program with the understanding that agents would . . . use it to violate RESPA by making illegal referrals to lenders." It further alleged that "Zillow actively monitored and encouraged lenders and agents to violate RESPA, contacting agents to make sure they are making referrals." The plaintiffs offered statements from two anonymous witnesses who were Zillow employees. The first was a regional sales manager who stated that co-marketing lenders received fewer leads than their co-marketing agents but continued to participate in the program because "lenders expected real estate agents to refer business." She further stated that she did not believe "lenders recoup[ed] advertising costs through leads from the Zillow site but through the referral relationship forged with the real estate agent."

A second anonymous witness was a sales and operations trainer on the co-marketing program. She stated that "[e]very agent and lender knew that the Co-Marketing program was for the lender to get leads and referrals," and that "everyone knew that the lenders paid the agents for leads and referrals." She further stated that Zillow trained its sales representatives to "track the number of referrals lenders received from the co-marketing program."

Based on the anonymous witnesses’ statements, as well as the other allegations in the SAC, the court could draw a reasonable inference that Zillow designed the co-marketing program to allow agents to provide referrals to lenders in violation of RESPA, and that such referrals were occurring. The SAC contained particularized facts alleging that there was an understanding between Zillow and the co-marketing participants that in exchange for lenders paying a portion of agents’ advertising costs, lenders would receive mortgage referrals from their partnering agents. That arrangement—although not ostensibly based on an oral or written agreement—was evinced by participating agents allegedly providing, and Zillow allegedly tracking, referrals to participating lenders. Such allegations were sufficient to support an "agreement or understanding for the referral of business" based on a "pattern or course of conduct" in violation of RESPA.

Fair market value of co-marketing services. The SAC alleged that the co-marketing program was not protected by RESPA’s safe harbor "because it permitted lenders to pay a greater share of the marketing budget than is justified by the number of leads provided by the program." The SAC contained new factual allegations describing how the co-marketing program’s pricing "was drastically more expensive for lenders than comparable product offerings by Zillow." The SAC additionally alleged that the price of co-marketing advertising did not bear a rational relationship to its actual market value because the price was based on different criteria than other advertising Zillow sold directly to lenders. The plaintiffs asserted that these variations in pricing demonstrated that co-marketing advertising fell outside RESPA’s safe harbor. The court drew a "reasonable inference" that Zillow designed the co-marketing program to allow lenders to pay more than fair market value for the advertising they received and therefore fell outside RESPA’s safe harbor provision. Viewed in the light most favorable to the plaintiffs, the SAC alleged facts allowing an inference that co-marketing lenders primarily valued leads and referrals.

Taken together, the SAC’s allegations allowed a reasonable inference that the co-marketing program allowed lenders to pay more than fair market value for the advertising Zillow provided in return. These allegations satisfied the court’s prior order to "assert particularized facts" demonstrating that Zillow designed the co-marketing program to violate RESPA, and that "Zillow was instructing and encouraging third-parties to commit such violations."

CFPA theory rejected. The SAC alleged that Zillow "substantially assisted" co-marketing agents and lenders in committing RESPA violations, which represent "abusive practices" in violation of the CFPA. The court declined to rule that RESPA violations represent an abusive practice under the CFPA and rejected this CFPA theory of liability.

Misleading statements. The plaintiffs asserted that defendants made materially misleading publicly filed statements regarding its general legal compliance, and officers’ statements regarding the co-marketing program and the CFPB’s investigation of it. In publicly filed SEC statements, Zillow allegedly made statements or omission regarding the company’s compliance with government regulations. These statements included Zillow’s initial registration statement that was signed by defendant officers. The initial registration statement also included a merger agreement between Zillow and Trulia with a warranty that Zillow was not in conflict with, in default, breach or violation of any law. The plaintiffs alleged that these statements were misleading "for failing to disclose that Zillow’s co-marketing program was designed to allow real estate agents and lenders to violate RESPA."

The court characterized Zillow’s general legal compliance statements as opinions supported by embedded facts. But Zillow’s opinion that it was endeavoring to comply with the law was based on the factual assertion that it was "obtaining assurances of compliance from our advertisers and customers for their activities through, and the content they provide on, our mobile applications and websites." That statement was not one of belief, but rather expressed that Zillow was taking affirmative action to ensure compliance, the court noted. The plaintiffs thus have alleged particularized facts demonstrating that the defendants’ legal compliance statements were materially misleading. The SAC plausibly alleged that the defendants designed the co-marketing program to allow agents and lenders to exchange payments for referrals in violation of RESPA, and that Zillow was encouraging this practice. The plaintiffs also allege particularized facts demonstrating that the co-marketing program was designed to allow lenders to pay above fair market value for the advertising services they received from Zillow. The defendants’ omission of such facts made their opinion about its general legal compliance materially misleading. The omitted facts suggested Zillow did not actually intend or endeavor to comply with laws and regulations such as RESPA.

In its prior order, the plaintiffs had not pleaded particularized facts demonstrating that the change to the co-marketing program was done in response to the CFPB’s investigation. The court noted that "[w]hile the confidential witness states that she believes the changes were implemented in response to a government investigation, neither she, nor the amended complaint, contain particularized facts that demonstrate the co-marketing program was altered to ‘remedy RESPA violations identified by the CFPB.’" The SAC cured that deficiency, the court ruled, because it plausibly alleged that the co-marketing program violated RESPA by allowing lenders to pay above fair market value for the advertising Zillow provided.

Scienter. The SAC contained particularized facts that plausibly allege Zillow designed the co-marketing program in a way that violated RESPA and that Zillow was encouraging such violations. Having made that finding, the court concluded that the allegations, viewed holistically, supported a strong inference that both defendant officers were deliberately reckless in making their materially misleading statements. The SAC alleged particularized facts demonstrating that the co-marketing program was part of Zillow’s core operations and that the defendant officers had displayed their familiarity with the program.

Loss causation. Because the SAC successfully pleaded a material misleading statement regarding the co-marketing program’s compliance with RESPA, it now plausibly alleged that Zillow’s August 2017 statements represented a ‘corrective disclosure’ supporting loss causation. The SAC plausibly alleges that the defendants made material misleading statements with the requisite scienter that caused the plaintiffs’ losses. As such, the court found that the SAC adequately pleaded loss causation.

Control person liability. As the SAC plausibly alleged Section 10(b) violations against Zillow, and alleged that defendant officers’ corporate positions gave them control over Zillow, the SAC plausibly alleged a violation of Section 20(a) against the officer defendants.

The case is No. C17-1387-JCC.

Attorneys: Clifford A. Cantor (Clifford A. Cantor, Attorney at Law) for James Shotwell. Jonathan Stern (The Rosen Law Firm P.A.) for Jo Ann Offutt. Alexander Mircheff (Gibson, Dunn & Crutcher LLP) for Zillow Group, Inc.

Companies: Zillow Group, Inc.

MainStory: TopStory FedTracker Securities FraudManipulation WashingtonNews

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