“Lumpiness” insufficient When the Ship is Going Down

by David Cosgrove

Class action investors recently won a partial victory against Dolan Company in the 8th Circuit Court of Appeals. I stress partial because, while the trial court’s dismissal was reversed, its severe limitation of the loss–causation period was sustained.

The plaintiffs alleged that Dolan Company made misleading public statements about the financial condition of one of its litigation-support subsidiaries. Dolan allegedly knew as early as June of 2013 that the subsidiary, DiscoverReady, was on the brink of losing its primary customer, Bank of America. Despite this knowledge, Dolan subsequently praised the subsidiary’s prior and anticipated revenue growth, only later merely cautioning that future revenues “may experience lumpiness on a quarter-to-quarter basis.” Dolan made this statement on August 1, 2013 and apparently fell silent until November 12, 2013. On that date it issued a press release and filed its Form 10-Q, revealing that its unexpected revenue decline was “largely due to a reduction in work from [DiscoverReady’s] largest customer.” Dolan’s share price fell all the way to $.90 a share over the next 48 hours. It filed a Chapter 11 bankruptcy about 6 weeks later.

Section 10(b) of the Securities Exchange Act makes it unlawful to use or employ, in connection with the purchase or sale of any security, any manipulate or deceptive device. The implementation rule, 10(b)5, clarifies that it is unlawful to make any untrue statement of a material fact or to omit to state a material fact. Both the statute and the rule require a showing of “scienter.” Pursuant to the Private Securities Litigation Reform Act, scienter can be established by a deceitful or manipulative state of mind, severe recklessness, or motive and opportunity. But without a showing of motive and opportunity, other scienter allegations need to be strong. And since the Dolan executives did not sell their shares before they “came clean” in November, the District Court concluded that the class complaint lacked sufficient allegations of scienter. The Court of Appeals disagreed.

On appeal the plaintiffs argued that they had “adequately pled scenter by alleging that Dolan had been ‘severely reckless.’” Citing In re K-tel Intern, the Court of Appeals agreed, explaining in part that:

Without a showing of motive or opportunity, other allegations tending to show scienter would have to be particularly strong in order to meet the scienter standard for a securities fraud claim. “Severe recklessness,” for purposes of scienter requirement of a securities fraud claim, is defines as highly unreasonable omissions or misrepresentations involving an extreme departure from the standards of ordinary care, and presenting the danger of misleading buyers or sellers which I either known to the defendant or is so obvious that the defendant must have been aware of it.

The plaintiffs may have won that battle but then lost at least half the war, as the Court of Appeals sustained the district court’s dismissal of any claims running between November 12, 2013 and January 2, 2014. Like the district court, it concluded that there was no “loss-causation” between those dates because the January 2, disclosures failed to correct what was said on November 12, 2013. As such, the drop in stock prices after the November 12 disclosure could not be attributable to the earlier misrepresentations. As such, only those individuals who purchased shares between August 1 and November 11 had actionable damages. In other words, the drop in Dolan Company shares after the “record was corrected” on November 11 was likely caused by factors other than a revelation about the misleading nature of statements made in June. Perhaps the Court of Appeals explained it better than I am able:

A drop in stock price is not necessarily caused by an earlier misrepresentation. Lower stock prices “may reflect, not the earlier misrepresentation, but changed economic circumstances, changed investor expectations, new industry-specific of firm-specific facts, conditions, or other events, which taken separately or together account for some or all of that lower price.” Dura Pharm., 544 U.S. at 343, 125 S.Ct. 1627. Rand-Heart must show that Dolan’s fraud – “and not other events” – caused the price to fall after the January 2 press release. See Schaaf v. Residential Funding Corp., 517 F.3d 544, 550 (8th Cir.2008).

Nothing in the January 2 press release corrects previous misrepresentations. “Corrective disclosures must present facts to the market that are new, that is, publicly revealed for the first time, because if investors already know the truth, false statements won’t affect the price.” Katyle v. Penn Nat. Gaming, Inc., 637 F3d. 462, 473 (4th Cir.2011) (internal quotations omitted). Announcing the appointment of a restructuring officer on Januar 2, does not correct a misrepresentation; it elaborates on the previously disclosed plan to restructure. “In the financial markets, not every bit of bad new that has a negative effect on the price of a security necessarily has a corrective effect for purposes of loss causation.” Meyer v. Greene, 710 F3d. 1189, 1202 (11th Cir.2013). See also In re Williams Sec. Litig.-WCG Subclass, 558 F3d. 1120, 1140 (10th Cir.2009) (“To be corrective, the disclosure need not precisely mirror the earlier misrepresentation, but it must at least relate back to the misrepresentation and not to some other negative information about the company.”).

If you want to read the case for yourself, click here. It is a fairly good primer on fraud in the market class action securities litigation.