If you thought it was difficult to make a federal securities fraud claim stick in the Fourth Circuit, the court has now raised the bar even higher. The Fourth Circuit recently affirmed a trial court’s dismissal of securities fraud claims arising out of a company’s restatement of its financial results. Traditionally, financial restatements have proved fertile ground for plaintiffs to pursue such claims. The dismissal was based on the plaintiffs’ inadequate pleading of scienter (i.e., fraudulent intent) in their complaint. The case underscores the difficulties faced by plaintiffs in bringing fraud claims under the federal securities laws in cases where there is any plausible alternative explanation for the alleged misrepresentation or omission.
The corporate defendant, Municipal Mortgage & Equity (“MuniMae”), organized and managed investment partnerships. MuniMae historically treated these partnerships as off balance sheet entities. In 2003, new accounting guidance required MuniMae to include the assets and liabilities of the investment partnerships on its own financial statements. MuniMae, however, left many of the partnerships off of its balance sheet until 2008, necessitating a substantial restatement that cost $54.1 million to complete. News of the restatement and the associated costs were followed by a significant drop in MuniMae’s stock price.
Various MuniMae shareholders brought securities fraud claims under Section 10(b) of Exchange Act and Rule 10b-5. The shareholders contended that the company, along with its officers and directors, misled investors: (i) by issuing financial statements that did not comply with accounting principles, and (ii) by concealing the costs to the company of compliance with those principles.
The trial court dismissed the complaint for failure adequately to plead scienter, and the Fourth Circuit affirmed. The Fourth Circuit explained that the Private Securities Litigation Reform Act imposes a heightened pleading standard on fraud allegations in private securities complaints. The complaint must “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C. § 78u-4(b)(2).
Plaintiff sought to establish scienter based on, among other things: (a) three confidential witness statements, (b) high turnover in MuniMae’s CFO position, (c) MuniMae’s firing of its auditor in 2006, and (d) alleged insider trading by company management. The Fourth Circuit carefully evaluated each of these allegations and concluded that while many of the allegations would reasonably support an inference of scienter, they could just as reasonably support an inference that the defendants acted innocently or merely negligently. Accordingly, Plaintiffs failed to meet their pleading burden and the case was properly dismissed.
The case highlights the Fourth Circuit’s strict attention to the scienter requirement and the challenges associated with a claim under Section 10(b) or Rule 10b-5. In this case the company had restated its financial statements, which was effectively an admission both that the company had made a misstatement and that the misstatement was material – two core elements of a securities fraud claim. Furthermore, the plaintiffs alleged the existence of multiple “red flags” that should have alerted management to the accounting problems, red flags that the Fourth Circuit acknowledged were “not insubstantial.” The Fourth Circuit nevertheless held that the plaintiffs’ complaint was insufficient to establish the “strong inference of scienter” required to state a claim under Section 10(b) or Rule 10b-5.
The case, Yates v. Municipal Mortgage & Equity, LLC, is available HERE.