Second Circuit Declines To Adopt First Circuit's "Extreme Departure" Standard For Assessing Whether An Issuer Has A Duty To Disclose Interim Financial Information In Securities Offering Documents Under The Securities Act

by Shearman & Sterling LLP
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On June 21, 2017, the United States Court of Appeals for the Second Circuit affirmed a lower court’s decision dismissing a putative class action asserting claims under the Securities Act of 1933 (the “Securities Act”) against Vivint Solar, Inc. (“Vivint”), certain of its officers and directors, and the underwriters of its October 2014 initial public offering (“IPO”).  Stadnick v. Vivint Solar, Inc., No. 16-65 (2d Cir. June 21, 2017).  On appeal, plaintiff relied on the decision of the United States Court of Appeals for the First Circuit in Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996), to argue that Vivint was obligated to disclose in its IPO prospectus and registration statement financial information for the quarter that ended the day before the IPO because, according to plaintiff, the company’s performance during that time constituted an “extreme departure” from past performance.  In affirming the district court’s dismissal, the court declined to follow Shaw, holding instead that the issue of whether Vivint had an obligation to disclose the information should be based on whether the allegedly omitted information would have “significantly altered the total mix of information made available” at the time of the offering.

Vivint installs and then leases solar energy systems to homeowners.  A little over a month after Vivint’s October 1, 2014 IPO, Vivint announced a net income loss of $40.8 million for the third quarter of 2014, which missed analyst projections by 143%.  In the days after this announcement, Vivint’s stock price dropped by approximately 20 percent and fell below the offering price of $16 per share.  Plaintiff alleged that Vivint failed to disclose the interim third‑quarter financial results in the IPO offering materials in violation of Section 11 of the Securities Act.  The district court granted defendants’ motion to dismiss, ruling that the third-quarter results did not amount to an “extreme departure” from previous performance, which is a standard that had been applied by the First Circuit in Shaw, a case involving an alleged failure to disclose interim results, and had been applied by other district courts in the Second Circuit.

On appeal, the Second Circuit affirmed the district court’s dismissal of plaintiff’s Section 11 claim, but expressly declined to adopt Shaw’s “extreme departure” standard.  The court explained that the standard in the Second Circuit for assessing whether there is a duty to disclose interim financial results under the Securities Act is set out in DeMaria v. Andersen, 318 F.3d 170 (2d Cir. 2003), which held that such a duty can arise when “there is a substantial likelihood the disclosure of the omitted [information] would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.”  The court approved of the DeMaria standard because (i) it “rests upon the classic materiality standard in the omission context,” (ii) Shaw’s “‘extreme departure’ test leaves too many open questions,” such as the degree of change necessary to trigger the standard and which metrics should be considered, and (iii) the “extreme departure” test can be “analytically counterproductive” because it can fail to consider appropriately or sufficiently the context of the omitted information.  Applying the DeMaria standard, the Second Circuit determined that the alleged omissions were not actionable because the allegedly omitted information “was consistent” with Vivint’s disclosed results and because a reasonable investor would not have had “solid expectations” with respect to the two metrics focused on by the plaintiffs.  The Second Circuit further held that warnings by the company, including warnings that losses would continue, lent further support to its holding. 

Although the Second Circuit declined to endorse the First Circuit’s “extreme departure” standard, its decision places significant limits on Securities Act claims based on the alleged omission of interim information, including in particular, an emphasis on the consideration of all of the disclosures by a company.  If district courts do the same by taking a rigorous approach to assessing whether the omitted intra-quarter or interim information was material, there should be little, if any difference, between the Vivint and “extreme departure” approaches as applied going forward.  Interim financial data is often preliminary, subject to reconciliation and, almost by definition, partial with respect to any given fiscal quarter.  Particular care, as reflected by the Court’s analysis in Vivint, needs to be taken before declaring such alleged information to be material to investors.  

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