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Second Circuit Affirms Dismissal of Securities Fraud Suit on Materiality Grounds, Embracing SEC Staff Accounting Bulletin No. 99’s Quantitative and Qualitative Factors as Criteria for Materiality at the Motion to Dismiss Stage
April 20, 2015 Download PDF
On April 15, 2015, the Second Circuit issued an opinion in
IBEW Local Union No. 58 Pension Trust Fund & Annuity Fund,
et al. v. The Royal Bank of Scotland Group, PLC, et
al., No. 13-3289, affirming the district court's decision
granting defendants' motion to dismiss for failure to state a claim
of securities fraud. The decision makes clear that defendants
can prevail on materiality grounds on a motion to dismiss and that
the SEC Staff Accounting Bulletin ("SAB") No. 99's quantitative and
qualitative factors for assessing materiality are relevant criteria
for evaluating the legal sufficiency of a plaintiff's
complaint.
Background
Plaintiffs brought suit under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934 against Royal Bank of Scotland
("RBS") on behalf of a putative class of investors who acquired
American Depository Shares of RBS between October 17, 2007 and
January 20, 2009. Among other allegations, plaintiffs alleged
that RBS misrepresented the bank's subprime exposure in a December
2007 press release and falsely stated that the Financial Services
Authority had not required RBS to conduct the Rights Issue that RBS
conducted to raise capital in April 2008.
Specifically, plaintiffs claimed that, in a December 6, 2007 press
release, RBS misrepresented its total U.S. subprime exposure as
$10.3 billion, but later disclosed an actual exposure of $17.1
billion. (Op. 6-7). With respect to the Rights Issue,
plaintiffs claimed that RBS's statements that (1) its Rights Issue
was "purely the Board of RBS['s] decision," and (2) "[t]he
[Financial Services Authority (the "FSA")] are happy to see us
raising capital and encourage us in our plans to do so, but they
didn't request us to do it," were materially false because the CEO
of the FSA later testified that he told RBS on April 9, 2008 that
it was "specifically required" to conduct a Rights Issue.
(Op. 8-9).
Decision
The Second Circuit affirmed the district court's decision
dismissing plaintiffs' allegations, finding, with respect to the
subprime exposure allegations and the Rights Issue allegations,
that plaintiffs had failed to adequately plead materiality.
With respect to the Rights Issue statements, the Second Circuit
held, over a dissenting opinion by Judge Leval, that the statements
were not false because (1) RBS had decided to conduct the Rights
Issue five days before the FSA purportedly "specifically required"
the company to raise capital and (2) RBS had not fallen below FSA's
minimum capital requirements as of early April 2008.
(Op. 20-21). Importantly, however, the court went on to
consider whether, even if the statements were misleading, there was
"a substantial likelihood that the disclosure of the omitted fact
would have been viewed by the reasonable investor as having
significantly altered the 'total mix' of information made
available." (Op. 11, 15). The court carefully
considered the information already in the marketplace at the time
of the April 22 announcement and concluded that "critical facts"
were already known to the market at the time, including that "RBS
needed an infusion of capital," that RBS "was taking additional
write-downs," that FSA was "closely monitoring RBS's situation and
encouraging a Rights Issue" and that "there was generally a steep
deterioration in market conditions and credit market
outlooks." (Op. 21-22). In light of this information,
the court held that a "reasonable investor would have deemed the
difference between 'encouraged' and 'required' to be
immaterial." (Op. 21). [1]
With respect to the December 6, 2007 exposure statements, the
court began by noting that the SEC's SAB 99 considers a
misstatement related to less than 5% of the relevant items on a
registrant's financial statement to be presumptively
immaterial. (Op. 14.) Applying this test, it found that
plaintiffs' allegations related to such a small percentage of the
relevant items on RBS's financial statement (total assets and total
asset backed securities exposure) that they were presumptively
immaterial from a quantitative perspective.
The court noted, however, that SAB 99's 5% "rule of thumb" is not
conclusive and courts must also consider certain qualitative
factors that can turn a "quantitatively immaterial statement into a
material misstatement." (Op. 14). These factors are,
among others, "whether the misstatement 'arises from an item
capable of precise measurement'; 'masks a change in earnings or
other trends'; 'changes a loss into income or vice versa';
'concerns a segment or other portion of the . . . business that has
been identified as playing a significant role in the registrant's
operations or profitability'; 'involves concealment of an unlawful
transaction'; and whether 'a known misstatement may result in a
significant positive or negative market reaction.'" (Op.
14).
Applying these qualitative factors, the Royal Bank of
Scotland court found that plaintiffs had not alleged that "the
amount of exposure could have been calculated precisely, masks a
change in earnings, changes a loss into income or vice versa, or
involves an unlawful transaction, or that the misstatements
resulted in a significant positive market reaction." (Op.
16). Although the court found that "RBS's asset-backed
securitization group was a driving factor in its profitability," it
held that "this factor alone does not tip the scales in favor of
finding the misstatements material." (Op. 16). The
court therefore held that the plaintiffs had failed to adequately
plead materiality with respect to the December 6, 2007
statements. (Op. 17).
Analysis
The Second Circuit's decision confirms that defendants can prevail
at the motion to dismiss stage on materiality, which is an element
of a securities fraud claim that is often thought of as amorphous
and fact-intensive. The decision further demonstrates that it
is appropriate to assess both quantitative and qualitative
materiality at the motion to dismiss stage and that the SEC's
accounting pronouncements contain highly relevant criteria for this
evaluation. Further, the Royal Bank of Scotland
court's willingness to closely parse and evaluate the plaintiffs'
materiality allegations here, particularly with respect to its
analysis of the total mix of information in the marketplace
regarding the Rights Issue, should be encouraging to securities
fraud defendants and serve as helpful precedent for future
defendants at the motion to dismiss stage.
The Royal Bank of Scotland court's analysis of the
materiality of the December 2007 statements indicates that the
courts in the Second Circuit will apply more critical scrutiny to
the qualitative tests of SAB 99 than might previously have been
inferred from the Second Circuit's 2011 decision in Litwin
v. Blackstone Group, LP, 634 F.3d 706 (2d Cir. 2011),
which overturned a district court's dismissal on materiality
grounds. There, the court acknowledged the relevance of the
qualitative and quantitative factors set forth in SAB 99, but went
on to find that a misstatement related to less than 5% of an item
on a registrant's financial statement was qualitatively material,
in part because the alleged misstatement related to a segment that
played a "significant role" in the defendant's business.
Id. at 720. In contrast, the Royal Bank of Scotland
court found that the fact that RBS's asset-backed securitization
group was a driving factor in RBS's profitability was not enough,
on its own, to "tip the scales in favor of finding the
misstatements material." (Op. 16).
Royal Bank of Scotland provides important support for
defendants seeking to dismiss securities fraud lawsuits on
materiality grounds. The Royal Bank of Scotland
court was clear that materiality should be assessed from a
quantitative and qualitative perspective at the motion to dismiss
stage and that the importance of a business segment to a company
alone is insufficient to overcome the presumption of immateriality
for allegations relating to less than 5% of an item on a
registrant's financial statement. Further, Royal Bank of
Scotland demonstrates that an analysis of the total mix of
information in the marketplace need not wait until summary judgment
and that a court can conclude, as a matter of law, that an alleged
misstatement would not have altered this mix.
[1] Judge Leval dissented on this point, writing separately to express his opinion that RBS's statement that the FSA had not asked it to raise capital was materially false. Judge Leval found that a statement that the FSA had not told RBS to raise capital was false even if the CEO of the FSA did not tell RBS to raise capital until after RBS had decided to raise capital on its own. Judge Leval reasoned that a regulatory agency's finding that the bank's capital was dangerously low would be important to a reasonable investor and therefore the misstatement was material.