United States: Southern District Of New York Dismisses In Part Securities Fraud Claims Against Major Industrial Conglomerate, Allowing Claims Based Upon Factoring In Financial Filings To Proceed

Last Updated: September 12 2019
Article by Shearman & Sterling LLP

On August 29, 2019, Judge Jesse M. Furman of the U.S. District Court for the Southern District of New York dismissed most of the securities fraud claims in a putative class action against a major industrial conglomerate (the “Company”), and certain of its current and former executives, brought under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5.  AP-Fonden v. Gen. Elec. Co., 2019 BL 325702 (S.D.N.Y. Aug. 29, 2019).  Plaintiffs alleged defendants concealed performance problems in the Company’s insurance and power divisions.  The Court found, among other things, that plaintiffs did not adequately plead claims based upon allegedly misrepresented liabilities in the Company’s long-term care (“LTC”) insurance portfolio.  The Court did not, however, dismiss plaintiffs’ claim that the Company failed to disclose that it used “factoring” arrangements to generate current revenue by selling future revenues to third parties.

The Company has a diverse portfolio of businesses, including medical technology, aviation, oil and gas, power generation, and financial services.  In 2004, the Company spun off its LTC insurance portfolio.  Although it was no longer writing new LTC insurance policies, it agreed to reinsure much of the LTC insurance portfolio it was transferring.  A few years later, LTC insurers began to experience heavy losses because insurers overestimated the number of policy lapses and interest rates and underestimated the number of claims and how long benefits would be needed.  Around the same time, the Company was selling less power equipment, and consequently entering into fewer long-term service agreements (“LTSAs”) in connection with power equipment sales. 

In the fall of 2017, the Company cut its quarterly dividend in half.  Two months later, the Company announced that it needed to increase reserves for its insurance portfolio by $8.9 billion, resulting in a $6.2 billion charge to earnings.  The first complaint was filed in November 2017.  After several amendments and consolidation with other lawsuits, plaintiffs’ complaint alleged fraudulent statements and omissions over the period from February 27, 2013 to January 23, 2018 concerning (1) the risk and quality of the Company’s LTC insurance portfolio, and (2) its accounting and revenue recognition for certain LTSAs in its power division.  Plaintiffs alleged that the Company knew about its deteriorating LTC portfolio and that its reserves were inadequate but failed to disclose this information.  Plaintiffs also alleged, among other things, that the Company omitted to disclose its reliance on factoring to generate revenues, which allegedly concealed the declining volume of new LTSAs.

The Court granted defendants’ motion to dismiss, except as to plaintiffs’ claims concerning factoring.  First, pointing to the applicable five-year statute of repose, the Court dismissed all claims based on alleged misstatements or omissions made more than five years before they were first asserted in prior complaints or a motion to intervene.  Slip Op. at 14.  The Court rejected plaintiffs’ argument that because they raised claims based upon other statements in SEC filings, then any claim based upon any statement in the same filings was timely.

Next, the Court held that plaintiffs failed to state a claim based on the theory that the Company knew about its exposure to a deteriorating LTC insurance portfolio and that its reserves were insufficient (and lacked actuarial models that would allow it to assess reserve sufficiency).  Specifically, although the re-insurance liabilities were not included in a particular table in the Company’s Management Discussion & Analysis purporting to show “insurance liabilities,” there was a note in the table directing investors to a different part of the Form 10-K (Note 11) that showed significantly higher liabilities.  Because of the information contained in Note 11, the Court found that “no reasonable investor…could leave with the impression… [the Company’s] LTC liabilities were immaterial”.  The Court also found that the Company lacked the requisite scienter because it disclosed its LTC liabilities and directed readers how to find those disclosures. 

Likewise, the Court dismissed claims based on statements about the Company’s insurance reserves.  The Court held these were statements of opinion and that plaintiffs did not sufficiently allege defendants subjectively disbelieved the opinions they expressed.  The Court found that plaintiffs’ allegations about deficiencies in the Company’s actuarial models at most meant defendants allegedly possessed facts that should have led them to inquire further about the reserves, which is not a sufficient basis to assert a claim based on statements of opinion, in particular because the complaint did not include details about how pervasive the problems were with the actuarial models or who specifically knew about them. 

The Court also rejected plaintiffs’ claim that defendants violated Item 303 of Regulation S-K and various GAAP provisions by failing to make certain disclosures in the Company’s financial statements regarding its LTC insurance portfolio.  It found, among other things, that plaintiffs’ allegations did not create a “strong inference” of defendants’ “conscious recklessness,” but supported an alternative inference that defendants did not realize the “brewing storm” in their portfolio, masked in part by sloppy practices, and then made disclosures as they learned about the problems.

With respect to plaintiffs’ claims that the Company fraudulently engaged in “unsustainable” business practices concerning LTSAs, the Court found that plaintiffs did not adequately allege that defendants knew LTSA-related revenue projections were inaccurate or misleading.  The Court did, however, sustain claims based on the allegation that one of the Company’s subsidiaries generated cash by “monetizing receivables” through extensive factoring of LTSAs.  Because factoring LTSA receivables trades away future revenue for immediate cash, the Court concluded that those allegations sufficiently showed that factoring was a trend or event “reasonably likely to” materially impact the Company’s future revenue.

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