On October 8, 2020, the US Court of Appeals for the Ninth Circuit reversed the dismissal of a securities fraud class action suit against San Diego-based BofI Holding, Inc., now known as Axos Bank. In its opinion, a majority of the appellate panel held that a former employee's allegations of fraud in a whistleblower's lawsuit may qualify as a "corrective disclosure" and may be used to plead loss causation under the Private Securities Litigation Reform Act of 1995 ("PSLRA"), as long as the allegations are plausible, and even if there are no additional disclosures or evidence corroborating the allegations.
In so holding, the Ninth Circuit joined the Sixth Circuit in rejecting the "categorical rule that allegations in a lawsuit, standing alone, can never qualify as a corrective disclosure." In a dissenting opinion, one panelist expressed his preference for a bright-line rule that requires an external disclosure or evidence that confirms the allegations in a whistleblower's lawsuit over the majority's approach, which he fears opens the door for meritless securities fraud suits that impose exorbitant costs on companies.
The case is In re BofI Holding, Inc. Sec. Litig., No. 18-55415, 2020 WL 5951150. US Circuit Court Judges Paul J. Watford, Mar J. Bennet and Kenneth K. Lee sat on the panel for the Ninth Circuit.
District Court Proceedings
BofI Holding, Inc., is the holding company for BofI Federal Bank (collectively "BofI"), a federally chartered savings association. In the years preceding the litigation, BofI's stock price rose handsomely due to strong reported earnings growth. Between August 2015 and February 2016, however, the price of BofI's stock plummeted by more than 47 percent. As a result, BofI shareholders filed multiple securities fraud suits against the company and several of its officers and directors under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The lawsuits were consolidated into a putative class action, which was brought on behalf of all BofI shareholders who purchased publicly traded stock between September 4, 2013 and February 3, 2016. The shareholders alleged that BofI executives made false or misleading statements touting the bank's conservative loan underwriting standards, its effective system of internal controls and its robust compliance infrastructure. The shareholders predicated their showing of falsity on allegations attributed to confidential witnesses, former BofI employees who purportedly would testify that the bank, despite its public pronouncements, consistently overrode the concerns of internal auditors, altered reports and falsely responded to regulatory subpoenas.
The district court dismissed the operative complaint on the grounds that the shareholders failed to adequately plead loss causation, which is one of six elements a plaintiff must allege to state a securities fraud claim. To plead loss causation, the complaint relied on two corrective disclosures: (i) a whistleblower lawsuit filed in August 2015 by a former mid-level auditor at the company, alleging rampant and egregious wrongdoing at the company; and (ii) eight blog posts published by anonymous authors on the financial crowd-sourced website Seeking Alpha, arguing that things at BofI were not as rosy as they seemed. In dismissing the complaint, the district court reasoned that because the whistleblower lawsuit contained only "unconfirmed accusations of fraud," it could not have disclosed to the market that BofI's alleged misstatements were actually false. To qualify as a corrective disclosure, the district court held, the lawsuit had to be followed by "a subsequent confirmation" of the fraud, which the shareholders had not alleged. The district court further held that the blog posts could not serve as corrective disclosures because they relied on publicly available information, which was presumably already known to the market and thus reflected in the company's stock price. The district court dismissed the action with prejudice on these grounds, and plaintiffs appealed.
The Ninth Circuit Panel's Majority Holding
The Ninth Circuit reversed the district court's decision. Disagreeing with the district court's reasoning, the Ninth Circuit held that the plaintiffs alleged particularized facts plausibly suggesting that the market perceived the whistleblower's allegations as credible and acted upon them on the assumption that they were true. The whistleblower's descriptions of wrongdoing by the company were, as alleged by the shareholders and credited by the Ninth Circuit, highly detailed, specific and based on firsthand knowledge that the whistleblower likely possessed by virtue of his position as a mid-level auditor at the company. Additionally, the shareholders alleged that BofI's stock price fell by more than 30 percent immediately after the market learned of the whistleblower's allegations. Although the Ninth Circuit acknowledged that the whistleblower's motivations for coming forward may not have been entirely pure, because he lodged his allegations in a lawsuit seeking money from BofI, it nevertheless concluded that a price drop of that magnitude would not be expected in response to whistleblower allegations perceived as unworthy of belief. Thus, the Ninth Circuit joined the Sixth Circuit in rejecting the categorical rule that allegations in a lawsuit, standing alone, can never qualify as a corrective disclosure:
If the market treats allegations in a lawsuit as sufficiently credible to be acted upon as truth, and the inflation in the stock price attributable to the defendant's misstatements is dissipated as a result, then the allegations can serve as a corrective disclosure. The plaintiff must, of course, prove that the defendant's misstatements were false, but that can be done through proof other than the corrective disclosure itself.
According to the Ninth Circuit, the whistleblower's allegations "established fire and not just smoke."
Separately, the Ninth Circuit agreed with the district court's conclusion that plaintiffs failed to plausibly allege that the Seeking Alpha blog posts constituted corrective disclosures, although the panel disagreed somewhat with the district court's reasoning. The Ninth Circuit concluded that, even if the posts disclosed information that the market was not previously aware of, it was not plausible that the market reasonably perceived the posts as revealing the falsity of BofI's prior misstatements. The posts were authored by anonymous short-sellers who had a financial incentive to convince others to sell, and the posts included disclaimers from the authors stating that they made "no representation as to the accuracy or completeness of the information set forth in this article." The Ninth Circuit thus held that a reasonable investor reading these posts "would likely have taken their contents with a healthy grain of salt."
Partial Dissent
Judge Lee dissented from the majority's holding that a whistleblower's lawsuit can qualify as a corrective disclosure for purposes of pleading loss causation. Judge Lee acknowledged that he agreed with much of the analysis in the majority's "thoughtful" opinion, which attempted to balance competing concerns on a difficult issue. Judge Lee, however, feared that the majority's decision "will have the unintended effect of giving the greenlight for securities fraud lawsuits based on unsubstantiated assertions that may turn out to be nothing more than wisps of innuendo and speculation." And, as Judge Lee explained, "even meritless securities fraud lawsuits impose an exorbitant cost on companies."
First, Judge Lee disagreed with the majority's conclusion that the whistleblower's allegations against BofI are plausible enough to constitute a corrective disclosure. Indeed, BofI has not issued any financial disclosures that would confirm the whistleblower's allegations that he first aired in 2015. Moreover, in the five years that have passed since the whistleblower disclosed his allegations of misconduct at BofI, investigations commenced by multiple government agencies into BofI have adduced no evidence corroborating the allegations. Thus, Judge Lee noted, "it may turn out that there may be smoke but no fire." Accordingly, the parties may end up in a scenario in which the whistleblower fails to prevail at his trial, which should occur sometime next year, and BofI, nevertheless, settles this case for a substantial sum to avoid litigation costs.
Second, Judge Lee also disagreed with the majority's use of the plausibility standard under Iqbal and Twombly to analyze the allegations in the whistleblower's lawsuit. An insider account will almost always have a "patina of plausibility" because, as Judge Lee observed, it will likely be based on some non-public allegation that cannot be easily disputed or rebutted at the pleading stage. The plausibility standard, therefore, provides little comfort to companies that may face securities fraud lawsuits based on unsubstantiated insider allegations.
Third, Judge Lee disagreed with the majority's analysis of the stock drop. The fact that BofI's shares plummeted 30 percent after the whistleblower publicly accused his former employer of fraud did not, as the majority concluded, demonstrate that the whistleblower's allegations revealed the "truth" and acted as corrective disclosure. Rather, In Judge Lee's estimation, the whistleblower's lawsuit is better construed as a disclosure of "an added risk of future corrective action." Based on the foregoing, Judge Lee concluded that "if a securities fraud lawsuit turns on insider allegations of wrongdoing in a whistleblower lawsuit, I would prefer a bright-line rule that requires an external disclosure or evidence that confirms those allegations."
Separately, Judge Lee agreed with the majority that the Seeking Alpha posts are not corrective disclosures. He preferred, however, to base the decision on the grounds that the posts contain public information only and that the Ninth Circuit "should not credit anonymous posts on a website notorious for self-interested short-sellers trafficking in rumors for their own pecuniary gain."
Key Takeaways
Congress passed the PSLRA because it expressly recognized that securities class actions threaten to impose unduly burdensome costs on publicly traded companies and their directors and officers. Accordingly, for 25 years, the PSLRA's heightened pleading standards have stood as a bulwark—although imperfect in some cases—against meritless suits. The Ninth Circuit's decision in BofI Holding may erode some of the protections for securities class action defendants that Congress intended to provide in the PSLRA.
In addition, securities class action plaintiffs' confidential witness allegations have been met with increasing skepticism by courts over the past decade. The Ninth Circuit's BofI Holding decision may portend a new trend in securities class actions, in which shareholder plaintiffs seize on unsubstantiated (and possibly meritless) whistleblower complaints as a foundation for pleading loss causation in future cases.Visit us at mayerbrown.com
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