We have seen the scenario before – shortly after its debut, an IPO company releases unexpected results, the company’s share price declines, and the lawsuits appear. Usually when this happens, the updated results pertain to reporting periods following the IPO. But what about a situation where the disappointing results pertain to a reporting period that was completed prior to the IPO – in fact, the day before the IPO? That was the situation involving Vivint Solar, where the company released results for the reporting period ending September 30, 2014 – that is, just a day before the company’s October 1, 2014 IPO –several weeks after the company’s debut.
The subsequent lawsuit against Vivint raised the question of the standard to be used to determine when an IPO company must disclose interim financial information in its registration statement in order to ensure that its disclosures are not otherwise misleading.
The plaintiff shareholder attempted to argue, in reliance on the First Circuit’s 1996 decision in Shaw v. Digital Equipment, that the company should have released the third quarter results at the time of the IPO because the results represented an “extreme departure” from the company performance reflected in the registration statement. In affirming the trial court’s dismissal of the lawsuit, the Second Circuit rejected the plaintiff’s attempt to rely Shaw, saying that the correct standard under its own 2003 decision in DeMaria v. Anderson is not whether the omitted information represents an “extreme departure,” but rather whether from the perspective of a reasonable investor the omitted information would have significantly altered the total mix of information available.
The Second Circuit’s discussion of the appropriate standard to be used in determining when interim financial information must be disclosed in a registration statement is interesting and raises a number of issues, as discussed below. The Second Circuit’s June 21, 2017 decision in the Vivint Solar case can be found here.
Background
Vivint Solar is a residential solar energy installation company. In order to take advantage of renewable energy tax credits, Vivint continues to own the energy units it installs, making its money from selling the solar energy generated to the home owners. The company finances the energy unit installations with funds provided by outside investors. In light of the outside investors’ role, Vivint allocates its income between its public shareholders and the outside investors. To calculate the shareholders’ income, Vivint subtracts from overall income the portion allocated to the outside investors. Thus, the portion of income allocable to shareholders is susceptible to changes in the amount of income allocable to the outside investors, particularly if, for example, the income allocable to outside investors is negative. Because of these factors, Vivint’s income to shareholders can vary substantially from quarter to quarter.
Vivint completed an IPO on October 1, 2014. In its registration statement, the company identified “key operating metrics,” including, for example, system installations, megawatts installed, and estimated contract payments remaining.
On November 10, 2014, Vivint issues a press release disclosing the financial results for the quarter ending on September 30, 2014 (that is, the day before the company’s IPO). The press release reported that net loss attributable to the outside investors had declined from a negative $45 million in the prior quarter to negative $16.4 million in the third quarter, contributing to a substantial decrease in the net income for shareholders from a positive $5.5 million in the prior quarter to negative $35.3 million in the third quarter. The press release did, however, note that the company had surpassed analysts’ estimates of the key operating metrics the company had identified in the registration statement. The company’s share price declined 22.5% based on the press release.
Finally, on November 12, 2014, the company issued is quarterly report on SEC Form 10-Q in which the company disclosed that the company’s solar installations in Hawaii had decreased by 15%. The company’s share price declined 5%.
Plaintiff shareholders filed a securities class action lawsuit under Sections 11 and 15 of the Securities Act of 1933 in the Southern District of New York against the company, certain of its directors and officers, the offering underwriters, and its private equity sponsor. The defendants moved to dismiss, arguing among other things that Vivint’s registration statement was in in compliance with SEC Reg. S-X because it included financial statements that were less than 135 days old. In dismissing the plaintiff’s claim, the district court rejected the plaintiff’s argument, made in reliance on the First Circuit’s 1996 opinion in Shaw v. Digital Equipment Company (here), that Vivint should have disclosed the third quarter results at the time of the IPO because the company’s third quarter results represented an “extreme departure” from previous performance. The plaintiff appealed.
The June 21, 2017 Opinion
In a June 21, 2017 opinion written by Judge John M. Walker, Jr. for a unanimous three-judge panel, the Second Circuit affirmed the district’s dismissal of the plaintiff’s action.
In affirming the district court, the Second Circuit addressed the question of what the standard is for determining when interim financials must be disclosed in a registration statement. The Second Circuit rejected the plaintiff’s attempt to argue that the First Circuit’s “extreme departure” test was the appropriate standard. The Second Circuit said that the Shaw test is “not the law of this Circuit” and further that it expressly declined to adopt the Shaw test.
Instead, the Second Circuit said, the appropriate standard and operative test to be used in determining whether or not Vivint had omitted information necessary to make other registration statements not misleading is the “traditional materiality test” in the Second Circuit’s 2003 opinion in DiMaria v. Andersen (here). Under this standard, a duty to disclose the omitted information arises “if a reasonable investor would view the omission as significantly altering the total mix of information made available.”
In declining to adopt the First Circuit’s “extreme departure” test when assessing the materiality of a registration statement’s omissions, the Second Circuit noted that its own DiMaria standard “rests upon the classic materiality standard in the omissions context.” Shaw’s “extreme departure test” also “leaves to many open questions,” such as the degree of change necessary to constitute an “extreme departure, what metrics a court should use in assessing the degree of the departure; and the role of the familiar “objectively reasonable investor.” The Shaw test in some situations, the Second Circuit said, can be “analytically counterproductive.”
The Second Circuit noted that attempting to apply the “extreme departure” standard in this case demonstrates its “unsoundness.” While the plaintiff sought to rely on two financial metrics in making the argument that the omitted third quarter information represented an “extreme departure,” the two metrics, the Second Circuit said, “are not fair indicators of Vivint’s performance.” The use of the “extreme departure” test “makes little sense in this context and confuses the analysis.”
Applying instead the DiMaria test rather than the Shaw test, the Second Circuit concluded based on its review of the six prior quarters and on the company’s unique accounting and reporting method, that the failure to disclose the third circuit information was not an actionable omission because “a reasonable investor would not have viewed Vivint’s omission as significantly altering the total mix of information made available.” In reaching this conclusion, the court said that the plaintiff’s argument was “too myopic, both temporally and with regard to the number of relevant metrics.” The court said that taking into account of the metrics relevant for assessing Vivint’s performance, and not just the metrics on which the plaintiff sought to rely, the omissions of the third quarter results did not render the publicly available information misleading.
Indeed, the court said, the omission was not material even according to the metrics on which the plaintiff sought to rely, as the company’s financial performance on the metrics on which the plaintiff sought to rely fluctuated sharply over the time period reported and there was never a trend of shareholders’ earnings established.
Finally, the Second Circuit said that it found no basis for holding that Vivint had failed to fulfill its affirmative disclosure obligations under Item 303 of Reg. S-K with regard to the evolving regulatory regime in Hawaii and the impact of its revenues and prospects in Hawaii.
Discussion
Observers of securities class action litigation lawsuit filing trends know that IPO companies are more susceptible to class action securities suits than are more seasoned companies. IPO companies often do not have a long operating history so their performance post-IPO can fluctuate, which may disappoint investors. Also because of the shorter operating history and because of the adjustments involved in becoming a publicly traded company, IPO companies sometimes stumble out of the gate, which also can spark investor ire.
When IPO companies attract securities suits, the plaintiff shareholders often allege that the company omitted information from the registration statement that was needed to make the information that was disclosed not misleading. The possibility for this type of argument seems unusually magnified where, as here, the financial quarter ended the day a company completed its IPO. The fact is that the market’s reaction was negative when the third quarter information was released a few weeks after IPO. There is certainly an intuitive case to be made based on the market’s reaction that the third quarter results were material.
The question, however, is not whether or not or how the market reacted when the information was later disclosed but whether or not the company had an obligation to report on the interim financial results at the time of the IPO. In attempting to answer this question, the First and the Second Circuits have developed what appear to be diverging standards. The First Circuit concentrates just on the supposedly misleading information and whether or not the omitted information represented an “extreme departure” from the results that were reported. The Second Circuit, by contrast, requires that the court look not just at the omitted interim financial information, but rather look at the omitted information in context, in light of the total mix of information. The Second Circuit standard requires that the court look not just at the omission but at the bigger picture.
We now have a situation where two federal appellate circuits have promulgated differing standards to determine when interim financial information must be disclosed. The question arises is whether or not we now have a “split between the circuits” of the kind that might attract the attention of the U.S. Supreme Court.
I think it is probably too early to tell whether or not this is the kind of issue that the Supreme Court might be interested in taking up. The Supreme Court is most interested in circuit splits if the difference between the circuits creates the possibility of different outcomes based on nothing more than the circuit in which a case was filed. It isn’t clear here whether the difference between the First Circuit test and the Second Circuit test would in fact lead to different outcomes.
After all, the district court here granted the motion to dismiss in this case even under the Shaw standard – the district court said that the plaintiffs had failed to show that the omitted third quarter information represented an extreme departure from the results that were reported. So the outcome in this case, at least, was the same regardless of which test was applied. It seems unlikely that a future litigant would succeed in persuading the Supreme Court to take up a case based on a circuit split unless the litigant can show that the difference between the circuits risks a difference in outcomes.
Finally, with respect to the appellate court’s conclusions about the company’s disclosures of the risks of regulatory change in Hawaii, the court, as the Skadden Arps law firm noted in its June 22, 2017 client alert about the Vivint decision (here), the court “made clear that risk warnings can satisfy an issuer’s affirmative obligation to disclose a negative trend under Item 303 of Regulation S-K.”
Court Notes: Second Circuit Judge John M. Walker, Jr., once the Court’s Chief Judge, took senior status in 2006. Judge Walker is the first cousin of the former President, George H.W. Bush, and is the first cousin, once removed, of the former President, George W. Bush, and of the former Florida governor, Jeb Bush. (Judge Walker and George H.W. Bush have two grandfathers in common.) Walker, a 1966 graduate of the University of Michigan Law School, was first appointed as a federal district court judge by Ronald Reagan in 1985. Judge Walker was elevated to the Second Circuit in 1989. According to Ballotpedia (here), Judge Walker was nominated to the Second Circuit by President George H.W. Bush.