On August 23, 2023, the United States Court of Appeals for the
Second Circuit affirmed in part and vacated in part an order
dismissing a putative securities class action against a property
and casualty insurer (the "Company"), various corporate
officers and board members of the Company, the Company's
outside auditor, and multiple underwriters of the Company's
sale of securities. New England Carpenters Guaranteed Annuity
and Pension Funds, et al. v. AmTrust Financial Services Inc., et
al., 20-1643 (Aug. 23, 2023). In vacating the district
court's dismissal in part, the Second Circuit held that in
light of its more recent precedent, certain alleged misstatements
of opinion were actionable as alleged in the complaint, and
therefore reversed the district court's dismissal of claims
related to those alleged misstatements, but otherwise affirmed the
district court's decision dismissing the remaining
claims.
The Company is one of the largest publicly traded property and
casualty insurers in the United States, providing workers
compensation, commercial automobile insurance, general liability,
and extended service and warranty coverage. In April 2017, the
Company restated five years of its financial results to correct
what it acknowledged were significant errors in its annual and
quarterly reports filed with the SEC, disclosing, among other
things, that it had improperly recognized most of the expected
revenue from certain extended warranty contracts at the start
rather than over the life of the contracts. The Company also
disclosed that it had improperly accounted for certain
discretionary employee bonuses by treating the bonuses as expenses
in the year they were paid rather than the year they were earned by
employees. Plaintiffs, investors in the Company, brought suit
against the Company, certain of its officers, members of its board
of directors, its former outside auditor, and certain underwriters
of the Company's securities for allegedly misstating the
Company's financial condition and results in violation of
Sections 11, 12, and 15 of the Securities Act of 1933
("Securities Act"), and Section 10(b) and 20(a) of the
Securities Exchange Act of 1934 ("Exchange Act") and the
corresponding Rule 10b-5. The district court dismissed
plaintiffs' Third Amended Complaint (the
"Complaint"), holding that none of the alleged
misstatements were actionable.
According to the Complaint, during the relevant time period, the
Company recognized revenue related to promotion, marketing, and
administration services at the time of the sale of its Extended
Service Plans ("ESPs"), but deferred a portion of service
revenue based upon an estimate of administrative services to be
provided in future periods. Starting in 2010, the Company made a
number of acquisitions that contributed to much of its growth.
According to plaintiffs, one of the companies it acquired
previously had been instructed by the SEC to recognize the revenue
generated by its ESPs on a straight-line basis over the life of the
contracts; however, after the acquisition the Company reverted back
to the original time-of-sale approach to revenue recognition. The
Company's stock price increased precipitously between 2012 and
2016, but some analysts allegedly reported that the Company may
have been using "accounting gimmicks to inflate its earnings
and net equity." In February and March 2017, the Company
publicly announced that accounting errors had prompted it to delay
the filing of its 10-K for the year ending December 31, 2016, and
that it needed more time to complete its consolidated financial
statements. In early April 2017, the Company filed its Form 10-K
for 2016, which included restated financial results for the years
ending December 31, 2012, 2013, 2014, 2015, and 2016, as well as
each interim period during 2015 and 2016. The restatement allegedly
revealed that the Company's income and earnings had been
significantly overstated since 2012.
Plaintiffs alleged that the restatement identified two material
accounting errors. First, according to plaintiffs, the Company had
mistakenly relied on the "upfront recognition of a portion of
warranty contract revenue associated with administration services,
... instead of deferring recognition of the revenue over the life
of the contract;" and second, discretionary employee
"bonuses ... were expensed in the year paid but ... should
have been accrued [as an expense] in the year earned based on"
accepted accounting standards.
Plaintiffs' principal challenge under the Securities Act
related to the two alleged accounting errors. The district court
determined that the Company's financial statements reflected
the exercise of subjective judgment and were thus non-actionable
statements of opinion. The Second Circuit disagreed, citing its
recent interpretation of the Supreme Court's decision in
Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension
Fund, 575 U.S. 175, 179 (2015), which unequivocally
"rejected the proposition that there can be no liability based
on a statement of opinion unless the speaker disbelieved the
opinion at the time it was made." See Abramson v. Newlink
Genetics Corp., 965 F.3d 165, 175 (2d Cir. 2020). The Second
Circuit asserted that "[i]f a statement turns on the exercise
of subjective judgment, a plaintiff will be unable to establish
that it is false merely by showing that other reasonable
alternative views exist," and "[w]here those alternatives
exist, the speaker making the statement (expressing an opinion) can
choose among them without running afoul of the federal securities
provisions at issue here." However, the Court further held
that "[o]pinions are thus actionable ... not only when
'the speaker did not hold the belief she professed,' ...
but also if the statement of opinion contains embedded statements
of fact that are untrue, or the statement omits information whose
omission conveys false facts about the speaker's basis for
holding that view and makes the opinion statement misleading to a
reasonable investor." The Second Circuit then considered
whether plaintiffs stated a claim under Section 11 of the
Securities Act against the Company and its director defendants
based on the Company's past recognition of revenue for extended
warranty contracts using the time-of-sale approach, as well as its
practice of recording discretionary bonuses as expenses when they
were paid rather than earned.
With respect to the extended warranties, the Second Circuit
rejected defendants' argument that the initial representations
about the revenue recognition practices were statements of opinion
rather than fact because assessing value to the customer on a
standalone basis is an inherently subjective enterprise, finding
that the Company never actually contended that its customers could
resell the administrative services associated with the warranty
contracts on a standalone basis or that vendors are able to sell
them separately. The Court also agreed with plaintiffs that
subjective judgments about the sufficiency of historical evidence
to support a particular accounting treatment presupposes the
existence of some historical evidence, which was not contained in
the Complaint. The Court therefore found that the Company's
"representations about the warranty contract revenue reported
in its historical consolidated financial statements misled
investors to conclude that the company was aware of some historical
evidence in support of recognizing the revenue on a
non-straight-line basis, when in (alleged) fact, it was not."
Accordingly, it was plausible that the Company "said one thing
and held back another."
With respect to the issue of alleged discretionary bonuses, the
Second Circuit rejected the Company's argument that its
decision to expense bonuses in the period they were paid rather
than earned was an exercise of subjective judgment. The Court found
that there was "some reason to conclude that [plaintiffs] have
plausibly alleged that [the Company's] method of deferring the
recognition of expenses related to bonuses until the bonuses were
paid ... was objectively improper rather than an exercise of
subjective judgment." The Court noted that the Company had a
practice of paying bonuses, and there was therefore no basis to
conclude that the continued payment of earned bonuses was not
"probable" and such bonuses therefore could not be
expensed when earned. The Court further concluded that it need not
decide whether the alleged statements related to bonus payments
were statements of fact or opinion, because the Complaint
adequately alleged that it was improbable that the earned bonuses
would not be paid. Therefore, the Company's statements did not
"fairly align[] with the information in the issuer's
possession at the time," and there was no basis for the
Company to state that the bonuses should be expensed in the year
they were paid rather than the year they were earned.
As to the remaining Section 11 claims, the Second Circuit found
that they "rest[ed] on certifications by company executives
regarding, among other things, the accuracy of [the Company's]
financial reporting, its conformity with GAAP, and the
effectiveness of [the Company's disclosure controls and
procedures." The Court agreed with the district court that
these statements were non-actionable statements of opinion. The
Court also found that the certifications about the accuracy of the
Company's financial reporting signaled that they were opinions
by stating that they are "based on [the] knowledge" of
the officer. Moreover, the Complaint failed to adequately allege
that the Company executives who signed the certifications did not
believe what they certified, and failed to allege any facts that
establish a lack of meaningful inquiry, other than the fact that
the certification turned out to be wrong.
With respect to the Securities Act claims against the Underwriter
Defendants, the Second Circuit rejected the underwriters'
contention that plaintiffs lacked standing to assert Section 12
claims against them unless plaintiffs specifically identify which
underwriter sold the security at issue. Noting that this was an
issue the Court had not yet addressed, the Second Circuit held that
plaintiffs "adequately established standing under Section
12(a)(2) by alleging that they purchased securities pursuant to the
'pertinent offering documents' or in the relevant offerings
underwritten by the defendants." Having determined that
plaintiffs adequately alleged standing, the Court found that the
same analysis applied to the Securities Act claims against the
Underwriter Defendants as against the Company, and found that
plaintiffs sufficiently alleged Securities Act claims regarding
statements concerning the Company's past recognition of revenue
for extended warranty contracts using the time-of-sale approach, as
well as its practice of recording discretionary bonuses as expenses
when they were paid rather than earned.
Turning to the Exchange Act Claims, the Second Circuit held that
the Complaint did not adequately plead scienter based on the
Company's alleged motive and opportunity to commit fraud.
According to the Court, the alleged financial incentives to keep
share prices high and fuel the Company's acquisition strategy
did not raise an inference of scienter, as those motives are
present with any company. The Court found equally unavailing
plaintiffs' allegations that top executives sold shares, as the
alleged selloff began several months before the purported class
period. The Court further found that the Complaint failed to allege
facts providing evidence of misbehavior or recklessness, noting
that "[n]one of the alleged facts in the
Complaint—including the 'magnitude' of [the
Company's] restatement and the duration of the period it
covered—satisfy these requirements." Likewise, the Court
rejected plaintiffs' argument that the Company must have known,
or recklessly disregarded, that the SEC had previously advised the
company it acquired in 2010 that its time-of-sale approach was
"improper and that its warranty business compelled a
straight-line revenue recognition approach." The Court found
instead that the Company's resort to a time-of-sale approach
after the acquisition, though wrong, was more plausibly explained
by the changes to the guiding accounting principles since 2006 or
to the Company's negligence and not indicative of
scienter.
Finally, the Court found that plaintiffs abandoned their Securities
Act claims against the Company's outside auditor, and agreed
that the Exchange Act claims against the auditor must be dismissed
because the Complaint did not adequately allege that the alleged
misstatement in the auditor's 2013 Audit Opinion was
material.
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