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
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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