Court Denies Motion To Dismiss Our Quorum Health Corporation Complaint

Attorney: Michael J. Wernke
Pomerantz Monitor May/June 2018

Chief Judge Waverly D. Crenshaw, Jr. of the Middle District of Tennessee recently denied defendants’ motion to dismiss Pomerantz’s securities fraud class action involving Quorum Health Corporation (“Quorum”) and Community Health Systems, Inc. (“CHS”). CHS is one of the nation’s largest operators of hospitals. Quorum, an operator and manager of hospitals, was spun off from CHS in April 2016. The action, brought on behalf of investors in Quorum who purchased Quorum shares after the spinoff, alleges that Quorum, CHS and certain of their officers violated section 10(b) of the Securities Exchange Act as well as section 20(a), the “control person” provision, by issuing financial statements for Quorum that misrepresented its financial condition.

Specifically, our complaint alleges that CHS hatched a scheme to unload its worst-performing hospitals at an inflated price. It set up the new subsidiary, Quorum, to buy these hospitals from CHS for $1.2 billion, which Quorum borrowed. That price was based on fraudulent calculations of “good will” attributable to those hospitals. Goodwill is an intangible asset that that results when one company purchases another for a premium value. The value of a company’s brand name, cus­tomer base, and good customer relations are examples of goodwill. That is, when a company like CHS purchases hospitals like those that came to make up Quorum, it must record as goodwill the amount it paid for those hospitals in excess of the fair value of the assets. A company must then periodically test the goodwill and record an “impairment” to the goodwill when it is more likely than not that the fair value of the as­set has declined below its carrying amount (or book value). This occurs when “triggering events” lead management to believe that the expected future cash flows of an asset have significantly declined.

The inflated value of Quorum’s goodwill was then reflected in Quorum’s financial statements, which were dissemi­nated to investors when Quorum’s stock started trading as a separate public company.

We allege that the defendants knowingly inflated Quorum’s goodwill and failed to take a necessary impairment. As a result of the defendants’ false statements about Quorum’s goodwill, investors that purchased Quorum stock in the market following the spin-off paid an inflated price. The truth was revealed when Quorum and CHS each announced only a few months after the spin-off was completed (and CHS received its $1.2 billion) that each company was severely impairing its goodwill. As a result, Quorum’s stock price plummeted $4.99, almost 50%, damaging investors.

Defendants’ main argument for dismissal was that their statements of goodwill, which are considered statements of opinion under the law, were not false and misleading when made, or made with the intent to mislead inves­tors. The court rejected these arguments, finding that the multiple “triggering events” or “red flags” indicating that the goodwill was impaired were known to the defendants prior to the spin-off. For example, in the months prior to the spin-off, CHS’s stock price decline 78%, correspond­ing to a decline in market capitalization of $5.6 billion. The court also noted the extremely poor performance of the hospitals that made up Quorum as an indicator that the goodwill was impaired. Thus, the court held that because the complaint alleged that the defendants’ state­ments of goodwill did not fairly align with the information they knew, Pomerantz adequately alleged that the defen­dants knew that their statements of goodwill were false.

This opinion is particularly significant because the court held that the CHS defendants, in addition to the Quorum defendants, were “makers” of the false statements of goodwill in Quorum’s initial financial statements even though the filings were made on behalf of Quorum, not CHS. Normally, only the company and officers whose stock the class purchased are liable for false statements under the federal securities laws. Here, that would be Quorum and its officers. However, the court accepted our argument that CHS and its officers should also be liable for the false statements because Quorum was part of CHS prior to the spin-off and all of Quorum’s financials in the spin-off documents were calculated by CHS.

The Ascendancy Of “Event-Driven” Securities Cases

Attorney: Matthew C. Moehlman
Pomerantz Monitor May/June 2018

Corporate fraud comes to light by different routes. The Securities Exchange Act’s reporting requirements are designed to compel disclosure and transparency by public companies. Even so, investors cannot always count on bad corporate actors to blow the whistle on themselves.

When a third party reports an event that calls in to question the truth of a company’s statements to the market, some commentators refer to the resulting litigation as “event-driven.” These types of cases have become more common in recent years, as companies have found ways to avoid obvious admissions that their previ­ous statements were wrong. In some quarters, particularly the defense bar, event-driven cases are criticized as applying 20/20 hind­sight to an unprecedented bad event. But in our view, this ignores the many cases in which a company knows but conceals a risk that just such an event will occur. When the event then does occur and investors suffer losses due to the market’s reaction to the materialization of the concealed risk, we believe that the company should be held accountable.

RESTATEMENT CASES – A DWINDLING CATEGORY OF SECURITIES SUIT

Fifteen years ago, securities fraud often came to light when a company restated its past financial results. For example, if a company had engaged in several large, pre-arranged, round-trip transactions with no economic purpose, in order to inflate its reported revenue and cash flow, it might announce that it was restating its financial results to correct them. If the stock then plunged, share­holders suing to recoup their losses could invoke the restatement as an admission that the company’s earlier financials were materially misstated. Since materiality and falsity are two elements of a securities claim, therestatement would significantly strengthen the share­holders’ case.

Times have changed. Litigation analysts report that in the ten years since the Enron securities litigation wrapped up, the number of reissuance restatements filed by pub­lic companies has steadily declined—from nearly one thousand in 2006 to just over a hundred in 2016. Reg­ulatory reforms aimed at deterring accounting fraud may account for the downturn, or corporations may simply have learned that restatements increase litigation risk and learned not to lead with their chins.

In any event, astute shareholders should stay attuned to multiple non-company sources for revelations that dam­age their investment portfolio. Let’s look then at several examples of recent cases in which news reported by third parties prompted shareholder litigation.

EVENT-DRIVEN CORRUPTION CASE— IN RE PETROBRAS SECURITIES LITIGATION

A case prosecuted by this firm, the securities litigation re­lating to the Brazilian state-owned energy giant Petróleo Brasileiro S.A.-Petrobras, shows how investors may first learn of a fraud from external sources and events rather than a company announcement.

Reports of corruption had dogged Petrobras for years. The endgame began in early 2014, when newspapers reported that the Brazilian federal police had arrested a retired Petrobras executive as part of a crackdown on black-market money-laundering.

Petrobras did not mention the incident explicitly in its an­nual report filed the following month, saying only that it was conducting routine internal investigations into certain issues.

Petrobras had still not disclosed the findings of those investigations when, months later, the police released sworn affidavits in which the executive testified to orches­trating a decades-long kickback and bid-rigging scheme along with other top Petrobras executives, over a dozen large construction companies, and many of Brazil’s lead­ing political figures.

In addition to not divulging the scheme, Petrobras never restated its financials, despite having overvalued its fixed assets by, according to its own estimates, $30 billion.

Petro­bras wrote off $2.5 billion as kickback-related overpay­ments, and took a $16 billion asset impairment. Petro­bras argued in its motion to dismiss that $2.5 billion was immaterial to its financial results under SEC guid­ance regarding materiality from a legal and accounting standpoint. In denying Petrobras’ motion, the district court observed that materiality is not limited to a purely quantitative assessment but can also include qualitative factors, such as concealment of an unlawful transaction. In that regard, the court noted that Petrobras’ misstat­ed financials concealed an illegal kickback scheme that, when revealed, called into question the integrity of the company as a whole. The court also found that Petro­bras’ assertions of integrity and high ethical standards were actionable because they were alleged to have been made to reassure the market, and the market may have relied on their truth.

EVENT-DRIVEN PRODUCT CASE— MATRIXX INITIATIVES, INC. V. SIRACUSANO

Some events that lead to actionable claims implicate a company’s representations about its products. Matrixx Initiatives, Inc. v. Siracusano involved a drug manufac­turer that failed to disclose that its popular cold remedy had caused a small number of users to lose their sense of smell. When a morning television show revealed this potential side effect, the stock plummeted. On appeal to the Supreme Court of the United States, Matrixx argued that the possibility of loss of smell was so minute as to be immaterial. The Court disagreed. It found that misstate­ments need not be statistically significant to be material, and held that Matrixx’s press releases touting the safety and efficacy of the cold drug were actionable.

EVENT-DRIVEN OPERATIONS CASE— IN RE VALE S.A. SECURITIES LITIGATION

An event may also reveal a company’s statements about its operations to have been materially false and mislead­ing. In November 2015, it was reported that the Fundão dam in Minas Gerais, Brazil had collapsed, releasing tons of toxic sludge on the village below and leading to the worst environmental disaster in Brazil’s history. The dam was jointly owned by Vale S.A., a multi-national mining concern whose securities trade on NASDAQ.

The dam collapse shattered Vale’s carefully-crafted im­age as a good corporate citizen. While some economists say that the only social responsibility of business is to in­crease profits, socially responsible investing has become a major force across global markets, with over $23 trillion in responsibly invested assets reported to be under man­agement. Vale, like a number of large industrial compa­nies, published a detailed annual “Sustainability Report” in order to win inclusion in the Dow Jones Sustainability Index. Vale stated in one sustainability report that it would “prevent, control or compensate for [environmental] im­pacts,” and that it had “policies, systematic requirements and procedures designed to prevent and minimize risks and protect lives.” The district court found that these statements were actionable. The court, moreover, found that Vale’s executives had been privy to studies showing that the dam was structurally unsound for years before the foreseeable risk of its collapse became a reality.

Pomerantz Secures Milestone Settlement In Yahoo

Attorney: Hui Chang
Pomerantz Monitor May/June 2018

Pomerantz is co-lead counsel in a securities fraud class action suit brought by investors in the Northern District of California on behalf of shareholders of Yahoo! Inc. (“Yahoo”). The case arises from the two biggest data breaches in U.S. history, in which Russian hackers stole the records of all of Yahoo’s three billion users in 2013 and compromised the accounts of 500 million users in 2014. In early March 2018, Yahoo agreed to pay $80 million to settle the action filed by the plaintiff shareholders in the action. Plaintiffs alleged that Yahoo and some its officers failed to disclose that these breaches had oc­curred and also failed to disclose two additional massive data breaches in 2015 and 2016, which affected approxi­mately 32 million Yahoo users and caused financial harm to its investors. The suit further alleged that defendants knowingly concealed its deficient security practices and the 2014 data breach from the market. Plaintiff share­holders alleged that the company’s share price fell over 31 percent during the class period in reaction to its data-breach disclosures. These data breach disclosures also had a substantial and quantifiable financial impact on Yahoo when Verizon Communications, Inc. reduced its bid to acquire Yahoo by $350 million, to $4.4 billion.

The proposed Yahoo settlement, which is still subject to final court approval, will be the first substantial shareholder recovery in a securities fraud class action related to a cybersecurity breach. Historically, data-breach disclosures by publicly traded companies have not been generally followed by significant stock price declines, making it hard to show that investors suffered material harm. With stock prices largely unaffected, cyber-related disclosures have instead mainly driven shareholder derivative orconsumer protection actions. For years, data breach classactions have been typically dismissed early on by courts, and were generally unsuccessful.

Recently, however, investors are far more focused on cybersecurity issues and more highly-publicized data breaches have been accompanied by stock price declines. While in the past, investors seemed to be indifferent to news of data breaches, investors now appear more aware of the increased risks of security breaches. This past year alone saw the filing of a handful of securities fraud class actions related to cybersecurity breaches, with the publicly traded companies Equifax Inc., PayPal Holdings, Inc. and Intel Corporation among those sued following cybersecurity breach announcements.

The Yahoo action is significant for another reason as well: on April 24, 2018, the U.S. Securities and Exchange Commission (“SEC”) imposed a $35 million fine on Yahoo in connection with the 2014 data breach, marking the first time a publicly traded company has been fined for a cybersecurity hack. The SEC recounted in its order that Yahoo found out in December 2014 about Russian hack­ers breaching the company’s systems to obtain user-names, phone numbers, encrypted passwords and other sensitive information, yet did not disclose the hack until 2016, when it was closing a deal with Verizon. While the SEC acknowledges that large companies are at risk of persistent cyber-related breaches by hackers, it did not excuse companies from reasonably dealing with these risks and of responding to known cyber-breaches. The SEC said that Yahoo continued to mislead investors with generic public disclosures about the risks of cyber-related breaches when it knew a significant breach had occurred.

The SEC has also recently toughened its reporting guidelines by updating its guidance on cybersecuritydisclosures. The guidance stresses the importance ofcybersecurity policies and procedures and advisescompanies that they need “disclosure controls andprocedures that provide an appropriate method ofdiscerning the impact that such matters may have on the company and its business, financial condition andresults of operations.” It also calls for public companies to be more open when disclosing cybersecurity risks, with companies expected “to disclose cybersecurity risks and incidents that are material to investors, including the con­comitant financial, legal or reputational consequence.”

This milestone settlement in Yahoo, in combination with updated SEC guidelines, may provide the foundation that allows plaintiff shareholders to bring securities fraud actions to pursue these claims with greater success.As exemplified by the Yahoo action, Pomerantz has been at the forefront of cyber-related securities fraud actions.

Are Cryptocurrency Offerings Subject To Federal Securities Regulation?

Attorney: Michele S. Carino
Pomerantz Monitor May/June 2018

The ability to raise capital through an Initial Coin Offering, or “ICO,” has been hailed as a boon to innovation and economic growth, allowing small businesses and start-ups to bypass traditional (and more expensive) financing sources, such as venture capitalists and investment banks. In fact, in the first four months of 2018, ICOs have raised over $4 billion in funding, already exceeding the $3.3 billion raised in ICOs in 2017, and well ahead of the amounts raised through traditional venture capital.

But what exactly is an ICO, and what are investors buying? And what happens if they don’t get what they expected? Until recently, this emerging, decentralized capital mar­ket has been largely unregulated, exposing investors to price volatility, pump-and-dump schemes, and outright theft by fraudsters and hackers – oftentimes, with no legal recourse. Regulators have now started to take action, making it clear that while cryptocurrencies may be novel, they are not outside the bounds of existing laws.

Cryptocurrency, also known as virtual currency, coins, or “tokens,” is a representation of value that can be digitally traded and exchanged, and that may entitle the owner to certain other rights, such as access to a technology or platform. But it is more than just digital money. Accord­ing to the Securities and Exchange Commission (“SEC”), coins and tokens may also qualify as “securities” under U.S. laws, and thus be subject to regulation, including registration and disclosure requirements. The seminal Supreme Court case SEC v. Howey Co., decided in 1946, sets forth the test for determining if a financial instrument – actual or virtual – is an “investment contract” that meets the definition of a security. Specifically, a transaction is an investment contract if: (1) money is invested in a common enterprise, (2) the investor expects profits from the investment, and (3) the profit comes from the efforts of someone other than the investor. An instrument must meet all three criteria to be considered a security. Coins and tokens, like any other financial instrument, can take many forms, but to the extent a company utilizes coins or tokens to raise capital with the promise of increased value based on the company’s plans or growth prospects (e.g., launch of a new technology or product), coins and tokens seem to satisfy the “common enterprise” and “efforts of others” elements of the Howey test, in the same way as shares of stock. Indeed, just as with stock, the value of a  coin or token on an exchange will fluctuate depending on the perceived performance of the issuing company.

Seeking to avoid the complications and costs of compli­ance with U.S. securities laws, many entities have re-packaged and re-labeled coins as “utility tokens” and have downplayed the expectation of profit and/or prom­ised some future use, such as participation in a digital community. But the SEC recently clarified that labels do not matter: “Whether a par­ticular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.” SEC Chairman Jay Clayton further stated: “By and large, the [ICOs] that I have seen … directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”

While some have decried the regulatory intrusion into this new digital frontier, and others simply have gone the route of blocking U.S. investors from participating in offerings, the benefits of increased investigation and enforcement more than outweigh the potential downside. Industry insiders, including Joseph Lubin, the co-founder of the cryptocurrency Ethereum, and Brad Garlinghouse, CEO of Ripple, agree that curbing fraud will strengthen and legitimize cryptocurrencies and the distributed ledger platforms (“blockchains”) on which they trade. Moreover, to the extent ICOs mirror initial public offerings or other smaller offerings or private placements, there is already a well-established legal framework to ensure both access to capital and protection for investors, including that the coins or tokens be registered and that the issuer make adequate disclosures. These requirements would provide investors with recourse under the Securities Act for initial sales, as well as potential recovery in the instance of market manip­ulation and insider trading, which have been rampant in secondary markets for coins and tokens.

The SEC’s involvement in this area is likely to increase, as evidenced by the creation of a new cyber task force charged with policing ICOs. That task force already has been busy – the SEC filed a fraud suit against the organizers of the PlexCoin ICO in December, with the founder sentenced to jail by Canadian authorities. In recent weeks, the SEC has launched an investigation into Overstock.com’s token sale through its subsidiary tZero, which was supposed to be the first fully-compliant ICO by a publicly-traded company, but which has now been postponed. The SEC also halted trading in Longfin Corp., a cryptocurrency business, alleging that executives com­mitted securities fraud by running up the stock price and then illegally selling large blocks of restricted stock to the public while the price was elevated. The SEC obtained a court order freezing more than $27 million in trading proceeds before the illicit gains could be transferred to offshore entities.

Cryptocurrencies may still disrupt the financial industry and change the way we do business in the future. How­ever, in terms of regulation, the old adage that “the more things change, the more they stay the same,” may still hold true, especially in terms of investor protection.