In Yates v. Municipal Mortgage & Equity, LLC, No. 12-2496 (4th Cir. Mar. 7, 2014), the United States Court of Appeals for the Fourth Circuit affirmed the dismissal of a securities fraud claim under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”), 15 U.S.C. § 78(b), against defendant Municipal Mortgage & Equity (“MuniMae”) and its individual officer and director defendants. The Court held that plaintiffs failed to plead facts sufficient to give rise to a strong inference of defendants’ scienter under the Private Securities Litigation Reform Act of 1995 (“PSLRA”), 15 U.S.C. § 78u-4, et seq. The Court declined to accept that the inference of scienter offered by plaintiffs — supported by statements from confidential witnesses, presence of red flags, allegations of insider trading and general business incentives — was at least as compelling as the opposing inference of mere negligence that could be drawn from the amended complaint. Yates is one of the few reported decisions from the Fourth Circuit applying the PSRLA, and it solidly reaffirms the PSLRA’s requirement that a plaintiff plead more than just allegations based upon conjecture and happenstance to satisfy heightened pleading requirements.
During the putative class period (May 3, 2004 to January 29, 2008) MuniMae was involved in organizing investment partnerships to pool low-income housing tax credits (“LIHTCs”) and sell them to investors. Prior to 2003, MuniMae treated its LIHTC investment partnerships as off balance sheet entities. In 2003, the Financial Accounting Standards Board adopted Interpretation No. 46R (“FASB 46R”), requiring that a company that is the primary beneficiary of “Variable Interest Entities” consolidate the entities assets and liabilities onto its financial statements. MuniMae began asserting compliance with FASB 46R in the first quarter of 2004. However, at that time MuniMae internally concluded that FASB 46R did not require it to consolidate for financial statement purposes all of tis LIHTC investment partnerships. MuniMae continued to assert compliance with FASB 46R through 2006. In September 2006, MuniMae announced it would be restating certain financial statements and through a series of later disclosures finally announced that the restatement would deal with FASB 46R accounting errors. As a result of the piecemeal disclosures, MuniMae’s share price dropped precipitously. The following day, MuniMae disclosed the full extent of the restatement’s scope and MuniMae’s stock experienced an additional decline. Eventually, in April 2008, MuniMae disclosed that it had spent over $54 million on the restatement.
Plaintiffs filed a class action complaint alleging that defendants made false representations that MuniMae was complying with FASB 46R and concealed the expected cost of the restatement in violation of Section 10(b). The United States District Court for the District of Maryland held that the amended complaint did not sufficiently allege a claim under Section 10(b) because it did not meet the PSLRA’s heightened pleading standard for scienter allegations. Plaintiffs appealed.
The Court of Appeals affirmed. First, the Fourth Circuit held that the confidential witness testimony supplied by plaintiffs did not support a “strong inference of wrongful intent.” The testimony did suggest that defendants knew earlier than disclosed that MuniMae was not in compliance with 46R and that the required restatement would be a difficult and costly undertaking. It also indicated that the issue was difficult and complex and had thrown MuniMae into “confusion and chaos” — which the Court held supported the opposing inference that the defendants were merely negligent. In fact, the Court explained, defendants’ subsequent disclosures negated an inference of fraudulent intent because, although the disclosures were not “as timely or as fulsome” as plaintiffs would have liked, they gave rise to a compelling inference that the MuniMae defendants were attempting to keep the investing public informed.
Second, the Court held that while there were several “red flags” concerning MuniMae’s core operations — the need in and of itself for several restatements, frequent accounting meetings, the firing of outside auditors, and rapid CFO overturn — they did not in and of themselves give rise to a strong inference of scienter. Not only was the FASB 46R accounting error not especially obvious, but the other warning signs easily lent themselves to benign interpretations as a result of MiniMae’s obvious attempts to get a handle on its creeping accounting problems.
Third, the Court of Appeals followed the decisions of several other Circuits in holding insufficient plaintiffs’ allegation that the individual defendants “must have acted intentionally or recklessly” merely because they were senior executives and the LIHTC investment partnerships represented a core business of MuniMae.
Fourth, in addressing plaintiffs’ allegations concerning insider trading, the Court held that while the overall value of MuniMae shares sold during the class period was higher than in previous years and thus consistent with an inference that the insiders who traded had a motive to commit fraud, the inference that the trades were innocent was stronger. There were no allegations that the insiders timed their sales to take advantage of any particular disclosure. Nor was the level of any insiders’ divestiture particularly alarming. Moreover, the Court noted, the fact that several of the individual defendants traded under non-discretionary Rule 10b5-1 plans further weakened any inference of fraudulent purpose.
Finally, the Court held that plaintiffs other allegations of motive were similarly lacking as the alleged motivations amounted to nothing more than “financial motivations common to every company.”
Thus, in Yates, the Fourth Circuit reaffirmed the heightened standard of pleading a plaintiff must meet to satisfy the PSLRA. Specifically, the Court emphasized that the allegations of scienter under Section 10(b) cannot be read in a vaccum. They must be holistically analyzed in comparison with the disclosures actually made by defendants. General business motivations, insider trading and the core nature of the problems alleged by plaintiffs cannot turn a company’s repeated attempts to inform investors of the ongoing and ever-evolving nature of a problem into intentional rather than merely negligent conduct.