Court: District Court, D. Massachusetts; October 28, 2014; Federal District Court
Plaintiffs in a proposed class action allege that First Marblehead Corporation (FMD) and two executives violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 by misrepresenting a 2009 transaction and its tax implications. Defendants seek dismissal, claiming that plaintiffs failed to satisfy the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA). The court allows the motion to dismiss.
FMD, a Boston-based company listed on the New York Stock Exchange, previously centered its business on the origination and securitization of private student loans. Following the 2008 financial crisis, FMD faced significant defaults and revised its business model. In March 2009, it converted its subsidiary, GATE Holdings, into a trust (NC Residuals Owners Trust) and sold its interest to VCG Owners Trust, known as the VCG Transaction. FMD announced this transaction on April 6, 2009, indicating it would yield a tax refund for previously paid taxes and eliminate future tax obligations related to cash flows from special purpose statutory trusts.
The announcement included an Asset Services Agreement with VCG, where FMD would provide advisory services for an annual fee based on the outstanding principal balance of loans, payable after cash flows are distributed. Following the announcement, FMD’s share price surged by 44%. The press release contained a "Safe Harbor Statement," cautioning that future tax consequences were complex and uncertain, while subsequent filings continued to highlight the anticipated tax benefits of the VCG transaction.
On May 8, 2009, FMD anticipated receiving a cash refund and eliminating future tax liabilities due to its transaction with VCG. In November 2009, FMD reported a $176.6 million tax refund from the IRS, resulting from the sale of the Trust Certificate and operating losses for fiscal 2009. However, FMD cautioned that the tax benefits from the VCG transaction were not guaranteed, highlighting the complexity and uncertainty of the tax implications. FMD warned that if the IRS or state authorities challenged its tax position, it could significantly impact the company's financial condition and liquidity. The September 2009 Form 10-K noted that failure to realize expected tax benefits could lead to substantial fluctuations in stock price and investor losses.
In April 2010, the IRS initiated an audit of FMD's tax returns for 2007, 2008, and 2009. FMD disclosed receiving $189.3 million in federal and state tax refunds during the first nine months of fiscal 2010, which were contingent on the sale of the Trust Certificate. The May 2010 10-Q emphasized that the company's liquidity could be adversely affected if expected tax consequences were not realized. In the same month, FMD's board approved a $2 million bonus for CEO Meyers and increased his salary to $800,000, praising his efforts in improving the company's viability and potential tax savings of $430 million.
In its September 2010 10-K, FMD reiterated the ongoing IRS audit and the unpredictability of its outcome, while KPMG confirmed that FMD's financial statements complied with U.S. accounting standards. The company continued to characterize the tax implications of the VCG transaction as “complex and uncertain,” warning that the audit could lead to adjustments in received tax refunds and incur substantial costs from potential investigations or audits.
From November 2010 to August 2013, FMD consistently communicated the uncertainty regarding the tax consequences of the VCG transaction in quarterly statements, noting an ongoing IRS audit and the potential for substantial costs arising from challenges to the transaction's income tax treatment. In its 10-K reports for 2011 and 2012, FMD warned that its stock price could significantly fluctuate based on the audit's outcome. By August 15, 2013, FMD alerted investors that the IRS intended to disallow tax refunds related to the VCG transaction, expecting a Notice of Proposed Adjustment (NOPA) that could approximate $300 million in proposed adjustments. FMD emphasized that the NOPA represented an initial IRS position and not a final determination, with intentions to contest it vigorously. Following these disclosures, FMD's share price fell over 35% in one day. On September 13, 2013, FMD received two NOPAs indicating that the VCG transaction should be recognized as financing rather than a sale. FMD acknowledged the audit and appeals might incur significant costs and expressed concerns about its liquidity amid ongoing audits. In a subsequent 10-Q filed in February 2014, FMD reiterated the risks associated with the IRS audit and its potential impact on liquidity. Between June and December 2013, FMD's cash reserves significantly diminished, leading to a notification from the New York State Exchange Regulation regarding non-compliance with listing standards due to its stock price falling below $1.00 per share.
FMD's stockholders approved a 1-for-10 reverse stock split on November 12, 2013, reducing the number of common shares from 250 million to 25 million, effective December 2, 2013. On February 19, 2014, FMD's stock closed at $6.45 per share. The complaint does not clarify if the IRS's proposed adjustments are final or if FMD has appealed, though FMD intends to vigorously contest these proposed adjustments, asserting a strong position.
To survive a motion to dismiss under Rule 12(b)(6), a complaint must present sufficient factual allegations to establish a plausible claim for relief. Violations of Section 10(b) of the Securities Exchange Act are subject to the heightened pleading standards of the Private Securities Litigation Reform Act (PSLRA), which aims to prevent abusive litigation. This requires plaintiffs to specify false statements and provide a strong inference of scienter. Additionally, allegations sounding in fraud must comply with Rule 9(b), necessitating a detailed account of the fraudulent circumstances.
In the discussion of the Section 10(b) claim, plaintiffs assert entitlement to damages due to misleading statements made by defendants about the VCG Transaction, its tax implications, the IRS audits, and FMD's financial status. The plaintiffs allege that FMD misaccounted for the Trust Certificate Transaction to gain tax benefits and misled investors about the nature of the IRS audit, framing it as routine rather than an investigation into accounting irregularities. Section 10(b) prohibits manipulative or deceptive practices in securities transactions, and Rule 10b-5 makes it unlawful to make false statements or omissions of material facts that mislead investors.
To withstand a motion to dismiss a Section 10(b) claim, a plaintiff must adequately plead six elements: (1) a material misrepresentation or omission; (2) scienter; (3) a connection to the purchase or sale of a security; (4) reliance; (5) economic loss; and (6) loss causation. Defendants contend that the plaintiffs have failed to adequately plead scienter, a requirement satisfied by facts that create a strong inference of fraudulent intent or a reckless disregard for disclosure obligations. A strong inference must be more compelling than any opposing inference of non-fraudulent intent. When evaluating competing inferences, courts adopt a holistic approach, considering all alleged facts. Compelling evidence of scienter may include direct evidence indicating that company officers were aware of withholding material information. Indirect evidence can also support a strong inference of scienter, which need not be conclusive or irrefutable. Allegations of GAAP violations or accounting irregularities alone are insufficient for a securities fraud claim, but significant distortions in accounting figures may suggest scienter due to potential complicity or recklessness of top officers. Insider trading or unusual stock sales by defendants are strong indicators of scienter, while the lack of such allegations can detract from a finding of scienter. Additionally, efforts by defendants to warn investors about risks can counteract an inference of scienter.
An outside auditor's involvement can significantly diminish the likelihood of inferring intent to defraud, as established in case law. Specifically, the approval of allegedly fraudulent accounting by an external auditor may cast doubt on claims of impropriety. Simply holding a high-ranking position within a company is inadequate to substantiate allegations of scienter, as demonstrated in relevant cases. In the context of the plaintiffs' claims against FMD, they argue that a transaction was a sham aimed at securing unwarranted tax benefits, violating Generally Accepted Accounting Principles (GAAP). However, the evidence presented does not convincingly indicate that FMD intended to defraud investors; rather, it suggests a good faith rationale for characterizing the transaction as a sale.
Key points include: FMD issued warnings about the complexities and uncertainties of the tax implications of the transaction, potentially weakening the inference of scienter. The company fully disclosed the transaction's details to investors, and its external auditor, KPMG, confirmed that FMD's financial statements adhered to GAAP. Although FMD may have taken aggressive tax positions, the allegations do not support the notion that the defendants were aware of any fraudulent nature of the transaction. Furthermore, the plaintiffs failed to establish scienter for CFO Klipper and CEO Meyers based merely on their titles and backgrounds, which does not meet the heightened pleading requirements established by the Private Securities Litigation Reform Act (PSLRA). Generalized assertions of motive are insufficient to create a strong inference of scienter.
CEO Meyers's potential scienter is bolstered by his receipt of a substantial bonus and salary increase linked to the successful execution of the VCG Transaction, as established in Aldridge v. A.T. Cross Corp. Financial incentives significantly exceeding typical compensation structures can indicate scienter, particularly when fraudulent actions yield tangible benefits for the officer. However, Meyers's bonus was awarded 17 months post-transaction, and the company provided various justifications for his compensation changes. He had previously accepted a nominal salary of one dollar for two years, with his new salary of $800,000 still lower than his predecessor's $1,000,000. There is no indication that the bonus was contingent on the transaction or that he was aware of it at the time of execution. Additionally, while plaintiffs note Meyers's past questionable financial conduct related to FMD stock, this does not sufficiently illustrate his mindset concerning the VCG Transaction. The allegations do not meet the heightened pleading standards of the PSLRA.
Regarding the Section 20(a) claim under the Securities Exchange Act, which holds corporate officers and directors liable for securities fraud, liability is contingent upon an underlying violation. Since the plaintiffs failed to plead a primary violation of Section 10(b), Count II against both individual defendants is dismissed. The court has allowed the defendants' motion to dismiss, noting that the amended complaint inadequately alleges material misrepresentation and loss causation. The defendants also contend that most contested statements were forward-looking and included cautionary language, invoking a statutory safe harbor. Due to the plaintiffs' inability to sufficiently allege that the defendants acted with the necessary scienter, the court will not address these additional arguments.
