In re EZCorp, Inc. Securities Litigations

Citations: 181 F. Supp. 3d 197; 2016 U.S. Dist. LEXIS 154097; 2016 WL 6462186Docket: 14 Civ. 6834, 14 Civ. 8349

Court: District Court, S.D. New York; March 31, 2016; Federal District Court

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Purchasers of common shares in EZCORP, Inc. have filed a class action lawsuit against the company, its senior executives, and sole shareholder Phillip Ean Cohen, alleging securities fraud. They claim that the defendants misrepresented the company's profitability, decision-making processes, and compliance with lending regulations, thereby artificially inflating EZCorp's value. The lawsuit cites violations of Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5, which prohibit manipulative practices and false statements of material fact in securities transactions. Additionally, under Section 20(a) of the Act, the shareholders allege that Cohen and the executives are liable as "controlling persons" for these misrepresentations.

The executives have filed a motion to dismiss the claims, arguing that the plaintiffs failed to adequately plead misrepresentation, scienter (knowledge of wrongdoing), and loss causation. Cohen and the executives also jointly moved to dismiss the control person liability claims. The court granted the motions in part and denied them in part, allowing the claims related to misrepresentation concerning lending regulations against the executives and EZCorp to proceed, as well as the control person liability claims against all defendants. All other claims were dismissed. The lawsuit pertains to EZCorp stock purchases made between April 19, 2012, and October 6, 2014. During this period, the company, led by CEO Paul Rothamel and CFO Mark Kuchenrither, paid Cohen’s consulting firm, Madison Park, $20.2 million for services, which the executives claimed were independently evaluated and approved.

EZCorp acquired Cash Genie, a UK-based online lender, at the start of the class period. During this time, Cash Genie engaged in lending practices prohibited by the Financial Conduct Authority (FCA), including rolling over consumer loans excessively, where interest was charged on the principal amount without repayment. An account manager noted a loan being rolled over over 30 times, and employees were incentivized to permit indefinite rollovers. Other improper practices included "double logging," where debt collectors posed as other lenders to obtain credit card information, and unauthorized interest charges lacking management oversight.

The FCA's rules banning these practices took effect on July 1, 2014, shortly before the class period's conclusion. The Office of Fair Trading (OFT), the FCA's predecessor, had previously indicated intentions to audit consumer credit companies starting in February 2012 for compliance with guidance on responsible lending. This guidance deemed the aforementioned practices as "deceitful, oppressive, or otherwise unfair or improper," warranting the potential rescission of a lender's consumer credit license. The guidance specifically prohibited unsustainable rollovers and mandated effective affordability assessments.

In March 2013, the FCA imposed a limit on rollovers to two occasions due to evidence of abusive lending practices, with formal rules published by February 2014. Shareholders claim that EZCorp executives made materially false statements concerning Cash Genie’s operational practices, the approval process for Madison Park’s consulting contract, and financial reporting during the class period. Specific statements by executives Rothamel and Kuchenrither during investor calls asserted compliance with UK regulations and best practices. However, on November 7, 2013, Rothamel acknowledged that Cash Genie did not adhere to best practices, resulting in corrective measures to improve underwriting and collections. Rothamel reiterated in January 2014 that compliance issues had been rectified.

Shareholders allege that the Madison Park consulting contract was improperly imposed on EZCorp, counter to the company's claims of objective vetting and approval. They contend that Cohen exploited his voting power to secure a deal from which he profited significantly, while it was detrimental to EZCorp. The shareholders reference executive statements made in SEC Forms 8-K and 10-K asserting that the contract underwent thorough analysis and approval. Following the termination of the contract in May 2014, EZCorp underwent executive management changes, which shareholders claim were facilitated by Cohen's unilateral amendments to the company’s bylaws, enabling him to consolidate control over the board and limit special meeting calls. Analysts expressed concerns regarding Cohen's influence over EZCorp after these changes. Additionally, the shareholders assert that from September 30, 2011, to December 31, 2012, EZCorp's financial statements violated GAAP by overstating the value of its investment in UK pawnbroker Albemarle & Bond due to failure to report timely impairment charges. On April 29, 2014, EZCorp acknowledged a complete impairment of its investment in A.B. The shareholders argue that GAAP compliance necessitated these impairment charges in earlier financial reports. For the complaint to overcome a motion to dismiss under Fed. R. Civ. P. 12(b)(6), it must present a plausible claim, meaning it should provide factual content allowing reasonable inference of liability. The court will accept the allegations as true and draw favorable inferences while requiring more than mere labels or formulaic recitations. The complaint must also meet the heightened pleading standards of the PSLRA and Fed. R. Civ. P. 9(b) concerning securities fraud.

The Private Securities Litigation Reform Act (PSLRA) mandates that plaintiffs specify misleading statements, the reasons for their misleading nature, and provide detailed facts indicating a strong inference of the defendant's required state of mind. Similarly, Rule 9(b) requires plaintiffs to identify the fraudulent statements, the speaker, the time and place of the statements, and the reasons they are deemed fraudulent. Defendants contest the sufficiency of the shareholders' claims regarding misrepresentation and control liability. For a misrepresentation claim under Rule 10b-5, plaintiffs must demonstrate: misstatements or omissions of material fact, scienter, a connection to the purchase or sale of securities, reliance by the plaintiff, and that this reliance was the proximate cause of their injury. Control person liability requires showing a primary violation by the controlled individual, the defendant's control over them, and the defendant's significant participation in the fraudulent activity.

The court finds that the shareholders adequately stated a misrepresentation claim related to Cash Genie’s compliance with lending regulations and established control person liability against all defendants. The complaint identifies misrepresentations concerning regulatory compliance, distinguishing actionable statements from non-actionable puffery—general optimistic statements about reputation or compliance that do not provide a reasonable basis for investor reliance. The court determined that statements from executives regarding their adaptability to regulatory changes and general claims of success in regulatory efforts were too vague to be actionable. However, specific claims about Cash Genie’s compliance with regulatory and industry best practices, especially in light of contemporaneous regulatory announcements, were deemed to qualify as misrepresentations.

During an earnings call on April 19, 2012, Rothamel responded to a shareholder's inquiry about the UK regulatory environment by denying that Cash Genie engaged in unfair practices, despite recent scrutiny from UK authorities regarding compliance with fairness in lending guidelines. Investors could reasonably interpret his statements in light of this regulatory focus, especially considering Cash Genie's operating practices did not align with these guidelines. This context also applies to statements made in April 2013, asserting that recent regulatory actions would not negatively impact the business, as Cash Genie had adhered to best practices over the prior year. Although general statements about business practices are often deemed non-actionable puffery, the specific timing and context of these statements, following regulatory guidance, suggest they were not merely generalizations. 

The executives' claims regarding regulatory compliance are not shielded by the "bespeaks caution" doctrine or the PSLRA’s safe harbor provision. The bespeaks caution doctrine assesses whether misrepresentations are immaterial due to adequate cautionary disclosures. While the executives referenced cautionary language in their Forms 10-K and 8-K regarding FCA regulations, they neglected earlier statements lacking such caution and contradicting OFT guidelines. Cash Genie’s practices, including indefinite rollovers, significantly exceeded the FCA's proposed limits, indicating that cautionary language regarding regulatory compliance could mislead reasonable investors.

The PSLRA's safe harbor provision protects forward-looking statements accompanied by meaningful caution. However, the allegations suggest Cash Genie's practices violated the OFT’s guidelines, making the executives' statements about regulatory compliance factual rather than forward-looking. Consequently, these statements are not protected. Overall, while general statements about regulation may be seen as puffery, the specific claims regarding adherence to industry standards amidst ongoing regulatory scrutiny qualify as misrepresentations. The complaint does not adequately claim misrepresentations related to the approval of EZCorp's agreement with Madison Park.

Shareholders accuse EZCorp executives of misleadingly asserting the objectivity of the approval process for a consulting contract with Madison Park, owned by Cohen, the beneficial owner of all voting stock. However, their allegations lack factual support, relying instead on vague testimonials from confidential witnesses who express uncertainty about Madison Park's services and suggest Cohen's motivations without addressing the approval process directly. The shareholders reference a November 2012 investment call where an executive's silence on the consulting services is interpreted as an admission of a flawed approval process, but this interpretation is deemed unreasonable. The shareholders argue that Cohen's sole voting power implies a compromised approval process but also acknowledge the board's independence to terminate the agreement. The timing of board member replacements, occurring a year after the last approval of the Madison Park agreement, further undermines their claims. Under the PSLRA’s heightened pleading standard, shareholders must provide facts indicating a strong inference of scienter, which requires more than a mere plausible inference. This can be established by showing motive and opportunity for fraud or by presenting strong circumstantial evidence of intentional misconduct. For allegations against a corporate defendant, it suffices to show that someone whose intent can be attributed to the corporation acted with the requisite scienter. Without sufficient factual support, the claim of misrepresentation regarding the approval process must be dismissed.

The complaint sufficiently alleges scienter concerning Cash Genie but lacks similar allegations regarding EZCorp’s financial statement fraud. Shareholders claim executive recklessness based on access to information contradicting public statements about Cash Genie’s regulatory compliance, supported by confidential witnesses. One witness, a Cash Genie financial manager, details oversight deficiencies discussed in management meetings and confirms that management packs, which included internal control issues, were regularly shared with executives, including Kuchenrither. Another witness, the Interim Vice President of Cash Genie, corroborates that these management packs would have reached key executives. Additionally, a former Operations Manager confirms that audits highlighting management laxity were prepared for executive review. The collective testimony of these witnesses reveals a culture of poor lending practices and oversight at Cash Genie, contributing to EZCorp's eventual distancing from the company. Rothamel's public statements indicating extensive due diligence on Cash Genie prior to investment further suggest executives were aware of improper practices. The executives' dismissal of the witnesses’ reliability is undermined by evidence of direct interactions, including a relevant call involving Kuchenrither. The details regarding management reports meet the Second Circuit's standards for securities fraud pleading. Overall, the allegations create a strong inference of scienter for the executives, which could be attributed to EZCorp for primary liability.

The complaint does not adequately demonstrate scienter concerning misrepresentations in financial reporting. Generally, financial statements not adhering to GAAP are presumed misleading, but allegations of GAAP violations alone do not substantiate a securities fraud claim without evidence of fraudulent intent. Shareholders argue that executives' knowledge of information contradicting their public statements indicates scienter. They reference a Form 10-Q filed on May 10, 2013, which reflected an investment in A.B. using outdated stock prices despite A.B. announcing poor profit projections and a 30% stock price drop by April 19, 2013. However, the executives only recorded an impairment charge in November 2013, after failing underwriting discussions were disclosed in October. The shareholders’ failure to consider this additional context undermines their claim of scienter, as the executives’ actions were consistent with reasonable management expectations rather than fraudulent intent. The complaint's allegations of fraud by hindsight do not suffice to oppose a motion to dismiss. Furthermore, while loss causation must show that the risk leading to the loss was concealed by the alleged misrepresentations, it does not require a high burden of proof. The standard can be met with a simple statement indicating entitlement to relief, and a corrective disclosure is not necessary if the misrepresentations themselves are shown to have caused the loss.

The Court does not need to assess whether the executives' statements during conference calls regarding Cash Genie's operational practices qualify as corrective disclosures. Shareholders meet the loss causation pleading standard by alleging that the executives' misrepresentations concealed an investment risk, which became apparent when UK regulators audited Cash Genie and enforced existing lending standards, revealing that the company could not comply with proposed stricter regulations. As investors learned of Cash Genie’s actual operational failures, EZCorp’s stock value significantly declined, establishing loss causation related to the executives' misstatements about regulatory compliance.

To establish "control person" liability under Section 20(a), a plaintiff must show a primary violation by the controlled person and that the defendant controlled that person. Control can be demonstrated through ownership of voting securities or other means. The Second Circuit requires "culpable participation" as a third element, but its definition remains unclear, leading to differing interpretations among district courts. The majority view necessitates specific factual allegations of the controlling person's conscious misbehavior or recklessness to establish culpable participation, while the minority suggests that mere allegations of control suffice. The majority's requirement for particularized pleadings lacks a clear basis in the text of Section 20(a), which places the burden on the defendant to prove good faith and lack of inducement rather than requiring plaintiffs to plead these elements. The ongoing debate highlights the ambiguity surrounding the term "culpable participation" and its relationship to scienter.

The court addressed the application of the "culpable participation" prong in determining control person liability under Section 20(a) of the Securities Exchange Act. It noted that previous cases from the Second Circuit, such as In re WorldCom and Suez Equity Investors, indicate that a plaintiff does not need to prove the control defendant's mental state to allege culpable participation. In Suez, a control person claim was supported by allegations of an officer's primary responsibility for corporate dealings. However, this case is distinguished as it involves claims against both corporate defendants and their executives as primary violators. 

The allegations against Cohen, as the sole voting shareholder of EZCorp through MS Pawn, included his participation in day-to-day operations. The court found that these allegations, combined with Cohen's ownership status and access to information, were sufficient to meet the pleading standard for control person liability. The court also referenced a similar case involving Pfizer where participation in management was deemed adequate to support such claims. Ultimately, the court concluded that the control person claims against Cohen and MS Pawn were sufficiently alleged, despite the varying legal standards applied in different cases. The defendants' motions to dismiss were granted in part and denied in part, allowing the control person liability claims to proceed.