Court: Court of Appeals for the Second Circuit; June 21, 2017; Federal Appellate Court
Plaintiff-Appellant Robby Shawn Stadnick is appealing the dismissal of his securities class action complaint by the United States District Court for the Southern District of New York. The case stems from Vivint Solar, Inc.'s Initial Public Offering (IPO) on October 1, 2014. Stadnick contends that Vivint should have disclosed financial information from the quarter ending just prior to the IPO, claiming that the company's performance represented an 'extreme departure' from expectations, as per the precedent set in Shaw v. Digital Equipment Corp. He also asserts that Vivint misled investors about expansion opportunities in Hawaii by not revealing the effects of changing regulations there.
The court found that the 'extreme departure' standard is not applicable in this Circuit and deemed Vivint's disclosures immaterial under the criteria established in DeMaria v. Andersen. Additionally, it ruled that Vivint did not mislead shareholders regarding its prospects in Hawaii. The appeal is evaluated based on the allegations in the complaint, with all reasonable inferences drawn in Stadnick’s favor.
Vivint Solar, a major player in the U.S. residential solar market, operates primarily in California and Hawaii and finances its operations through outside investors who contribute to joint investment funds. These funds finance the installation of solar systems, allowing Vivint to qualify for tax credits while customers engage in long-term leases for solar energy at reduced rates. Vivint has historically operated at a loss, relying on these investment funds to support its business model, which allocates income between public shareholders and outside investors.
Vivint employs the Hypothetical Liquidation at Book Value (HLBV) method for equity accounting, which assesses an individual's stake in the business based on a hypothetical liquidation at book value. This calculation, performed at the end of two consecutive quarters, indicates net gains or losses for individuals based on changes in their allocated share of profits or losses. Variability in income allocation between shareholders and Non-Controlling Interests (NCIs) can occur due to investor contributions and the timing of title transfers. For instance, if an investor's capital contribution does not grant them title until after a quarter, losses from that quarter may be allocated to NCIs instead of shareholders, and vice versa.
Throughout the relevant period, Vivint reported net losses, with NCI losses sometimes exceeding overall company losses, leading to increased income recognition for shareholders. In 2014, Vivint went public, issuing 20,600,000 shares at $16 each, raising approximately $300.8 million. The registration statement disclosed financial results for the six quarters preceding the third quarter of 2014, highlighting ongoing net losses and fluctuating figures for NCI losses and shareholder income. It also cautioned about the potential impact of its accounting practices on income allocation and identified key performance metrics, which included system installations and estimated retained value.
On November 10, 2014, Vivint released its financial results for the third quarter, revealing a decrease in NCI losses from negative $45 million in the second quarter to negative $16.4 million in the third quarter. This change contributed to a substantial decline in net income for shareholders, dropping from positive $5.5 million to negative $35.3 million, and a significant earnings-per-share drop from $0.07 to negative $0.45, missing analyst projections by 143%. Despite these results, Vivint's performance in key operating metrics exceeded analyst expectations, showing significant year-over-year growth in installations and contract payments.
Vivint's market share rose from approximately 9% in the first quarter to 16% in the third quarter of 2014. Following its IPO, Vivint filed its Form 10-Q for Q3 2014 on November 12, noting a decrease in net loss primarily due to the timing of solar energy system installations. The company reported a decline in solar installations in Hawaii from 15% to 12% of total installations between June and September 2014. Vivint’s stock price dropped from $14.74 to $11.42 (about 22.5%) between November 10 and 11, and further declined from $12.33 to $11.70 (approximately 5%) the day after the 10-Q release.
On February 13, 2015, Stadnick filed an amended complaint alleging violations of Sections 11, 12(a)(2), and 15 of the Securities Act of 1933, which was later superseded by a second consolidated complaint repeating the allegations. The district court dismissed the complaint for failure to state a claim on December 10, 2015. Stadnick appealed this dismissal, claiming the court erred in determining that the second amended complaint did not adequately allege a violation of Section 11 by failing to disclose Q3 2014 financial information and the adverse impact of regulatory changes in Hawaii.
Under Section 11, liability arises if a registration statement contains an untrue statement or omits a material fact necessary to make the statements not misleading. Stadnick alleged that Vivint's omission of Q3 financial data rendered disclosed information misleading, arguing that the performance represented an "extreme departure" from past results, despite acknowledging that Vivint did not violate SEC Regulation S-X, which only requires disclosure of financial statements more than 135 days old.
In the Second Circuit, the standard for determining the materiality of omitted interim financial information is based on the test from DeMaria v. Andersen, which states that a duty to disclose arises if a reasonable investor would consider the omission as significantly altering the total mix of information available. The court specifically rejects the 'extreme departure' test from Shaw, which involved a case where Digital Equipment failed to disclose substantial losses prior to an IPO, ultimately leading to a significant drop in stock prices. The First Circuit found that the omitted information was material, as it created a substantial likelihood of an extreme departure from past performance.
In DeMaria, the plaintiffs alleged that the failure of ILife to disclose first-quarter financial results constituted a misleading registration statement under Section 11. However, the court ruled that the omission did not violate Section 11 because ILife had previously disclosed losses and warned investors about ongoing challenges, thus not misleading a reasonable investor.
The Second Circuit reaffirms that the operative test remains that established in DeMaria, and that the 'extreme departure' test from Shaw is not applicable in this jurisdiction, despite past reliance on some aspects of Shaw in earlier cases.
The case Iowa Pub. Emps. Ret. Sys. v. MF Glob. Ltd. emphasizes the necessity for courts to evaluate statements and omissions in context, referencing Shaw's principles. It distinguishes between Sections 11 and 12 of the Securities Act of 1933, as noted in In re Morgan Stanley, and applies the Rule 9(b) pleading standard for fraud allegations, as seen in Rombach v. Chang. The excerpt critiques the 'extreme departure' test for assessing the materiality of omissions in registration statements, arguing it raises ambiguous questions regarding the definition and metrics for determining an 'extreme departure' and can hinder analysis. In this case, Stadnick claims that fluctuations in income available to shareholders and earnings-per-share over three quarters represent an 'extreme departure,' but these metrics do not accurately reflect Vivint's performance due to normal business operations. The DeMaria test, which considers omissions within the total mix of available information, is deemed more appropriate. Stadnick did not meet the DeMaria standard, as a reasonable investor would not view Vivint's omissions as significantly altering the information mix. The materiality assessment must consider all disclosed metrics from early 2013 to mid-2014, alongside Vivint’s business model and HLBV accounting method. When evaluated in this broader context, the omissions regarding the third quarter of 2014 do not mislead investors, as total revenue and income metrics show consistent growth, contrasting with the focus on lesser metrics that imply instability.
Trends from the third quarter of 2014 indicate that the omission of certain performance metrics by Vivint was not material, as fluctuations in income and earnings-per-share had been ongoing since early 2013 without a consistent directional trend. A reasonable investor would not have formed expectations based on prior performance related to the third quarter. Vivint’s registration statement included sufficient warnings about income fluctuations due to its business model and anticipated ongoing operating losses, suggesting that the omission of third-quarter results was not material when viewed against key operating metrics, which had significantly improved.
Stadnick's allegations regarding Vivint's failure to disclose the evolving regulatory environment in Hawaii under Item 303 of Regulation S-K were also found lacking. He did not demonstrate that regulatory changes negatively impacted Vivint’s operations, nor did he show that the decline in Hawaii's installation share was materially relevant to the company's overall revenue or operations. The increase in total installations indicated that any decline in Hawaii could be offset by greater growth in other regions. Therefore, the court upheld the district court’s ruling that Vivint adequately fulfilled its disclosure obligations and affirmed the dismissal of Stadnick’s claims under Section 15, following the dismissal of his Section 11 claims.
The judgment of the district court is affirmed. The individual defendants include Gregory S. Butterfield (CEO, President, and director of Vivint during its IPO) and Dana C. Russell (CFO at the time of the IPO), along with other directors from that period. The underwriter defendants are Goldman Sachs & Co., Merrill Lynch, Pierce, Fenner & Smith Inc., Credit Suisse Securities (USA) LLC, Citigroup Global Markets Inc., Deutsche Bank Securities Inc., Morgan Stanley & Co. LLC, Barclays Capital Inc., and Blackstone Advisory Partners L.P. The court addresses the dispute regarding whether Stadnick’s allegations are based on fraud, which would necessitate meeting the heightened pleading requirements of Federal Rule of Civil Procedure 9(b). However, this issue is not resolved as Stadnick’s claims do not succeed even under the more lenient standards of Federal Rule of Civil Procedure 8(a). The court notes that Stadnick's reference to other circuits and the 'extreme departure' test does not alter the outcome, as those cases also relied on Shaw for different aspects. An appendix contains a chart of Vivint's disclosed metrics from its registration statement and subsequent filings, presented in thousands of dollars, excluding per-share data.
