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On February 1st, 2016, the Ninth Circuit revived in part a securities fraud action against CVB Financial Corporation (“CVB”) alleging that the company had made material misrepresentations concerning the likelihood that its largest borrower would default on its loans. Lloyd v. CVB Financial Corp., 2016 WL 384773 (9th Cir. 2016) (Hurwitz, J.). The Ninth Circuit held that “the announcement of an SEC investigation related to an alleged misrepresentation, coupled with a subsequent revelation of the inaccuracy of that misrepresentation, can serve as a corrective disclosure for the purpose of loss causation.” In the case before it, the Ninth Circuit found that the announcement of an SEC investigation into CVB’s “loan underwriting methodology and allowance for credit losses” could be deemed a corrective disclosure because CVB later wrote down certain of the loans in question and designated other loans as non-performing.

Court Finds Plaintiffs Adequately Alleged Falsity and Scienter as to Two Alleged Misrepresentations

Plaintiffs challenged as materially misleading a statement in CVB’s 2009 Form 10-K, filed in March 2010, representing that the company was “not aware of any . . . loans as of December 31, 2009 for which known credit problems of the borrower would cause serious doubts as to the ability of such borrowers to comply with their loan repayment terms.” Plaintiffs also asserted claims in connection with  CVB’s “nearly identical ‘no serious doubts’ statement in a 10-Q filed on May 10, 2010” that “differed from the previous ‘no serious doubts’ statement[] only in that it was ‘as of March 10, 2010.’” According to plaintiffs, both statements were misleading because Garrett Group, CVB’s largest borrower had “told CVB in early January 2010 that unless modifications to loan terms were made, Garrett could not meet its obligations and might file for bankruptcy.”

The Ninth Circuit acknowledged that the representation in CVB’s 2009 Form 10-K may have been “[t]echnically . . . true, given that the critical meeting with Garrett did not take place until January 2010.” However, the court found that “the statement was plainly misleading when made.” The Ninth Circuit explained that by the time CVB filed its 2009 Form 10-K in March 2010, “CVB had known for two months that there was a basis for serious doubts about the ability of Garrett, CVB’s largest borrower, to repay.” The court determined that “[t]he omission of that fact, combined with the reassurance that everything was fine as of December 31, 2009, [met] the pleading standard for a material omission.” The court found CVB’s May 2010 “no serious doubts” statement similarly misleading, and determined that plaintiffs had adequately alleged scienter as to both statements.

Notably, the Ninth Circuit concluded that the district court had erroneously “discounted” plaintiffs’ confidential witness allegations regarding when CVB learned of Garrett’s repayment challenges because those allegations were based on hearsay. The Ninth Circuit stated that “the fact that a confidential witness reports hearsay does not automatically disqualify his statement from consideration in the scienter calculus.” Rather, courts must “examine a confidential witness’s hearsay report to determine if it is sufficiently reliable, plausible, or coherent.” Here, the Ninth Circuit determined that the confidential witness allegations were “sufficiently reliable for pleading purposes” because they were “specific in time, context, and details, and involved important communications from a chief executive officer to his [b]oard.”

Court Holds CVB’s Announcement of an SEC Investigation into the Company’s Loan Underwriting Methodology and Allowance for Credit Losses Constituted a Corrective Disclosure

Turning to the question of loss causation, the Ninth Circuit explained that “investors must demonstrate that the defendant’s deceptive conduct caused their claimed economic loss.” The court noted that plaintiffs in securities fraud actions “typically” satisfy this requirement by alleging “that the defendant revealed the truth through corrective disclosures which caused the company’s stock price to drop and investors to lose money.”

In the case at hand, “[t]he only significant fall in CVB’s share price occurred after [the company’s] announcement” of an SEC investigation into CVB’s underwriting methodology and its allowance for credit losses. The district court had found that this announcement did not qualify as a corrective disclosure for loss causation purposes.

On appeal, the Ninth Circuit reversed the district court’s ruling. The Ninth Circuit noted that in Loos v. Immersion Corp., 762 F.3d 880 (9th Cir. 2014),[1] it had previously held that “the announcement of an investigation, standing alone and without any subsequent disclosure of actual wrongdoing, does not reveal to the market the pertinent truth of anything, and therefore does not qualify as a corrective disclosure” (quoting Loos, 762 F.3d 880). However, the Ninth Circuit explained that it had “left open [the question of] whether the announcement of an investigation can ‘form the basis for a viable loss causation theory’ if the complaint also alleges a subsequent corrective disclosure by the defendant” (quoting Loos, 762 F.3d 880). In CVB, the Ninth Circuit “answer[ed] that question in the affirmative.”

The Ninth Circuit observed that plaintiffs in the instant action alleged “much more” than simply the announcement of a government investigation. Plaintiffs asserted that CVB’s share price “dropped over 20% the day after the announcement” of the SEC investigation, but claimed that “the market hardly reacted at all” a month later when “CVB disclosed that it was charging off millions in Garrett loans.” The Ninth Circuit found that the market’s response “confirm[ed] that investors understood [the announcement of the SEC investigation] as at least a partial disclosure of the inaccuracy of the previous ‘no serious doubts’ statements.” The court concluded that plaintiffs had adequately alleged loss causation, and reasoned that “any other rule would allow a defendant to escape liability by first announcing a government investigation and then waiting until the market reacted before revealing that prior representations under investigation were false.”

The Ninth Circuit noted that its decision was “consistent” with the Fifth Circuit’s decision in Public Employees’ Retirement System of Mississippi v. Amedisys, 769 F.3d 313 (5th Cir. 2014).[2] In that case, the Fifth Circuit held that announcements of government investigations into a company’s Medicare billing practices could serve as corrective disclosures for loss causation purposes “when ‘viewed together with the totality of the other alleged partial disclosures’” (quoting Amedisys, 769 F.3d 313).