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(Article from Securities Law Alert, October 2016) 

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On September 30, 2016, the Southern District of New York dismissed with prejudice a securities fraud action against MDC Partners and certain of its officers and directors for failure to allege either material misstatements or scienter. North Collier Fire Control and Rescue Dist. Firefighter Pension Plan v. MDC Partners, 2016 WL 5794774 (S.D.N.Y. 2016) (Sullivan, J.).[1] The court held plaintiffs’ goodwill-related allegations were insufficient to meet the standard for pleading a securities fraud claim based on a misstatement of opinion. As to plaintiffs’ claim that defendants used a “misleading version of EBITDA,” the court found that companies are free to calculate EBITDA as they deem appropriate, provided they disclose their methodology. With respect to plaintiffs’ contention that the company failed to disclose the full amount of compensation paid to its CEO, the court found the allegedly underreported amount was neither quantitatively nor qualitatively material. Finally, the court held plaintiffs’ allegations of insider stock sales did not support an inference of scienter “because the vast majority [of those] trades occurred a year or more before the alleged revelation of the fraud.”

Plaintiffs Failed to State a Securities Fraud Claim as to Alleged Goodwill-Related Misstatements  

Plaintiffs contended that MDC Partners had “overstated its goodwill balance” in violation of Generally Accepted Accounting Principles (“GAAP”) by failing to record a goodwill impairment for a poorly performing subsidiary that was ultimately merged into another one of the company’s subsidiaries. The court held plaintiffs “failed to plead that [d]efendants made any false or misleading statements in connection with MDC’s goodwill reporting” for several reasons.

First, the court noted that “the law in the Second Circuit is clear that allegations of GAAP violations or accounting irregularities, standing alone, are insufficient to state a securities fraud claim.” The court explained that “GAAP provisions are subject to interpretation and tolerate a range of reasonable treatments, leaving the choice among alternatives to management.”

Second, the court observed that under “well-settled” Second Circuit law, “goodwill estimates are opinion statements because they depend on management’s determination of the ‘fair value’ of the assets acquired and liabilities assumed, which are not matters of objective fact and will vary depending on the particular methodology and assumptions used.” To plead a securities fraud claim based on an alleged misstatement of opinion, such as an estimate of goodwill, plaintiffs must allege that (1) “the speaker did not hold the belief she professed,” (2) “the supporting fact[s] she supplied were untrue,” or (3) “the stated opinion, although sincerely held and otherwise true as a matter of fact, omitted information whose omission made the stated opinion misleading to a reasonable investor.”  

Here, the court held the complaint did “not satisfy these pleading requirements.” The court found plaintiffs “allege[d] nothing more than disagreement with MDC’s accounting judgments, which cannot support a fraud claim.”

Plaintiffs Failed to State a Securities Fraud Claim Based on Allegedly “Nonstandard” Formulas for Calculating EBITDA 

Plaintiffs further claimed defendants “misleadingly” used “the common term EBITDA” in MDC’s public filings when in fact defendants calculated EBITDA based on formulas that allegedly did not comport with “the industry standard definition.” The court held plaintiffs “failed to plead that [d]efendants made any false or misleading statements in connection with MDC’s disclosures relating to EBITDA.”

The court explained that MDC’s Form 10-Qs did not “tout” or even use the phrase “industry standard” in describing the company’s use of EBITDA as one factor in measuring its performance. Moreover, the court found that MDC’s class period earnings releases “specifically explained how MDC had calculated the ‘EBITDA’ amounts reported in those releases.” The court held that “[n]o reasonable investor would ignore these definitions, much less assume that the reported EBITDA [was] governed by” a generic industry standard definition.

The court also rejected plaintiffs’ contention that “MDC misled investors by changing its ‘nonstandard’ calculation of EBITDA from quarter to quarter.” The court held “this argument misses the mark” because “EBITDA is a non-GAAP metric for which there is no right formula.” The court found “[t]he fact that a plaintiff may take issue with the way a company chooses to calculate these metrics is of no moment because it is not fraudulent for a reporting entity to calculate metrics that, like EBITDA, are not defined under GAAP.” The court explained that “[u]nless [p]laintiffs can show that MDC somehow misled investors about how it actually calculated EBITDA, which they have not, there can be no claim for fraud.”

Allegedly Underreported CEO Income Was Neither Qualitatively Nor Quantitatively Material 

Plaintiffs claimed that “MDC failed to disclose the true amount of compensation paid” to its CEO, both by “underreporting [his] perquisites,” such as the CEO’s use of a corporate apartment, and by allegedly “improperly reimbursing” certain of his expenses. The court found the allegedly underreported income was neither quantitatively nor qualitatively material under the factors set forth in Litwin v. Blackstone Group, 634 F. 3d 706 (2d Cir. 2011).

The court explained that in Litwin, the Second Circuit “made clear that courts may evaluate materiality at the pleading stage,” and courts that do so must consider both quantitative and qualitative factors. The court observed that the Second Circuit has held that “a five percent numerical threshold —i.e., at least a five percent difference between an inaccurate versus accurate financial disclosure — is a good starting place for assessing the materiality of the alleged misstatement.” The court further stated that “useful ‘qualitative factors’ include (1) concealment of an unlawful transaction, (2) significance of the misstatement in relation to the company’s operations, and (3) management’s expectation that the misstatement will result in a significant market reaction.”

Applying this standard to plaintiffs’ allegations concerning the CEO’s perquisites, the court found the amount at issue was “well below the Second Circuit’s 5% threshold.” The court held this category of compensation “was not materially misstated” given “its minuscule impact on [the CEO’s] overall compensation” and plaintiffs’ “failure to identify any qualitative factors that would otherwise support materiality.”

With respect to plaintiffs' allegations concerning expense reimbursements, the court found that if compared against the company’s total expenses for the year, the allegedly underreported reimbursements “would amount to a paltry 0.18% — well below the Second Circuit’s 5% threshold and clearly immaterial.” The court observed that if the underreported income was measured against the CEO’s compensation for the year, however, “the percentage lands above the threshold at 10.2%.”

The court determined that even if the appropriate benchmark was the CEO’s compensation for the year (rather than the company’s total expenses), the court could not end its analysis without “also consider[ing] qualitative factors of materiality.” The court found the amount of the allegedly underreported reimbursements would  “hardly register[ ]” to a reasonable investor. The court deemed it “not substantially likely that a reasonable shareholder” would have considered this additional compensation “important” “in deciding whether to purchase MDC securities.” The court concluded that the allegedly underreported reimbursements  did not amount to a material misstatement.  

Allegations of Insider Stock Sales Failed to Raise a Strong Inference of Scienter 

Finally, the court rejected plaintiffs’ effort to plead scienter based on insider stock sales because most of the “trades occurred nearly a year or more before the end of the [c]lass [p]eriod.” The court explained that it has “consistently held that stock sales occurring even a few months before the alleged revelation of the fraud do not raise a strong inference of scienter.” In this case, “[b]ecause the vast majority of the [i]ndividual [d]efendants’ trades occurred a year or more before the alleged revelation of the fraud,” the court held the insider stock sales did “not support an inference of fraudulent motive.”