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(Article from Securities Law Alert, November 2018) 

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On November 14, 2018, the Third Circuit affirmed dismissal of a securities fraud action alleging that a company failed to disclose regulatory violations by an affiliated entity. City of Cambridge Ret. Sys. v. Altisource Asset Mgmt. Corp., 2018 WL 5931509 (3d Cir. 2018) (Fisher, J.). The Third Circuit found “no authority to support the conclusion that [the defendant company] was obligated to disclose the flaws of a separate entity in its own filings.” The court also observed that “[w]hen a stock experiences the rapid rise and fall that occurred here, it will not usually prove difficult to mine from the economic wreckage a few discrepancies in the now-deflated company’s records.” The court underscored that “[h]indsight . . . is not a cause of action.”

As a preliminary matter, the Third Circuit declined to consider alleged misstatements made by any entities affiliated with the defendant company. The defendant company and other entities had been spun off from the affiliated entity at issue, and the companies worked together to capitalize on opportunities in the real estate market. The court explained that under the Supreme Court’s decision in Janus Capital Grp. v. First Derivative Traders, 564 U.S. 135 (2011), the “maker” of a statement for Rule 10b-5 purposes is “the person or entity with ultimate authority over the statement.”[1] The court therefore determined that “statements made by companies other than” the defendant company had no “legal significance” with respect to plaintiffs’ Rule 10b-5 claims.

The Third Circuit then considered the defendant company’s statements concerning the manner in which it benefited from its affiliate’s mortgage servicing expertise. The defendant company stated that it depended on the affiliate for mortgage servicing and would face financial risks if the affiliate could no longer provide these services. Plaintiffs contended that these statements were misleading because the defendant company was allegedly aware of but did not disclose the affiliate’s alleged regulatory violations. But the Third Circuit found that the defendant company’s statements did “not imply anything about the quality of [the affiliate’s] loan servicing.” The court determined that there was no basis for holding that the defendant company’s “reference to [the affiliate] carried some form of implied warranty” as to the quality of the affiliate’s services. The court stated that “[e]ven assuming that such an obligation could arise in some cases, it would make no sense to impose such a requirement where, as here, the allegedly ‘concealed’ information—[the affiliate’s] regulatory failures—was not only well-known, but typical of most mortgage servicers at the time.”

Plaintiffs also claimed that the defendant company misrepresented its recusal policy, pursuant to which the chairman of the defendant company’s board was required to recuse himself from transactions involving affiliated entities because the chairman founded these entities. Plaintiffs did not allege that the chairman failed to recuse himself from any transactions between the defendant company and the affiliated mortgage servicing entity. Instead, plaintiffs “speculate[d] that [the chairman] must have violated the . . . recusal policy because he is suspected to have done so with other companies.” The Third Circuit found plaintiffs’ allegations constituted “the very sort of speculative fraud by hindsight that the [Private Securities Litigation Reform Act] was intended to eliminate.”