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(Article from Securities Law Alert, July 2019) 

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On June 20, 2019, the Third Circuit affirmed dismissal of a securities fraud action alleging that a company “fraudulently lauded its financial health and misrepresented that its distributions were funded from the performance of the business.” Fan v. StoneMor Partners, 2019 WL 2529250 (3d Cir. 2019) (Restrepo, J.). The Third Circuit found that “for each category of alleged misstatements, [the company] disclosed sufficient information to render them immaterial.” The court further held that the company’s comprehensive disclosures belied any inference of scienter.

As to alleged misstatements concerning the company’s financial health, the court found that the company “repeatedly disclosed the risks it faced in its business.” For example, the company cautioned that its “substantial level of indebtedness could materially adversely affect its ability to generate sufficient cash for distribution to its unitholders, to fulfill its debt obligations and to operate its business.” The court determined that these types of disclosures “alert[ed] reasonable investors” to the company’s downside potential.

With respect to statements concerning the source of the company’s distributions, the court noted that the company’s Form 10-Ks defined “Available Cash as consisting of cash on hand at the end of that quarter, plus cash on hand from working capital borrowings made after the end of the quarter . . . less cash reserves.” The court determined that a reasonable investor would have known from this definition that the company’s “distributions were funded by more than just its operating revenue.” The court also found it significant that the company included in its annual reports both “GAAP and non-GAAP financials side-by-side, which demonstrated the mathematical reality that [the company] was not able to fund its distributions primarily from its day-to-day operations because much of that cash was being held in state trusts and was unrecognized by GAAP.” The court determined that these disclosures refuted plaintiffs’ allegation that the company “fraudulently concealed the fact that its distributions were not funded primarily from the current operating revenue.”

The court further found that the company’s “disclosures do not demonstrate an intent to defraud—rather, they accurately show how [the company] leveraged its assets in order to maximize its distributions despite the state trust requirements” that limited its ability to recognize proceeds as revenue under GAAP. The court explained that although the company “may have been caught by the risk inherent in its business strategy, . . . those risks were disclosed” to investors and thus “the pleadings do not demonstrate scienter as the [Private Securities Litigation Reform Act] requires.”