(Article from Securities Law Alert, July/August 2020)
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On August 3, 2020, the Second Circuit revived a putative securities fraud class action alleging that a real estate investment trust (“REIT”) “misled investors by failing to disclose a $15 million working capital loan it made to one of its major tenants” in May 2017, which the tenant then used to make partial rent payments to the REIT. Setzer v. Omega Healthcare Investors, 2020 WL 4431902 (2d Cir. 2020) (Wesley, J.). The Second Circuit found plaintiffs adequately alleged that the REIT’s “decision not to disclose the [l]oan . . . in the context of its disclosures regarding [the tenant’s] financial health” was “a sufficiently extreme departure from the standards of ordinary care to satisfy the [Private Securities Litigation Reform Act’s] requirement for showing recklessness.”
Background
In the first quarter of 2017, the REIT disclosed that the tenant had fallen behind on its rent payments. Analysts subsequently “raised concerns regarding [the tenant’s] ability to pay rent.” During a July 27, 2017 conference call with analysts, the REIT’s chief operating officer (“COO”) expressed optimism that the tenant’s “efforts will result in steadily improving margins and [will] eventually return to its former profitability.” In its second-quarter 10-Q, the REIT stated that the tenant “has been showing signs of operational improvement and is currently making partial monthly rent payments.” Plaintiffs contended that this statement “implied that [the tenant] had been making rent payments from its own operating income, when at least part of those rent payments was funded by the undisclosed loan [the REIT] had extended to [the tenant] several months earlier.” Plaintiffs further alleged that the REIT’s “repeated failure to disclose the existence of the [l]oan was part of a surreptitious scheme to avoid disclosing to the market both the gravity of [the tenant’s] financial woes and the likely impact on [the REIT’s] financial results.”
The district court found plaintiffs adequately alleged the materiality of the REIT’s failure to disclose the loan. However, the district court held that plaintiffs failed to plead scienter because there were no allegations of a GAAP violation, and the REIT otherwise disclosed the tenant’s financial difficulties. Plaintiffs appealed.
Plaintiffs Adequately Alleged That Defendants’ Failure to Disclose the Loan Was an Extreme Departure From the Standards of Ordinary Care
The Second Circuit began by noting that “[p]laintiffs’ theory of scienter is based primarily on recklessness.” The court explained that in order to state a claim that a material omission was reckless, plaintiffs must “allege a clear duty to disclose” and must further “allege facts supporting a strong inference of conscious recklessness—i.e., a state of mind approximating actual intent, and not merely a heightened form of negligence.”
The Second Circuit held that the REIT “was duty-bound to disclose that its loan was the source of [the tenant’s] rent payments.” The court found that “[b]y putting [the tenant’s] rental payments in play, [d]efendants were required to speak accurately and completely.” The court determined that “[t]he omission concealed the extent of [the tenant’s] solvency problems: [the tenant] could not pay rent without borrowing from its landlord.”
The Second Circuit further found that “the allegations in the [c]omplaint raise a strong inference that [d]efendants acted, at the very least, recklessly in choosing to disclose incomplete and misleading information regarding [the tenant].” The court focused its analysis on “[d]efendants’ degree of knowledge and the seriousness of the impact that result[ed] from their conduct.” The court noted that the tenant “represented seven percent of [the REIT’s] investment portfolio” and “was a significant source of income through rental payments.” The court found that because the tenant’s “performance plainly impacted [the REIT’s] overall financial health,” the REIT “had to know that revealing the full extent of [the tenant’s] performance problems would have been troubling news to its investors.” The court concluded that “[t]he facts as alleged create a compelling inference that [d]efendants made a conscious decision to not disclose the [l]oan in order to understate the extent of [the tenant’s] financial difficulties,” particularly because “multiple analysts ho[n]ed in on [the tenant’s] rental payments being key to [the REIT’s] prospects.”
The Second Circuit found it irrelevant for scienter purposes that plaintiffs did not allege “a GAAP violation or other accounting irregularity.” The court explained that “[w]hile loaning money to a tenant to pay its rent and then expressing optimism about that tenant’s performance because it is making partial monthly payments may not violate GAAP, it is still seriously misleading under the facts as alleged here.” The Second Circuit also noted that defendants’ “disclosures regarding [the tenant’s] financial difficulties” did not “alter [its] conclusion.” To the contrary, the court found “those disclosures support a finding of recklessness here as they strongly suggest that [d]efendants sought to use [the tenant’s] partial rental payments to express optimism and underrepresent the extent of those very problems.”
Alleging a Duty to Disclose, Standing Alone, Is Insufficient to Plead Recklessness in the Context of an Omission
The Second Circuit observed that “the distinction between materiality analysis and the recklessness prong of scienter warrants some attention” in the context of material omissions. The court explained that the “recklessness analysis resembles [the] materiality analysis” in such cases because “[a] defendant’s duty to disclose often depends on the importance of the omitted information under the circumstances.” The Second Circuit clarified that “where, as here, the duty to disclose is based on a requirement to disclose material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, and the recklessness inquiry requires assessing the seriousness of the defendant’s departure from its duty to disclose, . . . the seriousness required to adequately allege recklessness must typically go beyond the materiality showing required to allege a duty to disclose.”