By Jordan Crews
Today, in Yates v. Municipal Mortgage & Equity, LLC, the Fourth Circuit affirmed the district court’s dismissal of plaintiffs’ claims under section 10(b) of the Securities Exchange Act of 1934.
One of the defendants, MuniMae, was one of the nation’s largest syndicators of low-income housing tax credits (“LIHTCs”). Federal tax law provides LIHTCs to developers of low-income rental housing. MuniMae organized LIHTC investment partnerships (“LIHTC Funds”) to pool and sell the credits to investors. In 2003, the Financial Accounting Standards Board adopted Interpretation No. 46R (“FIN 46R”), which defined a new category of entities—Variable Interest Entities (“VIEs”). Under FIN 46R, “a company must consolidate onto its financial statements the assets and liabilities of a VIE if the company is its ‘primary beneficiary,’ that is, if the company absorbs the majority of the risks and rewards associated with the VIE.” MuniMae began reporting compliance with FIN 46R in the first quarter of 2004.
In September of 2006, MuniMae announced that it was restating its financial statements for fiscal years 2003 through 2005, and for the first quarter of 2006. MuniMae revealed that this restatement would address accounting errors with respect to FIN 46R, and that the Company would “be required to consolidate substantially all of the low income housing tax credit equity funds it has interests in.” In a conference call in January of 2008, MuniMae provided details to its investors regarding the restatement. With respect to FIN 46R, the Company disclosed that it had to consolidate 230 LIHTC Funds, which required it to review 6,000 separate financial statements. MuniMae had no automated process in place to review the accounting, so the work had to be done manually, which required a great amount of time and effort to fix the accounting mistakes. The price of MuniMae shares dropped an additional 22.416%, to $7.13 per share. MuniMae disclosed that it spent $54.1 million to complete the restatement.
Shareholders filed multiple lawsuits against MuniMae, alleging violations of federal securities laws. The district court dismissed the plaintiffs’ Exchange Act claims, holding that the complaint did not adequately plead scienter.
Under § 10(b) of the Exchange Act, a plaintiff must prove six elements: “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” To establish the scienter element, a plaintiff must prove that the defendant acted with “a mental state embracing intent to deceive, manipulate, or defraud.” At the pleading stage, it is sufficient to allege either intentional or severely reckless conduct. In the § 10(b) context, a reckless act is one that is “so highly unreasonable and such an extreme departure from the standard of ordinary care as to present a danger of misleading the plaintiff to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.”
The Private Securities Litigation Reform Act (“PSLRA”) imposes a heightened pleading standard on fraud allegations in private securities complaints. “[T]o the extent a plaintiff alleges corporate fraud, the plaintiff must allege facts that support a strong inference of scienter with respect to at least one authorized agent of the corporation.”
The Fourth Circuit agreed with the district court, holding that the allegations did not support a strong inference of wrongful intent. The Court acknowledged that the allegations permitted an inference that MuniMae knew that the Company was not in compliance with FIN 46R, and knew, or at least suspected, that consolidating the LIHTC Funds in accordance wit FIN 46R would be a difficult and costly undertaking. Nevertheless, the allegations did not support a strong inference of wrongful intent. The plaintiffs set forth evidence that MuniMae’s officers and an outside auditor debated how to account for the LIHTC Funds in light of FIN 46R. However, the Court held that such evidence “does not compel an inference of wrongful intent.” The Court noted that a more plausible inference is that there was an honest disagreement over the proper application of this challenging new accounting standard. This was not enough to support an inference of scienter.
The Court viewed MuniMae’s subsequent disclosures to its investors as negating an inference of fraudulent intent. The Court noted that MuniMae “(1) announced the hiring of an independent consultant to assist with the work of the second restatement, (2) identified the large number of personnel working on the accounting issues, and (3) expressed uncertainty as to the costs of the effort going forward.” This, in the Court’s view, gave rise to a more compelling inference that MuniMae was attempting “to keep the investing public informed, while working strenuously to correct the accounting errors they had discovered.” As such, the Court held that the scienter requirement was not sufficiently pled, and affirmed the district court’s dismissal of the claim.