Second Circuit Reverses Dismissal Of Exchange Act Claims Against REIT, Holding Plaintiffs Adequately Alleged Scienter
On August 3, 2020, the Second Circuit reversed the dismissal of Exchange Act claims against a real estate investment trust (the “Company”) and several of its senior officers for alleged misstatements regarding the financial health of one of the Company’s healthcare facility operators (the “Operator”). In re Omega Healthcare Investors, Inc. Securities Litigation, No. 19-1095 (2d Cir. Aug. 3, 2020). The district court had granted defendants’ motion to dismiss the amended complaint, finding that although plaintiffs adequately pled material misstatements, they failed to sufficiently plead scienter. The Second Circuit vacated the dismissal, holding that plaintiffs sufficiently pled scienter based on defendants’ alleged consciously reckless omission of certain material information that made certain statements in public filings and conference calls regarding the financial health of the Operator misleading.
The Company owns and leases operating space to various nursing facilities and bases its financial performance largely on rents paid by the facilities. According to the amended complaint, in late 2016 the Operator, which operated 59 facilities across the country, began to experience financial problems and became past due on its rent owed to the Company. At the time, the Operator was the Company’s second largest nursing home operator and represented seven percent of the Company’s investment portfolios. In response to the Operator’s financial difficulties, the Company allegedly provided the Operator with a $15 million working capital loan, which the Operator used to pay a portion of its rent to the Company.
Plaintiffs alleged that during a Q1 2017 conference call with analysts, one of defendant officers stated that the Operator was going through a “transition period” which led to “performance pressure” and discussed business changes the Operator would make in an effort to recover, including rebranding, moving its headquarters, and sales of certain of its facilities. According to the amended complaint, a different defendant officer stated on the same conference call that the Operator “was 45 days past due on its rent payments.” When asked by an analyst why the Company did not reflect this change in its guidance regarding its financial performance, the officer allegedly responded “‘at 45 days past due, to start fiddling around with guidance, just doesn’t make any sense’” and further “reassured the analyst” that the Operator would recover. The amended complaint alleged that the Company did not disclose the loan in the conference call or in any of its first quarter filings. Plaintiffs alleged that similar statements were repeated in the Company’s 10-Q for Q2 2017, which noted that the Operator “has been showing signs of operational improvement and is currently making partial monthly rent payments.” Plaintiffs alleged that the loan similarly was not disclosed on the Q2 2017 conference call or in the 10-Q for Q2 2017.
In opposing defendants’ motion to dismiss, plaintiffs contended that the statements made by defendants and omissions were misleading because they “implied that [the Operator] had been making rent payments from its own operating income, when at least part of those rent payments [were] funded by the undisclosed loan.” Plaintiffs further alleged that the Company’s “repeated failure” to disclose the loan was intended to conceal from the market “both the gravity of [the Operator’s] financial woes and the likely impact on [the Company’s] financial results.” While the district court found defendants’ omission of the loan to be materially misleading, in granting defendants’ motion to dismiss it held that plaintiffs failed to plead scienter, “because the Complaint failed to allege any GAAP violation and because [the Company] had ‘disclosed [the Operator’s] financial predicament repeatedly to investors.’” Plaintiffs appealed, asserting a theory of scienter “based primarily in recklessness.”
At the outset, the Second Circuit noted that a recklessness standard requires a plaintiff to “allege a clear duty to disclose . . . and further allege facts supporting a strong inference of ‘conscious recklessness – i.e., a state of mind approximating actual intent.’” Plaintiffs argued that defendants had a duty to disclose the loan because their omission rendered their statements “actionably misleading.” The Second Circuit agreed, holding that the Company’s “duty to disclose the [l]oan arose directly from Rule 10b–5’s requirement to disclose ‘material fact[s] necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.’” The Court continued that in reviewing defendants’ statements about the Operator’s rent payments, defendants’ failure to disclose the loan “gave a false impression of the financial health of one of [the Company’s] largest assets.” Moreover, in failing to disclose how the Operator used the loan, the Court found that defendants “effectively communicated that . . . [the Operator] could pay more than half of its rent from its earnings,” which “concealed the extent of [its] solvency problems.” Based on the Company’s statement that the Operator was “currently making partial monthly rent payments,” the Court found that the Company was “duty-bound to disclose that its loan was the source of [the Operator’s] rent payments,” and further found that plaintiffs had adequately alleged a “strong inference” that the Operator “could not have made its ‘partial monthly rent payments’ but for the [l]oan.” After finding that the Company’s duty to disclose the loan arose under Rule 10b–5, the Court noted that it did not need to address plaintiffs’ separate argument that Item 303 of Regulation S-K imposed an independent duty on the Company to disclose the loan.
In further evaluating plaintiffs’ allegations that defendants’ failure to disclose the loan constituted sufficient recklessness to plead scienter, the Second Circuit highlighted that a recklessness theory of scienter requires a plaintiff to “allege facts showing the defendant’s ‘conscious recklessness’” and that its behavior was “‘highly unreasonable and . . . represent[ed] an extreme departure from the standards of ordinary care 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 Second Circuit held that the Company’s decision to not disclose the loan to the Operator constituted a “sufficiently extreme departure from the standards of ordinary care” that satisfied the “PSLRA’s requirement for showing recklessness.” The Court further noted that in determining whether a strong inference of recklessness was adequately alleged, courts must look to a defendant’s “degree of knowledge and the seriousness of the impact that results from their conduct.” The Second Circuit found that “at the very least” the amended complaint “raised a strong inference” of recklessness in alleging defendants’ decision to “disclose incomplete and misleading information” about the Operator, and agreed with the district court’s holding that “there is no question that the inability of one of [the Company’s] ‘top’ tenants to pay rent absent the [l]oan was material.” But, unlike the district court, the Second Circuit determined that allegations regarding the Operator’s performance “plainly impacted [the Company’s] overall financial health” and that the Company “had to know that revealing the full extent of [the Operator’s] performance problems would have been troubling news to its investors.” As such, the Court held that plaintiffs adequately alleged defendants “made a conscious decision” and “chose to represent these numbers as ‘partial monthly payments’ indicating that [the Operator] was on the road to recovery,” which created a “strong inference that [defendant’s actions] constituted ‘conscious misbehavior’ . . . represent[ing] an extreme departure from the standards of ordinary care.” In supporting its determination, the Court took note of the allegation that numerous of the Company’s analysts had focused on the Operator’s rental payments being key to the Company’s financial prospects and the allegation that the Company had previously disclosed the possibility of a working capital loan to another troubled operator. Accordingly, in reaching this holding, the Second Circuit concluded that such an inference of scienter is “at least as compelling as any opposing inference one could draw from the facts alleged.”
As a result, the Second Circuit reversed the district court’s dismissal of the Section 10(b) claim due to lack of scienter, and further reversed the district court’s dismissal of plaintiffs’ control liability claims under Section 20(a), which the district court also had dismissed based on its finding of no primary liability.