Dailey v. Medlock Securities Fraud Complaint Dismissed by Sixth Circuit
In Dailey v. Medlock, 551 Fed.Appx. 841 (6th Cir. 2014), the Sixth Circuit Court of Appeals held the plaintiffs’ complaint failed to state an actionable federal securities fraud claim under F.R.C.P. 9(b) or the heightened pleading standards of the Private Securities Litigation Reform Act (PSLRA).
According to the complaint, Community Central Bank Corporation solicited investors to purchase private stock in Community Central Bank (CCB) through a Private Placement Memorandum (PPM) dated July 2009. On October 19, 2009 and December 16, 2009, Community Central Bank Corporation issued supplements increasing the offering to $5 million and extending the purchase period.
Plaintiffs, a group of twenty-one investors, purchased CCB stock on December 31, 2009 and January 29, 2010. Shortly thereafter, on March 29, 2010, the Michigan Office of Financial and Insurance Regulation (OFIR) issued a report finding CCB violated laws, rules, and regulations. Two days later, CCB reported $10 million in fourth quarter losses for 2009. Much of the operating loss came from a valuation allowance on CCB’s net deferred tax assets. CCB described the valuation allowance as a “one time non-cash charge to federal income tax expense.”
Near the end of 2010, CCB entered into a Consent Order with the FDIC and OFIR. Under the Order, CCB agreed to amend its business practices without admitting or denying any violations of law, rule, or regulation. In April 2011, CCB failed and went into receivership. In February of 2012, the plaintiffs filed their complaint against 13 individual CCB officers and directors alleging violations of the federal securities laws.
To establish a violation under §10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, a plaintiff must allege that a defendant made a material misrepresentation or omission with scienter and the plaintiff’s reliance on the material misrepresentation or omission resulted in the plaintiff’s economic loss. An omission is actionable if necessary to ensure that a statement made by the company does not mislead the market.
F.R.C.P. 9(b) requires a plaintiff to plead claims brought under §10(b) sounding in fraud with heightened particularity. In addition, the PSLRA requires a plaintiff to plead with particularity facts giving rise to the belief the statements made were misleading and facts giving rise to a strong inference the defendant acted with scienter.
A plaintiff pleading scienter must provide facts demonstrating a strong inference the defendant acted with the intent to deceive, manipulate, or defraud the plaintiff. A plaintiff adequately pleads scienter under the PSLRA if a reasonable person would consider the inference of scienter as convincing as any other plausible opposing inference. A misstatement or omission is material if a reasonable investor would view the omitted fact as significantly altering the total mix of information made available.
The plaintiffs alleged three categories of misstatements or omissions made by the defendants violated Rule 10b-5. First, the plaintiffs argued that a statement in the PPM indicated CCB maintained adequate levels of capital throughout 2009. Plaintiffs alleged this implication was misleading because the defendants knew CCB would take the valuation allowance at the end of 2009 and the defendants failed to disclose the information in the PPM or its supplements.
The Sixth Circuit held that the plaintiffs failed to plead any highly particularized facts to support their assertion that the defendants knew about the valuation allowance when they issued the PPM and its supplements. The court further noted that one-month before the plaintiffs purchased the stock, CCB filed a Form 10-Q with the SEC for the third quarter indicating CCB would not take a valuation allowance for that quarter. The 10-Q also stated that a valuation allowance might be necessary in the future, which could adversely affect CCB’s financial position. The court rejected the plaintiffs’ claim that the valuation allowance itself was evidence of the defendants’ prior knowledge. Consequently, the Sixth Circuit concluded that the plaintiffs’ allegations regarding the defendants’ prior knowledge of the valuation allowance failed to state a securities fraud claim under Rule 10b-5.
Second, the plaintiffs alleged CCB misled investors by describing CCB as “well capitalized” in the PPM and three SEC filings between May and November of 2009. The plaintiffs alleged using this term misled investors because the defendants failed to disclose that CCB was engaged in risky business practices that were later investigated by the OFIR. The court noted that the term “well capitalized” is a term of art under federal banking regulations and did not relate to a general assessment of CCB’s business practices. The plaintiffs did not argue that CCB failed to meet the definition of “well capitalized” under the applicable regulatory criteria. The Sixth Circuit emphasized that the PPM stated CCB was “well capitalized” pursuant to “applicable regulatory capital guidelines.” The PPM further stated that the purpose of the stock offering was to improve CCB’s capital levels in light of a poor economic forecast. In addition, the PPM included a twenty-three page detailed discussion of the risks related to CCB’s business. Lastly, the court noted that CCB accurately reported itself as “adequately capitalized” in its Fourth Quarter filings of 2009 when CCB’s status changed. Therefore, the Sixth Circuit concluded the plaintiffs’ allegation that the defendants misled investors by describing CCB as “well capitalized” failed to state a claim under Rule 10b-5.
Finally, the plaintiffs argued that the PPM’s statement that CCB’s operations were subject to extensive regulation by federal, state, and local governments was misleading because the defendants did not disclose they were violating laws and regulations and were under investigation by the OFIR. The plaintiffs did not plead with particularity what law or regulation the defendants violated. The Sixth Circuit noted the statement was factually accurate. The PPM did not represent that CCB believed it was compliant with the law. Under Sixth Circuit precedent, a nonspecific claim of legal compliance did not constitute an actionable claim for misrepresentation under Rule 10b-5 and did not require disclosure of purported illegal activity by a company. Accordingly, the Sixth Circuit held the plaintiffs failed to adequately plead an actionable Rule 10b-5 claim.
The Sixth Circuit went on to dismiss plaintiffs’ claim under §20(a) of the Exchange Act for control person liability, because the plaintiffs failed to state the requisite underlying claim for securities fraud under Rule 10b-5.
In conclusion, the Sixth Circuit Court of Appeals upheld the district court’s decision to dismiss the plaintiffs' federal securities fraud claims.
The primary materials for this case may be found on the DU Corporate Governance website.