On April 15, 2015, the Second Circuit issued an opinion in IBEW Local Union No. 58 Pension Trust Fund & Annuity Fund, et al. v. The Royal Bank of Scotland Group, PLC, et al., No. 13-3289, affirming the district court's decision granting defendants' motion to dismiss for failure to state a claim of securities fraud.  The decision makes clear that defendants can prevail on materiality grounds on a motion to dismiss and that the SEC Staff Accounting Bulletin ("SAB") No. 99's quantitative and qualitative factors for assessing materiality are relevant criteria for evaluating the legal sufficiency of a plaintiff's complaint.

Background

Plaintiffs brought suit under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Royal Bank of Scotland ("RBS") on behalf of a putative class of investors who acquired American Depository Shares of RBS between October 17, 2007 and January 20, 2009.  Among other allegations, plaintiffs alleged that RBS misrepresented the bank's subprime exposure in a December 2007 press release and falsely stated that the Financial Services Authority had not required RBS to conduct the Rights Issue that RBS conducted to raise capital in April 2008.

Specifically, plaintiffs claimed that, in a December 6, 2007 press release, RBS misrepresented its total U.S. subprime exposure as $10.3 billion, but later disclosed an actual exposure of $17.1 billion.  (Op. 6-7).  With respect to the Rights Issue, plaintiffs claimed that RBS's statements that (1) its Rights Issue was "purely the Board of RBS['s] decision," and (2) "[t]he [Financial Services Authority (the "FSA")] are happy to see us raising capital and encourage us in our plans to do so, but they didn't request us to do it," were materially false because the CEO of the FSA later testified that he told RBS on April 9, 2008 that it was "specifically required" to conduct a Rights Issue.  (Op. 8-9).

Decision

The Second Circuit affirmed the district court's decision dismissing plaintiffs' allegations, finding, with respect to the subprime exposure allegations and the Rights Issue allegations, that plaintiffs had failed to adequately plead materiality.

With respect to the Rights Issue statements, the Second Circuit held, over a dissenting opinion by Judge Leval, that the statements were not false because (1) RBS had decided to conduct the Rights Issue five days before the FSA purportedly "specifically required" the company to raise capital and (2) RBS had not fallen below FSA's minimum capital requirements as of early April 2008.  (Op.  20-21).  Importantly, however, the court went on to consider whether, even if the statements were misleading, there was "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."  (Op. 11, 15).  The court carefully considered the information already in the marketplace at the time of the April 22 announcement and concluded that "critical facts" were already known to the market at the time, including that "RBS needed an infusion of capital," that RBS "was taking additional write-downs," that FSA was "closely monitoring RBS's situation and encouraging a Rights Issue" and that "there was generally a steep deterioration in market conditions and credit market outlooks."  (Op. 21-22).  In light of this information, the court held that a "reasonable investor would have deemed the difference between 'encouraged' and 'required' to be immaterial."  (Op. 21). [1]

With respect to the December 6, 2007 exposure statements, the court began by noting that the SEC's SAB 99 considers a misstatement related to less than 5% of the relevant items on a registrant's financial statement to be presumptively immaterial.  (Op. 14.)  Applying this test, it found that plaintiffs' allegations related to such a small percentage of the relevant items on RBS's financial statement (total assets and total asset backed securities exposure) that they were presumptively immaterial from a quantitative perspective.

The court noted, however, that SAB 99's 5% "rule of thumb" is not conclusive and courts must also consider certain qualitative factors that can turn a "quantitatively immaterial statement into a material misstatement."  (Op. 14).  These factors are, among others, "whether the misstatement 'arises from an item capable of precise measurement'; 'masks a change in earnings or other trends'; 'changes a loss into income or vice versa'; 'concerns a segment or other portion of the . . . business that has been identified as playing a significant role in the registrant's operations or profitability'; 'involves concealment of an unlawful transaction'; and whether 'a known misstatement may result in a significant positive or negative market reaction.'"  (Op. 14).

Applying these qualitative factors, the Royal Bank of Scotland court found that plaintiffs had not alleged that "the amount of exposure could have been calculated precisely, masks a change in earnings, changes a loss into income or vice versa, or involves an unlawful transaction, or that the misstatements resulted in a significant positive market reaction."  (Op. 16).  Although the court found that "RBS's asset-backed securitization group was a driving factor in its profitability," it held that "this factor alone does not tip the scales in favor of finding the misstatements material."  (Op. 16).  The court therefore held that the plaintiffs had failed to adequately plead materiality with respect to the December 6, 2007 statements.  (Op. 17).

Analysis

The Second Circuit's decision confirms that defendants can prevail at the motion to dismiss stage on materiality, which is an element of a securities fraud claim that is often thought of as amorphous and fact-intensive.  The decision further demonstrates that it is appropriate to assess both quantitative and qualitative materiality at the motion to dismiss stage and that the SEC's accounting pronouncements contain highly relevant criteria for this evaluation.  Further, the Royal Bank of Scotland court's willingness to closely parse and evaluate the plaintiffs' materiality allegations here, particularly with respect to its analysis of the total mix of information in the marketplace regarding the Rights Issue, should be encouraging to securities fraud defendants and serve as helpful precedent for future defendants at the motion to dismiss stage.

The Royal Bank of Scotland court's analysis of the materiality of the December 2007 statements indicates that the courts in the Second Circuit will apply more critical scrutiny to the qualitative tests of SAB 99 than might previously have been inferred from the Second Circuit's 2011 decision in Litwin v. Blackstone Group, LP, 634 F.3d 706 (2d Cir. 2011), which overturned a district court's dismissal on materiality grounds.  There, the court acknowledged the relevance of the qualitative and quantitative factors set forth in SAB 99, but went on to find that a misstatement related to less than 5% of an item on a registrant's financial statement was qualitatively material, in part because the alleged misstatement related to a segment that played a "significant role" in the defendant's business.  Id. at 720.  In contrast, the Royal Bank of Scotland court found that the fact that RBS's asset-backed securitization group was a driving factor in RBS's profitability was not enough, on its own, to "tip the scales in favor of finding the misstatements material."  (Op. 16).

Royal Bank of Scotland provides important support for defendants seeking to dismiss securities fraud lawsuits on materiality grounds.  The Royal Bank of Scotland court was clear that materiality should be assessed from a quantitative and qualitative perspective at the motion to dismiss stage and that the importance of a business segment to a company alone is insufficient to overcome the presumption of immateriality for allegations relating to less than 5% of an item on a registrant's financial statement.  Further, Royal Bank of Scotland demonstrates that an analysis of the total mix of information in the marketplace need not wait until summary judgment and that a court can conclude, as a matter of law, that an alleged misstatement would not have altered this mix.