On November 22, 2019, Judge Jeffrey J. Helmick of the United States District Court for the Northern District of Ohio dismissed a putative class action asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 against a real estate investment trust (“REIT”) and its former officers (collectively “Defendants”), along with a healthcare company with which the REIT transacted (the “Company”) and its officers. Boynton Beach Firefighters' Pension Fund v. HCP, Inc., No. 3:16-CV-1106, 2019 WL 6251435 (N.D. Ohio Nov. 22, 2019). Plaintiffs alleged Defendants made false or misleading statements about the Company’s future prospects, but knew or should have known that the Company was engaged in unlawful billing practices because of due diligence in connection with the transaction with the Company and a subsequent government investigation. The Court held that plaintiffs’ allegations of scienter were based on impermissible hindsight pleading and dismissed the complaint.
The REIT leases real property it owns to healthcare companies. In 2011, the REIT purchased substantially all of the Company’s real estate assets. The REIT then leased those assets back to the Company and acquired a 9.9 percent equity ownership interest in it. From 2006 through 2012, the Company allegedly engaged in unlawful billing practices. Plaintiffs allege that three former therapists of the Company filed qui tam complaints asserting False Claims Act claims, and the Department of Justice (“DOJ”) served a Civil Investigative Demand on the Company in early 2013 and intervened in the qui tam actions in 2014. The Company’s revenues subsequently declined.
The complaint was brought on behalf of a class of investors in the REIT’s stock. Plaintiffs alleged that statements made by Defendants regarding the Company’s future prospects and its ability to make lease payments to the REIT were misleading given the Company’s alleged fraudulent billing practices. Plaintiffs further claimed that Defendants knew or should have known that the statements were false because of information Defendants allegedly gained from due diligence during the 2011 transactions and from the DOJ investigation.
Applying the nine-factor test set forth by the United States Court of Appeals for the Sixth Circuit in Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir. 2001), the Court found plaintiffs failed to plead scienter adequately. Among other things, the Court held the complaint did not allege adequately that Defendants (1) gained access to documents reflecting the Company’s alleged fraudulent practices during due diligence, (2) disregarded information from the DOJ investigation, (3) made adverse disclosures sufficiently close in time (allegedly two and three months) after the allegedly misleading statements, or (4) acted to save their salaries or jobs. The Court noted that the REIT acknowledged the existence of the DOJ investigation and offered reasons why the REIT believed the investigation would not adversely impact its ability to collect lease payments. While the REIT’s belief proved incorrect, the Court held that scienter cannot be alleged through hindsight. The Court also rejected plaintiffs’ emphasis on voluntary resignations of five executives as evidence of self-interest, because plaintiffs failed to show how the departures were unusual or connected to misconduct.
Finally, even when looking at plaintiffs’ scienter allegations “collectively,” the Court held that the complaint failed to establish a strong inference of scienter because it lacked factual support for the inference that Defendants must have known that the Company’s revenues were irreversibly declining. Instead, the Court recognized a strong countervailing inference that Defendants did not know that the allegedly fraudulent billing had improperly inflated the Company’s past revenues and undermined the reliability of them as a data point to measure the Company’s viability. The Court also noted that the REIT’s heavy reliance on income from the Company, “while perhaps a poor business strategy, is not evidence of scienter.”