On February 22, 2021, the United States Court of Appeals for the Fourth Circuit unanimously affirmed the dismissal of a putative class action asserting claims under Sections 10(b) and 20(a) the Securities Exchange Act of 1934 against a business development financing company (the “Company”) and three of its executives. In re Triangle Capital Corporation Sec. Lit., No. 19-2162 (4th Cir. Feb. 22, 2021). Plaintiffs alleged that the Company persisted in a risky investment strategy without adequately disclosing its risks. The District Court for the Eastern District of North Carolina dismissed the first amended complaint for failure to adequately allege scienter and denied as futile plaintiffs’ motion for leave to amend again. The Fourth Circuit affirmed and dismissed the action with prejudice, holding that the factual allegations related to “legitimate, subjective business judgments” and that, “to the extent we can make any inference of scienter from these allegations, it is exceptionally weak.”

The crux of plaintiffs’ allegations was that the Company pursued an investment strategy of mezzanine financing for smaller companies, through which the Company received a lower-priority security interest than other lenders and therefore also earned a higher yield. Plaintiffs alleged that the Company continued with this strategy through 2014 and 2015 while failing to disclose its risks, and despite the growing popularity of “unitranche” lending, which combined all debt into one package with a single blended interest rate.

The Fourth Circuit considered and affirmed the District Court’s rejection of five categories of allegations put forward by plaintiffs in an attempt to support an inference of scienter: (1) advice from the Company’s investment advisors, purportedly at some time between 2013 and 2015, to adopt a “unitranche-first investment strategy”; (2) statements made in 2017 by certain executives regarding the Company’s decision to continue with a mezzanine‑first strategy; (3) a public report in December 2015 that purportedly concluded that “the mezzanine market was rapidly shrinking”; (4) the replacement of the Company’s CEO in 2016 and subsequent shift in investment strategy; and (5) the Company’s efforts to raise capital through 2016 and 2017.

With respect to the purported investment advice to pursue a unitranche-first strategy, the Court found that these allegations were not stated with the required particularity under the Private Securities Litigation Reform Act (“PSLRA”), as plaintiffs “never specifie[d] when this advice was given, how firm in their conviction these investment advisors were in recommending [the Company] avoid mezzanine deals moving forward, or what a mix of mezzanine and unitranche investments should look like.” The Court concluded that these “ambiguities,” together with the fact that plaintiffs admittedly had not alleged any motive to defraud investors, “diminish[ed] the strength of any scienter inference that can be drawn from the allegation.”

Next, the Court further rejected that alleged statements in 2017 amounted to admissions regarding the Company’s knowledge in 2014 and 2015. The Court explained that “many bad investments will, in retrospect, look like the ‘wrong strategic call’” and that plaintiffs’ use of these statements “amount[ed] to little more than pleading fraud by hindsight.” For example, the Court noted that an executive’s observation that, looking back on 2014 and 2015, one “would reasonably conclude that there was a period where [the Company] was [chasing] yield more than it should have,” did not permit any reasonable inference that the Company “knew or recklessly disregarded the risk that pursuing yield necessarily required a sacrifice in the quality of their investments.” In addition, the Court held that the public report in December 2015 actually contradicted any finding of scienter because it “contains just as many optimistic statements about the state of the mezzanine lending market as it does those expressing concern with the potential changes in that market” and the report observed that “most firms’ portfolio credit quality was strong” and “[d]efault risk remains low.”

Similarly, the Court rejected plaintiffs’ other arguments based on events in 2016 and 2017 as impermissible attempts to plead “fraud by hindsight.” Specifically, the Court gave allegations regarding the replacement of the Company’s CEO no “weight toward a scienter inference” because there were no “allegations demonstrating Defendants’ contemporaneous knowledge that their 2014 and 2015 investments lacked quality.” Moreover, with respect to the Company’s alleged change in investment strategies and an executive’s alleged statement that the prior strategy had been the “wrong strategic call,” the Court explained that the Company’s SEC filings had warned that its portfolio companies were equivalent to “high yield” or “junk” securities and there was no allegation that the Company “knew or recklessly disregarded” that its investments bore more risk than “typical ‘high yield’ or “junk’ securities.” The Court also held that allegations based on the Company raising capital in 2016 and 2017, and its alleged motive to “keep share prices and dividends high in order to attract more investors,” were “generalized motives . . . shared by all companies” (emphasis in original) and were insufficient under the PSLRA to support an inference of scienter.

The Court concluded that, considering the allegations “holistically and in their proper context,” plaintiffs failed to support a “strong” inference of scienter and that the “much stronger inference” was that “Defendants had an honest debate about the merits of a subjective business judgment, and in hindsight, simply made the wrong choice with some investments.” In this context, the Court observed that the replacement of the CEO and change in investment strategy were “more reasonably read as an extension of that debate, rather than as an effort to cover up . . . fraud.” The Court further noted that the “breadth of Defendants’ risk disclosures to investors further strengthens the competing inference of innocence,” and that these disclosures included that the Company invested in “junk” securities that were “highly speculative” and that the Company faced risks from operating in a “highly competitive” lending environment.

Having affirmed the dismissal of the Section 10(b) claims with prejudice for failure to adequately allege scienter, the Court found that the failure to adequately allege scienter was “fatal” to the Section 20(a) claims against the individual defendants.