On May 15, 2019, the United States Court of Appeals for the Fifth Circuit partially revived a securities fraud suit brought by a doctor and his business partner against two former business associates under the Securities Exchange Act of 1934 (the “Exchange Act”). Masel v. Villarreal, —F.3d—, 2019 WL 2120536 (5th Cir. May 15, 2019). Plaintiffs alleged that defendants induced them to enter into a joint business enterprise through material misrepresentations and omissions about the effectiveness of defendants’ medical billing service. The Court held that the complaint adequately stated a claim against one of the individual defendants and her associated business entities, but that it was properly dismissed as to another individual defendant.
Plaintiffs claimed that defendants falsely represented that a particular medical test was very profitable and that defendants’ superior business practices allowed them to generate high payouts on insurance claims for those procedures. Id. at *1. Defendants had allegedly stated that they employed a “special algorithm,” referred to as a “secret sauce,” and made various statements about the financial results they were able to obtain. Id. The plaintiff doctor then established and invested in a collection of limited partnerships to provide those medical procedures, and hired defendants to manage the billing in exchange for a limited partnership interest in the companies. Id. at *4-5. These newly created companies, however, recovered only a small fraction of insurance claims, and, moreover, defendants allegedly stole business from these companies for the benefit of other clients.
The Court first considered whether the relationship between the parties involved an exchange of securities (as defined by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946)) such that a claim could be maintained under the Exchange Act. Id. at *4. Accordingly, the Court assessed whether there was (1) an investment of money (2) in a common enterprise (3) based on an expectation of profits to be derived solely from the efforts of individuals other than the investor—while understanding that the word “solely” should be understood to mean that the efforts of others are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” Id. at *4-5. The Court noted that limited partnership interests held by passive investors may “typically” be securities under Howey’s third factor, but that the instant situation was unusual in that it was defendants who had purchased the limited partnership interests, who had made alleged misrepresentations, and whose performance had failed to meet expectations; thus, defendants were less like typical limited partners who were passive investors relying on the activities of others. Id. at *5-6. However, distinguishing prior Fifth Circuit precedent in Frazier v. Manson, 484 F. Supp. 449 (N.D. Tex. 1980), aff’d, 651 F.2d 1078, the Court held that, although one who had managerial rights as a general partner could not assert that its related limited partnership interests satisfied the third prong of Howey, in a case like that at bar, in which defendants as limited partners had no formal managerial control, their active role in the enterprise could not overcome the presumption that a limited partnership interest is a security. Id. at *6. Thus, the limited partnership interests were properly viewed, at least for pleading purposes, as securities. Id. at *7.
The Court next addressed whether the seven misstatements and three omissions alleged by plaintiffs were actionable. The Court held that a statement that defendants had superior billing procedures that were capable of generating the highest payouts was not actionable because plaintiffs failed to allege with particularity that the statement was false when made. Id. at *8. The Court also concluded that two other statements were not actionable because plaintiffs failed to specify the place where the statements were made, as required by the PSLRA’s heightened pleading standard. Although plaintiffs argued that the statements were “obvious[ly]” made in correspondence because the complaint included misspelled words, quotations marks, and brackets, the Court held that the particularity required by the PSLRA could not be satisfied where the context in which a statement was made is to be inferred based on spelling and punctuation. Id. at *9. Further, the Court rejected plaintiffs’ request that they be granted leave to replead these allegations, holding that plaintiffs’ failure to request leave to amend at the district court constituted a waiver.
The Court also found all three alleged omissions not actionable. With respect to allegations that defendants failed to disclose their intent to set up competing businesses and that plaintiffs would not receive compensation for most claims, the Court held that plaintiffs failed to plead with particularly when these disclosures should have been made. Regarding a third alleged omission, defendants’ failure to disclose conflicts of interest, the Court held that, even assuming that defendants should have disclosed the conflict of interest when they were asked if they had other clients, the complaint did not plausibly allege that the conflict existed at that time. Id.
The Court concluded, however, that the remaining four alleged misstatements were adequately pleaded. The Court concluded that two alleged misrepresentations as to the capacity of the companies to perform were sufficiently pleaded based on the fact that claims were not collected upon. Id. at *10. The Court rejected defendants’ argument that plaintiffs were impermissibly attempting to plead fraud-by-hindsight, explaining that fraud-by-hindsight is impermissible in the context of scienter, but evidence of later events can provide useful circumstantial evidence that a given representation was false when made. The Court noted that in circumstances “where the representation in question concerned an asset or skill possessed by the defendant (here, an algorithm), the defendant’s failure to perform as promised casts doubt on whether he possessed that skill in the first place.” Id. The Court also concluded that the other two statements, which concerned the profits defendants could generate, related to the present capacity of defendants to perform. Id. at *11. As such, these alleged misrepresentations were also adequately pleaded.
The Court then assessed whether plaintiffs had adequately alleged scienter with respect to these four alleged misstatements. The Court concluded that plaintiffs adequately alleged that the defendant who ran the medical billing services company knew such representations were false because they were based on metrics and information in her control. Id. However, the Court held that scienter was not sufficiently alleged for another defendant, who served as a medical services technician, because plaintiffs failed to establish that this defendant understood the algorithm, how it worked, or whether it existed. Id. at *12.