Plaintiffs brought a putative securities class action on behalf of investors who purchased the common units of the Blackstone Group, LP (Blackstone) at the time of its initial public offering (IPO) on June 21, 2007. Plaintiffs alleged that Blackstone, and certain of its officers, failed to disclose facts relating to Blackstone’s substantial investment in a monoline insurer that insured collateralized debt obligations (CDOs) backed by subprime mortgages to higher-risk borrowers, and residential mortgage backed securities (RMBS) linked to nonprime and subprime mortgages. The district court dismissed the action for failing to allege a material omission. On February 10, 2011, the US Court of Appeals for the Second Circuit reversed, concluding that the plaintiffs had plausibly alleged that material information was omitted from defendants’ IPO registration statement and prospectus in violation of Sections 11 and 12(a)(2) of the Securities Act of 1933. Litwin v. Blackstone Group LP, Case No. 09-4426 (2d. Cir. Feb. 10, 2011)
Blackstone’s Investment in FGIC
According to the amended complaint, Blackstone is one of the largest independent alternativeasset managers in the world, with total assets under management (AUM) of approximately $88.4 billion (as of May 1, 2007). One of its largest business segments is Corporate Private Equity, which constitutes about 37.4 percent of Blackstone’s total AUM.1 Blackstone touted its private equity practice as one that “enhances all of [its] different businesses and facilitates [its] ability to expand into complementary new business.”
In 2003, Blackstone purchased an 88 percent interest in FGIC Corp. (FGIC) for $1.86 billion. FGIC is a monoline financial guarantor, and is the parent company of Financial Guaranty. Financial Guaranty had historically provided insurance for bonds. Prior to Blackstone’s IPO, however, Financial Guaranty began writing insurance on CDOs backed by subprime mortgages and RMBS linked to nonprime and subprime mortgages. Consequently, FGIC was exposed to billions of dollars of nonprime mortgages at the time of the IPO in the summer of 2007. ByMarch 10, 2008—approximately nine months after its IPO—Blackstone’s Corporate Private Equity segment reported revenues that were down 18 percent from 2006. Sixty-nine percent of this decline in revenues resulted from its investment in FGIC.
Plaintiffs alleged that, given Blackstone’s significant 23 percent equity interest in FGIC at the time of its IPO, Blackstone was required to disclose the then-known “trends, events or uncertainties” related to FGIC’s business that were reasonably likely to cause Blackstone’s financial information not to be indicative of future operating results.
Blackstone’s Investment in Freescale
Plaintiffs also alleged that in 2006, Blackstone invested $3.1 billion in Freescale Semiconductor, Inc. (Freescale), a semiconductor designer and manufacturer. The Freescale investment accounted for 9.4 percent of the Corporate Private Equity’s AUMand 3.5 percent of Blackstone’s total AUM. Shortly before Blackstone’s IPO, Freescale lost an exclusive agreement to manufacture wireless 3G chipsets for its largest customer, Motorola Inc., which led to a significant sales decline. Plaintiffs contended that these were “adverse facts that had a materially adverse effect on Freescale’s business and, concomitantly, the material corporate private equity fund controlled by Blackstone.”
Section 11 of the Securities Act of 1933 (the Securities Act) imposes liability on issuers and other signatories of a registration statement that, upon becoming effective, “contains an untrue statement of a material fact or omits to state a material fact required to be stated therein or necessary to make the statements therein not misleading.” Unlike fraud liability under the Securities Exchange Act of 1934 (the Exchange Act), which requires scienter, Section 11 requires only a material misstatement or omission to trigger liability. Under Section 11, a plaintiff must establish (i) a material misrepresentation; (ii) a material omission in contravention of an affirmative legal disclosure obligation; or (iii) a material omission of information that is necessary to prevent existing disclosures from being misleading.
The threshold issue before the Second Circuit was whether Blackstone’s Registration Statement and Prospectus omitted material information that Blackstone was legally required to disclose pursuant to Item 303 of the Securities and Exchange Commission’s (SEC) Regulation S-K. Under Item 303, a registrant must “describe any known trends or uncertainties…that the registrant reasonably expects will have a material…unfavorable impact on…revenues or income from continuing operations.”
As part of its analysis, the Second Circuit reaffirmed the familiar legal standard for materiality: a “statement or omission that a reasonable investor would have considered significant in making investment decision.” In assessing an item’s materiality, the Second Circuit noted that a court must consider both “quantitative” and “qualitative” factors. As guidance regarding the proper assessment of materiality, the court observed with approval that the SEC has stated that “the use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that a deviation of less than the specified percentage with respect to a particular item is unlikely to be material….”
The court also highlighted the fact that plaintiffs’ claims were not subject to the heightened pleading standard of Rule 9(b) of the Federal Rules of Civil Procedure. Rather, because the complaint did not allege fraud, the plaintiffs were required only to make a “short and plain statement of the claim” under Federal Rule of Civil Procedure Rule 8(a)—that is, the ordinary “notice pleading” standard. The Second Circuit concluded that plausibly alleging materiality under the notice pleading standard is significantly less burdensome than alleging materiality under the heightened pleading standard applicable to securities fraud cases.
Blackstone originally argued that the allegedly omitted information regarding FGIC and Freescale was part of the “total mix” of information available to investors. Indeed, the complaint alleges that there were facts that were publicly known at the time of the IPO. The Second Circuit found that, while information about FGIC’s shift to a less conservative strategy and Freescale’s loss of its exclusive contract with Motorola may have been part of public record, the “particular known trend, event or uncertainty that might have been reasonably expected to materially affect Blackstone’s investments” was not public knowledge and should have been disclosed.
There was no dispute that Blackstone’s investments in FGIC and Freescale fell below the presumptive 5 percent threshold of quantitative materiality suggested by the SEC. Rather, the Second Circuit determined that the lower court incorrectly analyzed certain qualitative factors related to materiality. For instance, the lower court erred in finding that the alleged omissions did not relate to a significant aspect of Blackstone’s operations. Because the company’s private equity segment played such a large role in Blackstone’s business and provided value to other parts of the business, the Second Circuit determined that a reasonable investor would want to know if information relating to that part of the business would have a material adverse effect on future revenues.
The fact that Blackstone’s $331 million investment in FGIC and its $3.1 billion investment in Freescale represented only 0.4 percent and 3.6 percent, respectively, of Blackstone’s total AUM, does not preclude a finding of materiality. The court further stated that “even where a misstatement or omission may be quantitatively small compared to a registrant’s firm-wide financial results, its significance to a particularly important segment of a registrant’s business tends to show its materiality.”
As a result, the Second Circuit held that plaintiffs had adequately pleaded that Blackstone omitted material information related to FGIC and Freescale that it was required to disclose under Item 303 of Regulation S-K.
Lessons from Litwin v. Blackstone
- Companies and underwriters should use caution when applying the “5 percent” rule of thumb for determining materiality. Qualitative factors, such as an alleged omission’s “significance to a particularly important segment of a registrant’s business” may be as important as quantitative data in demonstrating materiality.
- Under the Securities Act and SEC regulations, registrants have an affirmative obligation to disclose known trends, demands, events or uncertainties that are reasonably likely to have material effects on its financial condition, including how a particular investment involving a major segment of a company’s business may negatively impact future earnings. The fact that a trend may not yet have produced a material impact on a company’s financials may not protect a company for liability if the trend is known to the company’s management.