On November 19, 2019, Judge William M. Campbell of the United States District Court for the Middle District of Tennessee granted in part and denied in part motions to dismiss a putative class action under the Securities Act of 1933 and the Securities Exchange Act of 1934 against a healthcare company, certain of its officers and directors, and a private equity firm that previously owned the company. Plaintiffs alleged that the company failed to disclose that allegedly improper business practices were responsible for its revenue growth. In re Envision Healthcare Corp. Sec. Litig., No. 3:17-CV-01112, 2019 WL 6168254 (M.D. Tenn. Nov. 19, 2019). The Court held that certain of the claims against the company and the individual defendants were adequately pleaded and others were not, but dismissed all claims against the private equity firm for failure to adequately allege scienter.
With respect to the alleged misrepresentations, the Court held that plaintiffs sufficiently alleged that the company, in connection with its provision of physician staffing for hospital emergency rooms, improperly relied on billing insurers at out-of-network rates, whereas the company had represented that its growth was due to other factors. Id. at *7. The Court reasoned that, whether the company’s statements as to the sources of its growth amounted to fact or opinion, they could be viewed as misleading to a reasonable investor. Id. at *12. However, the Court concluded that certain other statements were not misleading to the extent they were fairly read in context as providing opinions as to certain factors related to growth but not a comprehensive listing of all such factors. Id. at *13. The Court further held that plaintiffs adequately alleged that the company misrepresented its level of performance even though it knew that certain key contracts were not performing as expected. Id. at *19. The Court also held that scienter was adequately alleged for certain individual executives, based primarily on the “core operations” theory that as high-level executives they must have been aware of the extent of out-of-network billing because it was central to the company’s business operations, and that they disregarded current factual information regarding the performance of the contracts. Id. at *22-23.
However, the Court held that statements regarding the company’s belief that it could successfully transition from out-of-network to in-network billing in a revenue neutral way were not misleading because they were forward-looking and statements of opinion, for which plaintiffs failed to allege facts showing that the opinions were not honestly held. Id. at *18. Moreover, the Court rejected allegations that the company failed to disclose its reliance on illegal “upcoding” of medical procedures on its invoices, holding that this practice was insufficiently alleged because it was based solely on a study of one insurer that covered only 16 of the 900 hospitals serviced by the company. Id. at *8.
With respect to the private equity firm, plaintiffs alleged that, during the period of the alleged misrepresentations, the private equity firm sold off its remaining holdings of the company. Id. at *3-4. Plaintiffs alleged that these transactions consisted of a form of insider trading in violation of Section 20A of the Exchange Act, and that the fund was liable as a controlling entity in violation of Section 20(a) of the Exchange Act and Section 15(a) of the Securities Act. Id. at *5, *29.
The Court emphasized that, in order to state a claim under Section 20A, a plaintiff must allege a requisite independent, predicate violation of the securities law, and show that he purchased or sold securities contemporaneously with the purchase or sale of securities that is the subject of the violation. Id. at *25. While, as noted, the Court concluded that plaintiffs had adequately alleged that certain of the named individual defendants knew about the company’s billing strategy that allegedly caused it to overstate its earnings, the Court held that plaintiffs failed to do so with respect to the private equity firm. Here, plaintiffs had alleged the private equity firm had been the majority owner of the company, had designated three individuals to serve on the company’s board of directors, and because the alleged billing practices constituted the core of the company’s earnings, the fund must have also been aware of these practices. Id. But the Court concluded that plaintiffs had alleged no fact suggesting that the directors the fund nominated communicated anything about the company’s alleged illicit practices “or anything else” to the fund and that “[w]ithout more, this is not enough to allege [the fund] was in possession of insider information at the time of the sales.” Id.
Plaintiffs also argued that scienter could be inferred, because the fund’s stock sales were substantial and came at times that were inherently suspicious, but the Court rejected these arguments. The Court first observed that because the fund “is a private equity fund whose sole purpose is to invest in companies and ultimately sell them” it was “not suspicious that it would divest itself of stock in large sales.” Id. at *26. Additionally, the Court noted that these sales happened “7 to 20 months before” the company’s stock first experienced a material decline. Id.
Finally, the Court rejected plaintiffs’ argument that because two of the directors the fund had nominated to the board remained on the board at the time the company made alleged misstatements concerning its earnings in a proxy statement, the fund was also liable as a control person. The Court held to the contrary that “[t]he fact that two of [the fund’s] nominees continued as directors on an eight-person board more than 18 months after [the fund] had any ownership interest in [the company] is insufficient to plausibly allege that [the fund] controlled or had the ability to control the content” of the proxy statement. Id. at *30. The Court also noted that there were no allegations that these two directors “continued to act on behalf of [the fund] rather than fulfill their fiduciary duties as board members” after the fund divested its holdings. Id.
With respect to plaintiffs’ claims under Section 12(a)(2) of the Securities Act based on a joint proxy and registration statement soliciting shareholder approval for a merger, the Court rejected the individual defendants’ argument that they were not “statutory sellers” as a matter of law. The Court acknowledged that the mere signing of a registration statement generally does not constitute solicitation within the meaning of Section 12(a)(2), but held that, because the registration statement recited that the individual defendants were “soliciting proxies” in favor of the merger, solicitation within the meaning of Section 12(a)(2) had been adequately alleged. Id. at *28.