On October 2, 2018, Judge John C. Coughenour of the United States District Court for the Western District of Washington dismissed a putative class action against Zillow Group, Inc. and certain of its executives asserting claims under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. In re Zillow Group, Inc. Securities Litigation, No. C17-1387-JCC (W.D. Wash. Oct. 2, 2018). Plaintiffs alleged misstatements by defendants regarding a Consumer Financial Protection Bureau (“CFPB”) investigation into, among other things, potential violations of the Real Estate Settlement Procedures Act (“RESPA”) arising out of Zillow’s “co-marketing” program between real estate agents and mortgage lenders. The Court dismissed the action for failure to adequately allege material misstatements or scienter, but granted plaintiffs leave to amend.
The co-marketing program allowed participating mortgage lenders to pay a percentage of a real estate agent’s costs for placing a listing on Zillow, in exchange for the lender appearing in the listing. Slip op. at 2. When a prospective buyer chose to share his or her contact information with the listing agent, that information would also be shared with the mortgage lender unless the buyer opted out. Id. at 2-3. Plaintiffs alleged that Zillow’s May 4, 2017 quarterly filing, together with a contemporaneous conference call and interview with Zillow executives, disclosed the existence of a CFPB investigation into the co-marketing program but expressed confidence that the program complied with RESPA, despite knowing that its design violated RESPA. On August 8, 2017, Zillow disclosed that the CFPB had concluded its investigation and intended to pursue further action regarding the co-marketing program if it could not reach a settlement, allegedly causing Zillow’s stock price to fall more than 15%. Id. at 4-5.
The Court rejected plaintiffs’ argument that Zillow’s August 2017 disclosure amounted to proof that Zillow had violated RESPA, rather than simply an acknowledgment that the CFPB intended to pursue further action if it could not reach a settlement with Zillow. Id. at 13 n.9. Moreover, the Court found that plaintiffs failed to make any particularized allegations to support either of plaintiffs’ theories for a RESPA violation — that co-marketing agents were providing referrals to lenders in exchange for unlawful kickbacks, id. at 11, or that specific mortgage lenders were forced to pay more than fair market value for the advertising services they received, id. at 13. The Court therefore similarly concluded that plaintiffs failed to allege facts demonstrating that Zillow had designed the co-marketing program to violate RESPA or that the co-marketing program facilitated RESPA violations. Id. at 15-16.
Because plaintiffs failed to allege facts supporting the existence of RESPA violations, the Court similarly determined that plaintiffs failed to allege Zillow’s statements that it “intended” or “endeavored” to comply with government regulations and was not in breach of any laws were misleading. Id. at 17. Moreover, the Court emphasized that the federal securities laws do not impose a duty to disclose the initiation of a government investigation, and even though a Zillow executive failed to disclose on a November 2015 conference call that the CFPB had already issued a civil investigative demand regarding the co-marketing program, statements on that call were not actionable because they failed to suggest that Zillow was not under regulatory scrutiny. Id. at 18-19. Finally, the Court found insufficient allegations that Zillow failed to disclose that it had made changes to the co-marketing program in response to the CFPB’s investigation. While the amended complaint described an anonymous witness who claimed that changes were made in response to a government investigation, the Court found these allegations insufficient to show that the changes were to remedy specific RESPA violations identified by the CFPB — or even that the CFPB had informed Zillow that it violated RESPA. Id. at 21-22.
The Court separately considered plaintiffs’ allegations regarding scienter of individual executives and found these insufficient as well. Specifically, the Court rejected plaintiffs’ argument that scienter could be inferred because one executive was aware of a 2014 lawsuit that included an allegation that individuals were using the co-marketing program to violate RESPA, noting that plaintiffs failed to allege exactly how the conduct alleged in that lawsuit constituted a RESPA violation. Id. at 23-24. Nor could scienter be inferred from an executive’s participation in and preparation for investor conference calls — particularly given that no material misstatement was alleged therein — or from a statement that the co-marketing program provided a “small” amount of revenue. Id. at 24-25. In addition, the Court determined that a Zillow executive’s sales of her Class A and Class C shares did not support an inference of scienter, because they represented less than 10% and 5% of the executive’s holdings of those share classes, occurred after the alleged corrective disclosure, and were consistent with sales during prior periods. Id. at 26. Ultimately, the Court concluded that plaintiffs’ allegations, taken as a whole, supported the contrary and more compelling inference that Zillow and its executives believed the co-marketing program did not violate RESPA. Id. at 28.
Finally, while emphasizing that plaintiffs failed to allege a material misstatement, the Court nevertheless considered plaintiffs’ loss causation allegations. The disclosure that the CFPB had invited Zillow to enter settlement talks fell into a gray area that was more than simply the existence of the investigation but short of a finding of fraudulent conduct. Id. at 31. Thus, the Court suggested that plaintiffs might plausibly allege loss causation in a further amended complaint, provided that the complaint adequately addressed other defects. The Court granted plaintiffs leave to file a second amended complaint, but cautioned that any such complaint must include particularized facts showing that Zillow designed the co-marketing program to violate RESPA and was instructing and encouraging third-parties to commit such violations, that defendants made material false or misleading statements with a strong inference of scienter, and that such statements caused the loss alleged by plaintiffs. Id. at 31-32.
This decision is a reminder that the existence of a government investigation, without more, is insufficient to adequately allege a securities fraud claim.