On 1 February 2016, in Lloyd v. CVB Financial Corporation, the federal appellate court based in California reinstated part of an action for securities fraud against a financial institution for alleged misstatements concerning the ability of its creditors to repay their loans. The court held that its ruling in 2014 in Loos v. Immersion Corporation (discussed in a prior edition of this publication)—namely, that “the announcement of an investigation, standing alone, is insufficient to establish” that the defendant’s statements or omissions caused the plaintiff’s losses (i.e., “loss causation”)—left open the question of whether the commencement of an investigation could support loss causation when the complaint also alleges a subsequent disclosure showing that the government investigation was focused on the defendant’s alleged misstatements. In Lloyd, the court answered that question affirmatively, and held that a subsequent revelation of an alleged misrepresentation can render the earlier announcement of a government investigation itself a basis for establishing loss causation.

In Lloyd, a lender, CVB Financial Corporation (“CVB”), was sued for securities fraud under Section 10(b) of the Exchange Act for saying that it was not aware of credit problems that would “cause serious doubts as to the ability of” borrowers to repay their loans. According to the complaint, however, this statement was false because CVB’s biggest borrower had told CVB before CVB made this statement that the borrower could not meet its loan obligations and might file for bankruptcy. The court accordingly held that the plaintiffs—the investors that purchased CVB’s stock—had adequately pleaded misstatement by the company.

At issue, however, was whether the plaintiffs had met the separate requirement under Section 10(b) of showing that the defendant’s misstatement caused their losses. This element of securities fraud is typically established by showing a drop in share price immediately after the revelation of the misstatement. In this case, CVB’s stock price dropped when it announced that the SEC was investigating its practices relating to loan underwriting, provisions for credit losses and other accounting practices. The defendants argued that, under the court’s prior ruling in Loos, the plaintiffs’ losses from the company’s alleged misrepresentation about borrowers’ ability to pay their loans could not be attributed to the drop in the company’s stock price that followed the announcement of the SEC investigation, because that announcement did not reveal anything about the company’s losses from its largest borrower. The court held, however, that CVB’s disclosure of the SEC investigation into its lending and accounting practices, which preceded the only significant decline in CVB’s share price, could satisfy the requirement that a plaintiff plead that the defendant’s misstatement or omission caused the plaintiff’s losses. This finding was supported by the fact that, one month after CVB’s disclosure of the SEC investigation, the company announced that it had lost millions of dollars on the loans at issue. The court concluded that “any other rule would allow a defendant to escape liability by first announcing a government investigation and then waiting until the market reacted before revealing that prior representations under investigation were false.” While the court here reversed the lower court’s dismissal of the claims described above, the court affirmed the dismissal of claims concerning other statements by the company that the court agreed were not false.

In Lloyd, the court determined that the announcement of a government investigation could support a showing that the defendant’s alleged misstatements caused the plaintiff’s losses in light of other factors corroborating this theory. Based on public commentary concerning how market participants understood the disclosures at issue, the court reasoned that the fact that “the market hardly reacted at all to CVB’s bombshell disclosure about its [losses from its] largest borrower, confirm[ed] that investors understood the” announcement of the SEC investigation as at least a partial disclosure of CVB’s prior misstatements about its borrowers’ ability to repay their loans. While this case provides an important qualification to the general rule, at least within the jurisdiction of this court, that the announcement of a government investigation cannot by itself support a showing that the defendant’s misstatement caused the plaintiff’s loss, it also reinforces the “context dependent” nature of this “loss causation” inquiry, which, even at the pleading stage, will often turn on the unique circumstances surrounding the disclosures at issue.