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Second Circuit Takes an “Extreme Departure” from the First Circuit’s Securities Disclosure Test

Finance and Securities

On Wednesday, June 21, 2017, the U.S. Court of Appeals for the Second Circuit set a new standard in Stadnick v. Vivint Solar, Inc., et al., No. 16-65 when determining whether to disclose interim financial information to investors in the prospectus. The Second Circuit fundamentally departed from the First Circuit’s standard in regards to disclosure in Shaw v. Digital Equipment, 82 F.3d 1194 (1st Cir. 1996).

Robby Shawn Stadnick brought a suit against Vivint Solar, Inc. (a solar energy unit installer) and its underwriters for violations of Sections 11 and 15 of the Securities and Exchange Act of 1933. Stadnick argued that Vivint misled investors by not disclosing their third-quarter financial losses of $40.8 million in the prospectus for the initial public offering. Stadnick additionally alleged that Vivint misled prospective shareholders by not disclosing the regulatory changes in Hawaii and how that could affect the company’s revenue. Stadnick relied on the First Circuit’s decision in Shaw, whereby there is a requirement to disclose information to investors when there is an “extreme departure” from previous quarters, which was the case for Stadnick. Vivint did follow SEC procedure by disclosing financial statements less than 135 days old, but they did not include the last minute loss, which is required under the First Circuit’s standard.

Justice Walker asserted that the “test of Shaw is not the law of [the Second] Circuit” and instead followed the test in DeMaria v. Andersen, 318 F.3d 170 (2d Cir. 2003) (Main Opinion, per Justice Walker p.4). In DeMaria, the Second Circuit explained that a duty to disclose interim financial information in the prospectus arises when “a substantial likelihood that the disclosure of the omitted [information] would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” (Justice Walker p.180, per TSC Indus, Inc. v. Northway, Inc., 426 U.S. 438, 449, (1976)).

Due to Vivint’s Hypothetical Liquidation at Book Value (HLBV) method and business model whereby the shareholders income varies each quarter depending on “(1) contributions by investors and (2) transfers of title to the funds that provided the requisite capital”, the measurement of the metrics do not fall under the standard of Shaw (Stadnick, per Justice Walker, p.7). Therefore, the Court concluded that this instance was not a case of “extreme departure” because using this metric does not provide a clear indication of Vivint’s performance. The registration statement of the third-quarter was “consistent with a pattern of fluctuation that began with the first quarter” and a reasonable investor “would not have harbored any solid expectations based on prior performance” especially since Vivint warned investors of such fluctuations (Stadnick, Justice Walker, pp.18-9). In regards to Stadnick’s claims against Vivint for misleading investors about the regulatory changes in Hawaii, the Second Circuit agreed that Vivint provided sufficient warnings in the registration statement that the business was “vulnerable to changing regulations” (Stadnick, Justice Walker, p.21). The Court ultimately confirmed the dismissal of the claims brought pursuant to Sections 11 and 15.

How does this decision alter the behaviors of public companies? Companies need to ensure that they disclose material information and assess when they have a duty to disclose interim financial information. It is important to make sure the metrics are consistent with previous quarters, and when there is an “extreme departure” (not necessarily in the sense of Shaw), that the information is disclosed in the prospectus.

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