Second Circuit Rejects Shaw‘s “Extreme Departure Test”

[On June 21] in Stadnick v. Vivint Solar, the Second Circuit provided important guidance for determining when an omission in a registration statement is material for purposes of a Section 11 claim. The decision holds that the materiality of an omission is not determined by asking whether the omitted information constitutes an “extreme departure from the range of results which could be anticipated,” as the First Circuit did in Shaw v. Digital Equipment Corp., 82 F.3d 1194, 1210 (1st Cir. 1996) (emphasis added), but rather by asking whether the reasonable investor would view the omission as “significantly alter[ing] the ‘total mix’ of information made available.” DeMaria v. Anderson, 318 F.3d 170, 180 (2d Cir. 2003) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 428, 449 (1976)).

The Alleged Omission

The claim in Vivint arose out of the IPO of the residential solar panel installer Vivint Solar. Vivint’s business is installing solar panels on homeowners’ roofs at no cost and then selling the generated electricity back to the homeowner at a discount from standard utility rates. Because this business model involves significant upfront costs (solar installations) before Vivant realizes revenue (selling electricity), Vivint has historically raised capital by reselling the installed solar systems to investment funds co-owned by outside investors and Vivint. The outside investors give Vivint money; Vivint uses the money to install solar systems; and Vivint then transfers the systems’ titles to the investment funds once the systems are installed. Given Vivint’s accounting practices, this series of asset transfers between Vivint and the funds can produce large, apparent swings in quarterly financial performance. If, for example, Vivint receives significant funds to buy solar systems in Q1 but does not transfer title to those system until Q2, it might report significant net income in Q1 and a significant loss in Q2, while it would have reported only a modest loss had the transfers occurred in the same quarter.

Before its 2014 IPO, Vivint disclosed financial results for the six quarters preceding Q3 2104, but it did not disclose results for Q3, which ended the day before the IPO. The disclosed results revealed “ever increasing overall net loses” because Vivint was installing many solar systems and had not yet begun to realize the bulk of the revenue from selling electricity. Thus, Vivint also disclosed that it considered its key operating metrics to be the number of solar installations and the anticipated revenue from its energy-sale contracts.

Several weeks after the IPO, Vivint issued a press release announcing its Q3 results. Those results disclosed significant declines in net income, from $5.5 million in Q2 to negative $35.3 million in Q3. The release, however, noted that Vivant exceeded analyst expectations as measured by its key operating metrics of number of solar installations and remaining contract payments. And the release reported that the net loss was largely attributed to the timing of the transfer of solar systems into investment funds.

Claiming that Vivint’s failure to disclose its Q3 earnings before the IPO was a material omission, plaintiffs sued, alleging Vivint’s registration statement violated Section 11. The district court granted Vivint’s motion to dismiss, finding that the plaintiffs failed to plead a material misrepresentation.

The Second Circuit’s Decision

On appeal, the plaintiffs relied heavily on the First Circuit’s decision in Shaw v. Digital Equipment Corp. Shaw says that an omission can be materially misleading where it is an “extreme departure from the range of results which could be anticipated.” 82 F.3d at 1210. Plaintiffs argued that the Second Circuit should follow Shaw and hold that the change in net income was such an “extreme departure.” The Second Circuit rejected that invitation.

First, the Second Circuit noted that Shaw‘s “extreme departure” test is not the law in Second Circuit. Rather, the Second Circuit assesses the materiality of an omission by asking only if the reasonable investor would view the omission as “significantly alter[ing] the ‘total mix’ of information made available.” DeMaria, 318 F.3d at 180 (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). The Court noted that it declined to adopt the extreme departure test for three reasons: (1) DeMaria applies the classic materiality standard applied by the Supreme Court; (2) Shaw‘s extreme departure language raises more questions than it answers, such as what departures are extreme; and (3) the test can be analytically counterproductive.

Second, the Court held that Vivint’s nondisclosure of the Q3 earnings didn’t pass the test because the fluctuations were in line with its disclosed business practices.

Takeaways

The Second Circuit makes clear that an omission must be assessed in the context of the total mix of available information, preventing plaintiffs from focusing on a single class of information in isolation.

Although the Second Circuit forcefully rejected Shaw‘s “extreme departure” test, the difference between the Circuits’ approaches could be viewed as largely semantic. As the Second Circuit noted, the Supreme Court held in TSC that an omission is material only if “the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Shaw‘s “extreme departure” language could just be seen as a label being used by that Court for information that the reasonable investor would consider as having significantly altered the total mix of available information under TSC. On that reading of Shaw, the First and Second Circuits simply use different vocabulary for what is, in effect, the same legal test.