Monday, August 29, 2011

Federal Appeals Panel Says Company Statements on Goodwill Were Subjective Opinion and Could Not Support 1933 Act Claims

An investor alleging that a company failed to write down goodwill in connection with an acquisition, and that its outside auditor falsely certified that the company financials were GAAP-compliant, did not state a claim under Sections 11 and 12 of the Securities Act since the statements regarding goodwill were subjective opinions rather than objective factual matters. Applying the US Supreme Court’s reasoning in the 1991 Virginia Bankshares v. Sandberg opinion, a Second Circuit panel ruled that the Section 11 and 12 claims failed because the investor failed to allege that the opinions on goodwill were both false and not honestly believed when they were made. (Fait v. Regions Financial Corp., CA-2, 10-2311, Aug. 23, 2011).

Although Virginia Bankshares involved claims under the Exchange Act proxy provisions, the Court addressed whether statements of opinions or beliefs could be considered factual statements under the securities laws, and the Second Circuit has applied the Court’s approach in Virginia Bankshares to claims under the 1933 Act. The panel assured that the standard being applied here does not amount to a requirement of scienter since a requirement that a plaintiff plausibly allege that a company misstated its truly held belief and an allegation that it did so with fraudulent intent are not one and the same.

In particular, the complaint asserted that the company overstated goodwill and falsely stated that it was not impaired, and vastly underestimated loan loss reserves and failed to disclose that they were inadequate. Relying on these allegations, the complaint further contended that the outside auditor falsely certified that the company’s financial results were presented in accordance with GAAP.

Under FASB standards, after an acquisition, goodwill is measured as any excess of the purchase price over the value of the assets acquired and liabilities assumed. US GAAP requires that goodwill be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. Goodwill is an intangible asset that is recorded similarly to any other asset, and any subsequent decline in its value is recorded as a loss. Loan loss reserves refer to the amount set aside to cover expected defaults or losses on loans.

According to the appeals panel, the allegations regarding goodwill did not involve misstatements or omissions of material fact, but rather a misstatement regarding the company’s opinion. Estimates of goodwill depend on management’s determination of the fair value of the assets acquired and liabilities assumed, which are not matters of objective fact. The investor did not point to any objective standard such as market price that the company should have used, but failed to use, in determining the value of the acquired company’s assets Absent such a standard, an estimate of the fair value of those assets will vary depending on the particular methodology and assumptions used. In other words, the statements regarding goodwill at issue here were subjective ones rather than objective factual matters.

Applying the US Supreme Court’s opinion in Virginia Bankshares, the panel said that the investor had to allege the company’s disbelief in, and the falsity of, the opinions or beliefs regarding goodwill. This requirement ensures that the allegations concern the factual components of the statements. Applying these principles, the appeals panel concluded that the investor did not adequately allege actionable misstatements or omissions regarding goodwill.

The investor relied mainly on allegations about adverse market conditions to support the contention that the company and its auditor should have reached different conclusions about the amount of, and the need to test for, goodwill. The complaint does not, however, plausibly allege that the company did not believe the statements regarding goodwill at the time they made them. Under Virginia Bankshares such an omission was fatal to the Section 11 and 12 claims.

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