A California federal court has dismissed a securities class action related, in part, to the COVID-19 pandemic. Judge R. Gary Klausner ruled that the defendant could not have anticipated the extent of the pandemic at the time of their January 2020 S-1 filing. The dismissal also hinged on the court’s findings that there was adequate disclosure about the underwriting business and loans in the registration statement.
Claims of Financial Puffery
The case in question, Berg v. Velocity Financial, Inc., leads with the allegation that the defendant real estate finance company misrepresented their underwriting practice’s risks. Further, the plaintiff claims the defendant failed to inform investors on nonperforming loan risks and distorted the real estate market and Velocity’s ability to capitalize on it.
The complaint cites Velocity’s statements on “attractive returns and minimizing credit losses”, “disciplined due diligence”, and “differentiated perspective and underwriting ability” as examples of fraud. Judge Klausner swiped these allegations away, relying on numerous precedential rulings where courts found similar claims to be “mere puffery” and, thus, not actionable.
The plaintiff also argues that Velocity made overly optimistic statements about the real estate market just as the pandemic was about to collapse the market. The defendant’s statements about a “substantial and durable market opportunity” in the offering materials were wholly unrealistic. Here, the judge also found that Velocity’s statements were exaggerations that cannot form the basis for a Section 11 securities claim.
No Hidden Rates
The plaintiff further claims that Velocity misled investors when it failed to include information on its increasing rate—a doubling—of non-performing loans in material public documents. This omission created an overly rosy picture of Velocity’s financial health, according to the plaintiff.
In dismissing the case, the court slapped this claim down. The judge points to a chart in the defendant’s S1 filing that showed an upward trend in nonperforming loans. Concerning the omission of information, the judge explained that in Section 11 private rights of action, liability only attaches when the offering materials become effective. Because the nonperforming loan percent did not double in the two quarters reported in the S1, there had not, in fact, been an omission of this rate increase.
Checking the Percents
The complaint next argues that the defendant mispresented the percent of nonperforming loans as 5.9% rather than 6.41% of the portfolio. The judge found fault with these allegations simply because this information was not part of the effective registration statement, the document that must be the source of any liability. The plaintiff’s data on this point came from a draft registration statement and a later 10Q filing—not the determinative registration statement.
Delinquency Rates are Not a Factual Issue
The plaintiff asserts that Velocity misrepresented the trajectory of delinquent loans. Again, the court focuses on the defendant’s data in the S-1 that showed estimated rates on nonperforming loans to silence this claim. The court went so far as to note that Velocity would not have had time to audit any late 2019 indicators of changes in these trends before the effective date of the IPO on January 6, 2020. In dismissing the action, the court said that reasonable minds “could not disagree that Velocity had begun and increased the use of short-term, interest-free loans.”
Disclosure under SEC Regulatory Items 303 and 105
The plaintiff claims that the defendants also violated the regulatory requirements of Items 303 and 305 of SEC Regulation S-K. They allege this violation occurred when the defendant failed to disclose that relaxed underwriting practices led to a larger proportion of nonperforming loans, that riskier, short-term loans were driving growth, and that the coronavirus was causing uncertainty in the real estate market.
The dismissal states that the Item 303 regulation requires registrants to “describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.”
The court disagreed with plaintiffs on this, finding that Velocity had disclosed its increased use of short-term loans and a chart on nonperforming loans in the S-1. Further, the court said that there was no need for Velocity to disclose anything about the pandemic in the offering materials because the plaintiff didn’t allege that the defendant would or could have known the extent of the presence of the virus in the U.S. at the time of the IPO.
Item 105 requires discussion of material factors that make an investment speculative or risky. The court disagreed with the Item 105 violation short-term loans and nonperforming loan trends claims for the same reasons as it disagreed with the Item 303 claims above. Likewise, because the plaintiff didn’t state how Velocity would have known about the coronavirus risks with any specificity, there was no need for specific disclosures.
A Harbinger for COVID-19 Related Securities Actions?
Clearly, future defendants and courts will look to Berg as a basis to absolve companies of claims that they failed to properly disclose the risks and impact of the coronavirus to investors. However, this argument will get fuzzier for lawsuits claiming securities violations that occurred later and later into the pandemic. Much of the Berg court ruling centers on the fact that in January 2020, no one knew much about the coronavirus presence and effect it would have on the U.S. economy. Courts may struggle to find a bright line as to when issuers should have known and disclosed the risks and impacts of the novel COVID-19 virus. This case will also stand for the proposition that Section 11 private action liability only attaches when the public filings become effective.