Eleventh Circuit Holds that False Statements Perpetuating Stock Price Inflation Are Actionable under the Exchange Act

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Susan M. Greenwood | Bloomberg Law Findwhat Investor Group v. Findwhat.com, No. 10-10107, 2011 BL 250754 (11th Cir. Sept. 30, 2011) The U.S. Court of Appeals for the Eleventh Circuit affirmed in part, vacated in part, and remanded for further proceedings a securities fraud class action against MIVA, Inc. (MIVA), former Chairman and CEO Craig Pisaris-Henderson, former President and COO Philip Thune, and former CFO Brenda Agius (collectively, Defendants). In discussing loss causation under Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 thereunder, the Eleventh Circuit held that "a defendant may be liable for fraudulent statements intentionally made that have the purpose and effect of propping up an already inflated stock price in an efficient market."

"Click Fraud" Allegedly Inflates MIVA Revenue

As the Eleventh Circuit explained, Internet commerce company MIVA provides "pay-per-click" advertising services for online sellers (Advertisers). Advertisers pay MIVA each time a user clicks on its advertisements. MIVA then shares the revenue with the websites (Distribution Partners) on which the advertisements appear. MIVA employs a system where advertisements appear on the websites based on keywords entered into the websites' search boxes. Advertisers also bid against each other for the order in which the advertisements will appear based on the keywords. MIVA and the Distribution Partners, however, only get paid if a user clicks on the advertisement and are transferred to an Advertiser's website. Advertisers anticipate that the clicks will translate to sales. MIVA further relies on the number of clicks per advertisement to sustain the price Advertisers pay for its services. According to the Court, the higher the number of clicks (and subsequent sales) that advertisements generate, the higher that Advertisers will bid to achieve first priority for advertisement placement and keyword association. This system, the Eleventh Circuit continued, relies on actual Internet users clicking on the advertisements. However, "click fraud" can invade the system. When click fraud occurs, the click is intended to force payment for the click without resulting in a subsequent sale. Click fraud employs such practices as spyware, browser hijacking software, and non-human traffic, each of which mimics clicks by actual users. Plaintiffs allege that beginning in 2003, two of MIVA's Distribution Partners engaged in click fraud, diminishing the company's revenue per click as the lower shared revenues drove away other Distribution Partners. By 2005, MIVA's renegade Distribution Partners accounted for 95 percent of click revenue from its top 50 Distribution Partners. Nevertheless, because click fraud produces short-term revenue gains, MIVA met or exceeded analyst projections throughout the class period. Indeed, plaintiffs allege that Defendants turned a blind eye to the click fraud in order to reap the rewards of meeting financial expectations. In May 2005, however, MIVA announced disappointing results for the first quarter of 2005 and revealed that click fraud had infected its financial success. MIVA's stock price fell 21 percent on the day of the announcement and continued to plummet over the next few days.

District Court Properly Dismissed 2004 Statements

According to plaintiffs, MIVA's Form 10-K filed March 5, 2004, failed to disclose that two Distribution Partners engaged in click fraud and, further, that the company "intentionally ignored and even encouraged illicit practices to generate click traffic." The Eleventh Circuit disagreed with the district court's assessment on March 15, 2007, that Defendants' statements were not misleading. As it explained, statements in MIVA's Form 10-K "unquestionably create the impression that MIVA maintains an active and sophisticated monitoring system for screening fraudulent traffic." In reality, however, Defendants allegedly had no "systems in place that would detect and remove distribution partners engaged in extensive fraudulent revenue-generating practices." Nevertheless, the Eleventh Circuit held that plaintiffs failed to adequately allege scienter. The Court noted that plaintiffs' detailed complaint failed to explicitly (or circumstantially) tie the scienter allegations to the date of the Form 10-K filing. Accordingly, the earliest inference of Defendants' knowledge was June 2004, three months after they filed MIVA's Form 10-K. The Eleventh Circuit rejected plaintiffs' "wholly speculative" argument that the complaint depicts an ongoing fraud that Defendants must have known of in March 2004. It refused "to project the Defendants' presumed knowledge of click fraud a full three months into the past. . . ." The Court further noted that the complaint referenced high-level corporate insiders who provided "detailed content" of meetings and other activities, but not dates. It concluded that the stronger inference from the complaint was not that these sources forgot the dates, but that "Plaintiffs or their sources omitted such dates strategically after concluding that the information would not be helpful to their allegations." Plaintiffs also alleged that in July 2004, MIVA held a public conference call during which Thune stated, among other things, that the company's revenue grew in June 2004. Plaintiffs, rather than argue the statement's falsity, contended that it was misleading because Defendants concealed that the revenue growth was due to click fraud. The Eleventh Circuit acknowledged that by revealing information about its operations, MIVA had a duty to disclose any additional facts "necessary to ensure that what was revealed is not 'so incomplete as to mislead.'" But, "'[r]equiring that disclosures be 'complete and accurate' . . . does not mean that by revealing one fact about a product, one must reveal all others that, too, would be interesting, market-wise.'" Thune's statement, the Court continued, was "a general report about an actual increase in total revenue in the preceding month across the Company as a whole," but "conveyed no message regarding the underlying quality of MIVA's click traffic." Accordingly, the alleged failure to disclose additional information about click fraud was not misleading. Otherwise, the Court said, "company reports of revenue growth — no matter how factually accurate and no matter the level of generality — would be made at the company's peril, carrying a concomitant obligation to reveal a detailed picture of every aspect of the company's operations that could possibly bear on future revenue."

Loss Causation Legal Error

Next, the Eleventh Circuit addressed two 2005 statements that the district court dismissed on summary judgment. According to the district court, plaintiffs' expert concluded that MIVA's stock price already was inflated prior to the alleged 2005 misstatements, and remained inflated, at the same level, after the alleged misstatements. "The [district] court reasoned that because the inflation level in MIVA's stock price did not change as a result of the alleged misrepresentations, these otherwise actionable statements by the Defendants could not have 'caused' the Plaintiffs' losses." The Eleventh Circuit held that the district court's loss causation analysis constituted legal error. It rejected the district court's conclusion that "confirmatory false statements have no immediate effect on an already inflated stock price in an efficient market" and therefore do not harm investors. Rather, the Eleventh Circuit said, "[f]raudulent statements that prevent a stock price from falling can cause harm by prolonging the period during which the stock is traded at inflated prices." (emphasis in original). Thus, "defendants can be liable for knowingly and intentionally causing a stock price to remain inflated by preventing preexisting inflation from dissipating from the stock price." (emphasis in original). The Court observed that the Fifth Circuit took a contrary view in Greenberg v. Crossroads Systems, Inc., 364 F.3d 657 (5th Cir. 2004). The Fifth Circuit held that confirmatory statements are not actionable. The Eleventh Circuit noted, however, that other circuit courts have not "embraced this view" and even Greenberg appears to contradict other Fifth Circuit precedent.

Issues on Remand

Although the Eleventh Circuit's holding avoids "immuniz[ing] defendants who knowingly disseminate materially false or misleading information simply because their fraud concerns false information already believed by the market," the opinion raised additional questions about the fate of plaintiffs' claims. The Court noted that its loss causation analysis assumed that plaintiffs met the other Section 10(b) elements, including reliance and a duty to disclose. In a footnote, however, the Court stated that without a disclosure obligation, "any loss resulting from the Defendants' omission . . . will not be cognizable. In addition, in a separate footnote, the Eleventh Circuit remarked that the district court, as well as Defendants, appeared "to conflate the concepts of reliance and loss causation." It explained that the argument that "Defendants' fraud did not affect the purchase price the Plaintiffs paid -- because the inflation in the price predated the fraudulent statements," speaks to reliance. Indeed, the Eleventh Circuit even referenced the classic rebuttal of fraud-on-the-market through evidence that "'the misrepresentation in fact did not lead to a distortion of price.'" These issues will be addressed by the district court on remand.
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