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Legal Update

Subjective Falsity Required For Section 11 and 12 Claims Based On Goodwill and Loan Loss Reserve Valuations

12 May 2010
Mayer Brown Legal Update

On May 10, 2010, the US District Court for the Southern District of New York held that accounting statements of goodwill and loan loss reserves are statements of opinion, and that they create liability under Sections 11 and 12 of the Securities Act only when a defendant did not actually hold the challenged opinion at the time it was made. In Fait v. Regions Financial Corp., No. 09-cv-3161, 2010 U.S. Dist. LEXIS 45421 (S.D.N.Y. May 10, 2010), the court dismissed the purported class action as well as the Section 11 and 12 claims because plaintiff failed to allege subjective falsity, i.e. that the disputed goodwill and loan loss reserve valuations did not reflect the defendants’ opinions at the time the financial statements were issued.

In its ruling, the district court applied the subjective falsity requirement from Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991), to Section 11 and Section 12 claims and recognized that goodwill and loan loss reserves are matters of opinion, rather than objective fact.

The Fait Decision

Alfred Fait brought a purported class action against Regions Financial Corporation, several of Regions’ board members, a company subsidiary, and Regions’ auditor for alleged violations of Sections 11, 12, and 15 of the Securities Act of 1933. He alleged that documents for an April 2008 securities offering incorporated Regions’ 2007 annual report and that the annual report contained false financial statements regarding goodwill and loan loss reserves.

Specifically, Fait alleged that (i) Regions had failed to write down $6.2 billion of goodwill attributed to the company’s 2006 acquisition of AmSouth Corporation “despite growing evidence . . . that serious problems existed [regarding] AmSouth’s loan portfolio,” and (ii) Regions had made only marginal increases to its loan loss reserves despite what plaintiffs claimed was a “high risk of loss inherent in its mortgage loan portfolio.” Fait, 2010 U.S. LEXIS 45421, at *5-*6. The auditor’s opinion that the financial statements complied with GAAP in all material respects was allegedly false for the same reasons.

Goodwill — The Fait court found that the alleged overstatement of goodwill did not involve misstatements or omissions of material fact because the fair value of the assets that Regions acquired from AmSouth, primarily its loan portfolio, was a “matter of judgment and opinion.” Id. at *12. As such, the valuation was only false at the time it was made if it “did not reflect management’s ‘honest opinion.’” Id. at *13. Because the complaint did not claim the alleged misstatements of goodwill in the annual report were knowing or reckless, plaintiff had no claim.

Loan Loss Reserves — Similarly, the court found that loan loss reserves “reflect management’s opinion as to the likelihood of future loan losses and their magnitude.” Id. at *17. Because the adequacy of the loan loss reserves was a matter of opinion, plaintiff’s complaint again had to allege that the annual report knowingly or recklessly misstated the loan loss reserves. Plaintiff’s claim was dismissed because it failed to do so.

Subjective Falsity — Applying Virginia Bankshares, Inc. v. Sandberg, the Fait court explained that “an opinion is actionable under Section 11 or 12 only if the complaint alleges that the speaker did not truly hold the opinion at the time it was issued.” Id. at *9 & n.31. Relying on In re Wash. Mut. Inc. Sec. Litig., 259 F.R.D. 490 (W.D. Wash. 2009), plaintiff argued that he did not have to plead subjective falsity for statements regarding the loan loss reserve provisions. Id. at *19, n.55. The district court rejected this argument as “unpersuasive” and conflicting with case law that cited Virginia Bankshares. Id. Absent allegations that Regions’ opinions were either knowingly or recklessly false, plaintiff had no Securities Act claims under Section 11 or Section 12. The Section 15 claims were also dismissed, since they required an underlying Section 11 or Section 12 violation.   

Claims against the Auditors — Finally, the court dismissed all of plaintiff’s claims against the auditors because claims that the audit opinion misstated Regions’ financial statements were derivative of plaintiff’s claims alleging misstated goodwill and loan loss reserves and insufficient as a matter of law. Id. at *15-*16, n. 46.

For more information about the Fait decision, or any other matter raised in this Legal Update, please contact at +1 312 701 7326 or James Schroeder at +1 312 701 7964.

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