The U.S. Court of Appeals for the Third Circuit recently reiterated the long-standing principles that a defendant's alleged misrepresentations may be rendered immaterial by a defendant's sufficient disclosure of information; and even if alleged misrepresentations are materially misleading, a Rule 10b-5 claim may still fail if the allegations do not demonstrate a strong inference of scienter. In Fan v. StoneMor Partners, 927 F.3d 710, 713 (3d Cir. 2019), the Third Circuit affirmed the district court's decision in which it found that StoneMor, a master limited partnership, sufficiently informed investors of its business practices and granted the defendants' motion to dismiss a putative securities fraud class action complaint.

The plaintiffs brought a complaint against StoneMor, its related entities and their executives after StoneMor announced that it would restate several years of previously reported financial statements. The restatement temporarily prevented StoneMor from selling equity units, receiving proceeds, and using those proceeds to pay down borrowings used to fund distributions. As a result, it was not able to make distributions. StoneMor's unit priced dropped by 45%, which the plaintiffs alleged was the result of the inability to make distributions.

StoneMor sells products and services for funerals, including products and services that customers may purchase prior to their death, which are known as "pre-need sales." A Pennsylvania state law requires that a percentage of proceeds from these pre-need sales be held in trust and released only when services are delivered at the time of the customer's death. Though pre-need sales cannot be represented as current revenue under generally accepted accounting principles (GAAP), StoneMor took several steps to account for the difference between its overall sales and its accessible cash. First, StoneMor reported non-GAAP financials to its investors in addition to its standard GAAP financials. Second, to avoid making investors wait until cash from the pre-need sales was released from trust, StoneMor borrowed cash so that it could make distributions to investors during the same quarter that pre-need sales were made. Third, StoneMor took proceeds from equity sales and paid down the cash that was borrowed to fund distributions to investors.

The plaintiffs alleged that the defendants made false or misleading statements regarding StoneMor's financial condition in its distribution announcements, press releases and public filings. For example, the plaintiffs took issue with StoneMor's statement that its distributions are determined by StoneMor's operating performance and available cash at the end of the quarter. The plaintiffs alleged that this was a false and misleading statement because the defendants could not fund distributions from StoneMor's day-to-day operations and that it was dependent on capital markets to make distributions.

In analyzing the alleged false or misleading statements, the Third Circuit reiterated the test for materiality that it previously announced in In re Westinghouse Securities Litigation, 90 F.3d 696, 714 (3d Cir. 1996). Materiality may be found if the disclosed information would have been viewed by a reasonable investor as having significantly altered the total mix of information available to that investor. The Third Circuit further explained that when analyzing whether an alleged misstatement is material, a court must determine whether or not defendants sufficiently disclosed facts and information to render the alleged misrepresentations not misleading.

The Third Circuit found that StoneMor had consistently disclosed facts and information to its investors that rendered its alleged misrepresentations not misleading. For example, the court observed that information about how StoneMor funded its distributions had been previously disclosed in StoneMor's Form 10-Ks, which defined the term "available cash" as cash "on hand" in addition to cash from "working capital borrowings." Accordingly, a reasonable investor would know that distributions were funded from other sources and not simply operating revenue. The court also observed that StoneMor's annual reports included both GAAP and non-GAAP financials, which showed that StoneMor could not fund its distributions from its day-to-day operations and rendered any alleged misstatement about the source of StoneMor's distributions immaterial.

In the second part of its analysis, the Third Circuit explained that even if StoneMor's alleged misrepresentations were materially misleading, the plaintiffs' claims would still fail because their allegations did not demonstrate a strong inference of scienter as required by the PSLRA. The court reiterated its holding from Institutional Investors Group v. Avaya, 564 F.3d 242, 252, 267 n.42 (3d Cir. 2009), that pleading scienter requires pleading allegations that demonstrate "an extreme departure from the standards of ordinary care." The court found that the plaintiffs failed to plead an inference of scienter because StoneMor's disclosures demonstrated that investors were provided relevant information regarding StoneMor's business practices, including details about its cash distributions. The court explained that "these disclosures do not demonstrate an intent to defraud—rather, they accurately show how StoneMor leveraged its assets in order to maximize its distributions despite the state trust requirements attached to its pre-need sales."

While the Third Circuit did not set forth any new standards in the StoneMor opinion, the opinion helpfully summarized the key Third Circuit cases that address materiality and scienter. Moreover, the decision reiterates that even though investors may suffer economic harm, investors must allege facts that demonstrate such harm was the result of fraud to state a claim under Rule 10b-5, even when there is a restatement of prior financial statements. Lastly, the disclosures discussed in the decision may provide helpful guidance and creative solutions for public companies seeking to inform investors of risks inherent in their businesses.

Robert L. Hickok is a partner and former co-chair of the litigation and dispute resolution department of Pepper Hamilton. He is a past member of the firm's executive committee. He can be reached at 215-981-4583 or [email protected].

Jay A. Dubow is a partner with the firm, resident in the Philadelphia office. He is a member of the firm's white-collar litigation and investigations practice group and is co-chair of the securities and financial services enforcement group. He can be reached at 215-981-4713 or [email protected].

Erica H. Dressler is an associate in the firm's trial and dispute resolution practice group, a seasoned and trial-ready team of advocates who help clients analyze and solve their most emergent and complex problems through negotiation, arbitration and litigation. She can be reached at 215-981-4691 or [email protected].