In Litwin v. Blackstone Group, L.P. (2011) the U.S. Court of Appeals for the Second Circuit concluded that the District Court erred in dismissing Plaintiffs’ complaint because Plaintiffs plausibly alleged that omitted or misstated trends from Defendants’ initial public offering registration statement and prospectus were material under Item 303(a)(3)(ii). In so holding, the Second Circuit stressed the importance of both a quantitative and qualitative analysis of materiality, stating that “[e]ven where a misstatement or omission may be quantitatively small compared to a registrant’s firm-wide financial results, its significance to a particularly important segment of a registrant’s business tends to show its materiality.” The decision casts doubt on the widely held belief amongst practitioners that a misstatement or omission that affects less than 5% of a firm’s assets is immaterial.
The case concerned the 2007 initial public offering of Defendant Blackstone Group, L.P., an alternative asset management and financial services company holding approximately $88.4 billion in assets in 2007. Plaintiff alleged misstatements and omissions with regard to its holdings in FGIC Corp., Freescale Semiconductor, Inc, and general residential real estate holdings.
The District Court dismissed all three allegations as insignificant and thus immaterial. First, the District Court analyzed the relative scale or quantitative materiality of the alleged FGIC and Freescale omissions. After noting the accepted 5% threshold as a starting place for a discussion of materiality, it dismissed the FGIC allegation as it represented a mere 0.4% of Blackstone’s total assets. Similarly, the court argued that the 3.6% investment in Freescale was immaterial especially since Plaintiffs could not show that the investment had lost all of its value. Finally, with respect to the alleged misrepresentation, the District Court noted that the complaint failed to “identify a single real estate investment or allege a single fact capable of linking the problems in the subprime residential mortgage market in late 2006 and early 2007 and the roughly contemporaneous decline in home prices.”
However, the Second Circuit declined to find immaterial as a matter of law the alleged omissions and misstatements related to FGIC, Freescale, and the residential real estate holdings.
In the cases of FGIC and Freescale, the Second Circuit did not find it dispositive that each individually accounted for less than 5% of Blackstone’s total assets. Indeed, the court suggested that FGIC and Freescale might be materially significant to the firm’s corporate private equity segment that accounted for 37% of the firm’s total size. The Court noted that Freescale accounted for 9.4% of the corporate private equity segment’s assets under management and was nearly three times larger than the segment’s next biggest investment.
The court further held that the alleged misstatements and omissions concerning the known downward trends affecting the firm’s residential real estate holdings were not necessarily immaterial as a matter of law. The alleged real estate assets amounted to at most 15% of the assets of the real estate segment and the segment comprised 22.6% of the firm’s total assets under management. The Second Circuit rejected the District Court’s argument that Plaintiffs had to point to a specific piece of real estate, holding that the lower court failed to appreciate the core of the Plaintiffs’ claim that Blackstone omitted material information.
In its analysis, the Second Circuit noted that “[e]ven where a misstatement or omission may be quantitatively small compared to a registrant’s firm-wide financial results, its significance to a particularly important segment of a registrant’s business tends to show its materiality.” However, the court qualified this rather sweeping assertion, stating that there are certainly “some defined boundaries” to the concept of materiality without providing further guidance.
Although the Second Circuit suggested that it was performing both a quantitative and a qualitative analysis, the majority of the court’s discussion is based on quantitative factors. The Second Circuit appears simply to have modified the District Court’s 5% materiality guideline. Instead of beginning by examining the alleged omissions in the context of Blackstone as a whole, the Second Circuit first looked at the quantitative effect of the omissions on individual segments of the firm. Although this examination was more involved than the District Court’s model, it is still very much quantitatively based.
Future defendants will argue that this precedent should be applied only to firms like Blackstone that consist of multiple segments, each of them holding a large number of diverse and valuable assets. This could be a plausible argument, as the Second Circuit was quick to stress that Blackstone had $87 billion worth of assets under management in 2007, but that the assets had been broken up and held by individual segments of the company.
Furthermore, future defendants may argue that the case of Blackstone is a unique one, as the alleged omissions preceded an IPO. The Second Circuit notes that the Blackstone executives stood to gain much financially from the 2007 public offering. The court stressed that it agreed with the lower court’s assessment that, had the three disclosures in question been made, the executives would have made less money from the deal. This assessment suggests that the court was willing to look at the alleged omissions in the aggregate. The court seemed to be implying that there may have been a trend of omissions here, and, accordingly, that it would be less likely to find any one alleged omission immaterial.
However, there exists the real possibility that Litwin v. Blackstone will become a general precedent, and, at least in the Second District, raise the bar for uncertainty and trend disclosures under Item 303. If this occurs, securities issuers’ exposure to unfounded lawsuits will increase, and, consequently, investors may be deterred from investing in U.S. markets. As the United States Supreme Court denied Blackstone certiorari this October, all interested parties must wait to see how lower courts apply the precedent to fully understand the consequences of the holding.