Lessons on Security Disclosure: Hutchinson v. Deutsche Bank

Hutchinson v. Deutsche Bank Securities, Inc. involved the issue of whether the defendant made false statements and omissions in its registration statement.[1] The defendant, CBRE Realty Finance, Inc. (“CBRE”), was a commercial real estate specialty finance company focused on originating, acquiring, investing, financing, and managing commercial real estate-related loans and securities.[2] The plaintiffs in the case were Philip Hutchinson, Sheet Metal Workers Local No. 33, and others (collectively “Plaintiffs”) who purchased shares of the defendant company.[3] In September 2006, CBRE floated its initial public offering (“IPO”).[4] CBRE filed its registration statement which offered 9,600,000 common shares to the public at $14.50 per share and the IPO raised approximately $144 million.[5]

At the time of the IPO, two mezzanine loans[6] were outstanding with developer Triton Real Estate Partners, LLC (“Triton”).[7] Five months after the IPO, CBRE announced its financial results for the fourth quarter of 2006, which showed that one of the mezzanine loans was non-performing while the other one was on CBRE’s watch list, but that CBRE had no impairments or loss reserves since inception.[8] In 2007, CBRE reported that it had advanced approximately $1.7 million to protect one of its loans and that it had foreclosed on the other.[9]

The Plaintiffs’ filed a complaint alleging that CBRE knew that these two loans were in trouble at the time of the IPO because Triton had missed certain tax payments on the properties that secured the loans, sales at the properties were declining, and one of the property developments was over budget.[10] Because the loans were in trouble, the Plaintiffs alleged that CBRE’s registration statement was materially inaccurate at the time it was filed since it failed to disclose that the Triton Loans were impaired.[11] However, the United States District Court for the District of Connecticut held that the plaintiffs did not plausibly allege that the omissions concerning the Triton loans were material because the loans were fully collateralized.[12] Specifically, the court noted that because the Triton loans were adequately collateralized at the time of the IPO, there existed no risk of loss to CBRE at that time.[13] Therefore, the court held that CBRE was not at risk of a material loss on the loans at the time the registration statement was issued.[14] Plaintiffs appealed.[15]

On appeal, the United States Court of Appeals for the Second Circuit stated that Section 11 of the Securities Act allows a person who purchased a security to sue if the registration statement filed with the SEC contained “either misstatements or omissions of material[16] fact.”[17] As long as the plaintiff establishes one of the three bases for liability, the  issuer’s liability is absolute.[18] The three bases for liability include: “(1) a material misrepresentation; (2) a material omission in contravention of an affirmative legal disclosure obligation; or (3) a material omission of information that is necessary to prevent existing disclosures from being misleading.”[19]

The appellate court held that the determination of whether a misstatement or omission is material is a fact-specific inquiry.[20] “A fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to act.”[21] In other words, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor as having a significant impact on the information made available.[22]

First, the appellate court explained that loans and other investments are considered impaired  when it is probable that the company will not be able to collect all amounts due under the original agreement.[23] Second, the court rejected the district court’s collateralization approach and said that the adequacy of collateral was but one qualitative factor to be considered in a larger inquiry.[24] The court then evaluated whether the fact was material based on quantitative factors.[25] The court explained that “even 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.”[26] That is, if a particular area of the company’s business is important to certain investors, then facts that are not considered material in the context of the business as a whole, may become material for purposes of the securities laws.[27]

In this case, the court found that the Plaintiffs did not allege that the mezzanine loans were of significance to investors other than the fact that they were part of CBRE’s business.[28] Second, the court explained that as a “company that makes real estate loans, mezzanine loans . . . are not the subject of investor’s fixation.”[29] Therefore, “any . . . impairment of the Triton loans [had to] be analyzed in relation to CBRE’s entire investment portfolio.”[30]

The court found that the Triton loans were not quantitatively material.[31] The court held that the impairment of the Triton loans was not material because the loans did not compose a significant portion of CBRE’s loan portfolio.[32] Also, “CBRE foreclosed on the Triton loans, long after the IPO, . . . incur[ring] a $7.8 million impairment charge.”[33] However, it was not alleged that CBRE knew of this figure at the time of the IPO.[34] As a result, the Second Circuit Court of Appeals held that the plaintiffs’ claim failed.[35]

The holding in Hutchinson cautions new registrants to consider detailed disclosure of certain financial impairments if the area of impairment is the subject of investor fixation and thus likely material. The other concern in this instance is whether the plaintiffs’ failure to frame its complaint to describe the mezzanine loans as significant to investors was determinative of the appellate court’s holding. It is possible that, if the plaintiffs had made this particular argument, the fact-finding inquiry would have led to an alternative holding. Therefore, even though the court held in favor of the issuer in this case, erring on the side of caution with impairment disclosures is highly recommended.