The use of equity proceeds from future investors to pay down borrowings used for distributions to current investors of “pre-need” revenue from burial service sales otherwise tied up in state-mandated trusts is not federal securities fraud, if disclosures of such “feedback loop” render any alleged non-disclosures immaterial.
Fan vs. StoneMor Partners LP, No. 17-3843 (3rd Cir., 6/20/19).
Plaintiffs, purchasers of limited partnership units in defendants’ burial products and services business, appealed from the district court’s dismissal of their federal securities fraud putative class action for lack of materiality in the misstatements alleged, or scienter in making them. Plaintiffs’ action followed a 45% price drop after defendants restated three years of financial statements that, under GAAP regulations, temporarily precluded defendants from additional equity sales needed to finance distributions. Due to the nature of its business, revenue from pre-need burial sales must be held in trust and could not be distributed, or under GAAP rules could not be booked as current revenue, until services were finally delivered.
Plaintiffs based their claim on three categories of misstatements: failure to disclose that: (1) defendants’ ability to make cash distributions was contingent on access to the capital markets; (2) the primary source of cash for distributions was cash flow when its real source of liquid cash was equity proceeds; and (3) that the distributions were actually funded by borrowings from defendants’ credit facility. Though fully recognizing this financial “feedback loop” – cash distributions funded by borrowed cash paid down through equity proceeds “attracted” through growing pre-need sales and cash distributions disclosed as current revenue in non-GAAP financials -- the Appellate Court affirms the judgment of the district court that the alleged misstatements were not material. According to the Court, defendants in its public financial filings and press releases disclosed sufficient information about its method for funding distributions to render any omissions immaterial.
As the Court points out, defendants’ Form 10-ks defined “Available Cash” to include substantial borrowings, which might materially adversely affect its ability to generate sufficient cash to continue paying distributions. Further, defendants’ parallel GAAP and non-GAAP financials “demonstrated the mathematical reality that [defendant] was not able to fund its distributions” from day-to-day operations, and defendants’ press releases clearly disclosed the use of equity proceeds to pay down the revolving credit facility which the company used for its borrowing needs. Finally, the Court finds, under the heightened pleading standards of the PLSRA, that, even if the alleged misstatements were material, defendants did not act with scienter. Characterizing defendants’ business as one of “the leveraging of assets to maximize distributions despite the state trust requirements attached to its pre-need sales,” the Court concludes that it is not their place “to correct the cost of doing business when it meets the requirements of the law.” Though the Court acknowledges “the economic harm to [defendants’] investors,” it “cannot say it was the result of fraud.”
(D. Franceski: Given the economic reality that the source of distributions to current investors was equity proceeds from future investors and “the economic harm” which the Appellate Court acknowledges, one might view defendants’ business as a “fully disclosed” [albeit non-actionable] Ponzi scheme. Perhaps the “security” of the trust proceeds, which was obviously of little help to plaintiffs as current investors, saved the day for defendants.)
(SOLA Ref. No. 2019-34-06)
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