Eric Goldman pointed me to this securities fraud case, of possible interest because it involves advertising-related claims. The investors sued defendant MIVA (aka FindWhat.com) and some principal officers for eleven false or misleading statements to the public, in violation of § 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The statements allegedly artificially inflated the price of MIVA’s stock until the truth came out, at which point the stock dropped and plaintiffs lost money.
The district court rejected all the claims, nine on the pleadings and two on summary judgment on the grounds that plaintiffs failed to show loss causation and damages. Plaintiffs appealed on two of the claims dismissed on the pleadings and on the claims on which summary judgment was granted.
The court of appeals affirmed on the first set and reversed on the second. Basically, earlier false statements weren't actionable, but later ones that perpetuated the falsehood were actionable for sustaining the stock price longer than it would have had the truth come out earlier.
MIVA provides pay-per-click ad services, putting ads on its distribution partners/affiliates’ websites. MIVA shares a portion of its ad revenue with its affiliates. MIVA uses keyword targeting; advertisers bid for a position in search results. MIVA’s revenue is determined by advertisers’ bidding price and the number of clicks MIVA generates. Bidding price itself depends on the conversion rate from clicks to sales.
Because of the pay-for-click arrangement, click fraud (clicking on ads just to get the advertiser to pay) can be very costly. Click fraud can come through automated or human intervention; it results in lower conversion rates because the source of the click is uninterested in purchase.
According to the complaint, in 2003 two of MIVA’s top revenue-generating partners, Saveli and Dmitri, who together accounted for almost 1/3 of MIVA’s revenue from 2003-2005, began using automated click fraud to generate revenue. “According to a former Business Development Manager at MIVA, Saveli and Dmitri were ‘turn and burn guys’ who focused primarily on driving in a lot of traffic, regardless of its quality.” (One thing advertising folks may find notable in securities cases these days is that, because of heightened pleading requirements and judicial hostility to such cases, the average securities fraud pleading is likely to have a lot of detail acquired from independent investigations, usually relying on informants with inside knowledge of the defendant’s operation—by contrast, in an advertising case the plaintiff may have a lot of knowledge of the parties’ products or services, but is less likely to be able to plead about the defendant’s internal operations with specificity.)
The resulting low-quality traffic caused advertisers to lower their bids, decreasing MIVA’s revenue. A former account manager described the result as “serious, serious bid deflation.” Revenue per click dropped from $0.20-$0.21 in early 2003 to $0.12 by June 2005. This had a domino effect, driving away high-quality distribution partners. In a downward spiral, plaintiffs alleged, MIVA increasingly relied on “greedy and unscrupulous distribution partners who were focused on only short-term gain.”
Thus, by summer 2005, MIVA’s “supposedly extensive and diversified partner network had shrunk, with 95 percent of the Company's click revenue coming from its top fifty distribution partners—the top two being Saveli and Dmitri.” The network, according to a former marketing manager, was now best described as a "house of cards ... held together by a thread."
The short-term gains from click fraud allegedly enabled MIVA to report an uninterrupted string of quarter-by-quarter financial gains, meeting or exceeding analyst growth expectations in every single quarter since 2003. “Perhaps demonstrating the Company's obsession with meeting Wall Street's forecasts, these expectations were sometimes met by as little as a penny.” (Maybe I don’t read about them, but are there any nonfraudulent companies that can do this for a multiyear period? Either analysts are just terrible, in which case I don’t get why people rely on them, or their projections exert pressure to commit fraud in a short-term-focused company and the market might want to apply a discount to exceeding expectations at least as much as it punishes falling short of them.) “Between 2003 and 2005, the Defendants issued public statements reporting seemingly unstoppable growth stemming from its primary pay-per-click business.”
Thus, plaintiffs alleged, that despite MIVA’s actual bid deflation, defendants allowed click fraud to continue to meet growth expectations at the expense of the company’s long-term health.
Meanwhile, during 2004 and 2005, regulatory scrutiny of click fraud intensified. “In an effort to lull investors and advertisers into believing that the Company was proactive and aggressive about policing click fraud, Defendant CEO Pisaris-Henderson claimed during a Company conference call on February 23, 2005 that, in the fourth quarter of 2004, the Company had voluntarily removed distribution partners representing $70,000 in revenue per day because ‘our focus is to deliver traffic that converts rather than just clicks alone.’” However, according to the Senior Director of Business Development responsible for the oversight and management of all of MIVA's affiliates, “no traffic was taken off line in the fourth quarter of 2004.” This senior director said that the February announcement clearly referred to Saveli and Dmitri, because that’s what they earned in a day, but they weren’t removed from the network. A former marketing manager said that it was "an open secret within the Company that Dmitri and Saveli were not taken off line in December 2004, and neither was anyone else."
On March 16, 2005, in its Form 10-K annual report to the SEC, defendants repeated their claim that in the "fourth quarter of 2004, we ceased displaying advertisements with distribution partners ... whose traffic did not adequately convert to revenue for our advertisers," and that "the removal of these distribution partners reduced our average click-through revenue by approximately $70,000 per day," in conformity with its "long-stated goal of [providing] high quality traffic to our advertisers.” Miva also stated that "[w]e do not rely on 'spyware' for any purpose and it is not part of our product offerings," that "[w]e have implemented screening policies and procedures to .... detect[ ] fraudulent click-throughs, which are not billed to our advertisers," and that "[w]e have developed automated proprietary screening applications and procedures to minimize the effects of ... fraudulent clicks."
Before the Nasdaq opened on May 5, 2005, MIVA issued a press release announcing disappointing first quarter 2005 results and the resignation of Brenda Agius as CFO. Later that day, defendants CEO Craig Pisaris-Henderson and COO Phillip Thune revealed to the public that click fraud had indeed been responsible for some of the Company's revenues, stating in a conference call with analysts and investors that "a couple" of MIVA's distribution partners had been employing "capabilities ... to get additional traffic that just simply don't adhere to our standards." That day, MIVA's share price plummeted over 21 percent from the previous day, from $6.16 to $4.83, and continued to drop for the next few trading days, closing at $4.46 on May 9, 2005.
The court of appeals first addressed statements made on March 5, 2004 and July 26, 2004. The first was properly dismissed because plaintiffs failed to plead scienter with the requisite specificity and the second because the plaintiffs failed to allege falsity or misleadingness.
To survive a motion to dismiss, a 10b-5 claim must satisfy both Rule 9(b) and the additional pleading requirements of the PSLRA. For claims based on false/misleading statements, “the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed." If scienter is required, "the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind."
As to the insufficient claims: One stemmed from MIVA’s March 5, 2004 10-K, which said, “The FindWhat.com Network is dedicated to delivering high-quality keyword ads as a result of an Internet user's search query. As such, we have written and strictly enforce advertising guidelines to try to ensure high relevancy standards.” It continued, “We employ an integrated system of numerous automated and human processes that continually monitor traffic quality, often eliminating any charges for low quality traffic proactively from the advertisers' accounts. We enforce strict guidelines with our Network partners to ensure the quality of traffic on the system.” It also stated that it “expect[ed]” that its business partners would behave lawfully and ethically.
The district court found that these statements weren’t misleading because MIVA wasn’t warranting that it lacked current questionable associations, and that a “dedication” to high-quality traffic wasn’t inconsistent with the existence of low-quality traffic. Moreover, the Form 10-K was mostly forward-looking statements that were appropriately accompanied by cautionary statements.
The court of appeals disagreed about whether this could be materially misleading. There were statements of present fact about MIVA’s “integrated system ... that continually monitor[s] traffic quality," and claims that "[w]e enforce strict guidelines ... to ensure the quality of traffic," which “unquestionably create the impression that MIVA maintains an active and sophisticated monitoring system for screening fraudulent traffic.” These statements could have misled a reasonable investor. Assuming the truth of the other facts alleged, these statements triggered a duty to disclose the system’s grave defects, and the failure to disclose wasn’t cured by any general cautionary or risk-disclosing language, since MIVA offered only general warnings about risks inherent to its business model, not specifically tailored to risks from click fraud. It would be deceptive to withhold information about actual known breaches of click-fraud monitoring systems already touted in the 10-K.
However, the court of appeals still affirmed because plaintiffs failed to plead scienter adequately. What was required was intent to defraud or severe recklessness, meaning highly unreasonable omissions or misrepresentations involving an extreme departure from the standards of ordinary care that present a danger of misleading others that is either known to the defendant or that is so obvious that the defendant must have known of it. The PSLRA requires that the complaint’s allegations create “a strong inference” of scienter, meaning that the inference must be more than plausible or reasonable. It must be at least as compelling as any alternative inference of nonfraudulent intent. Each act or omission must be evaluated separately and for each defendant, though the court’s inquiry must be holistic (it need not ignore the other acts or omissions when evaluating each one individually).
Essentially, plaintiffs didn't plead enough specifics to generate a strong inference of scienter until mid-2004 at the earliest, when there was a meeting to discuss terminating Saveli and Dmitri. This put the earlier statements off-limits. Defendants’ motives to meet Wall Street revenue expectations were insufficient to establish scienter—mere motive and opportunity is insufficient. (It’s tough out there for a securities plaintiff.)
The court of appeals disagreed about whether this could be materially misleading. There were statements of present fact about MIVA’s “integrated system ... that continually monitor[s] traffic quality," and claims that "[w]e enforce strict guidelines ... to ensure the quality of traffic," which “unquestionably create the impression that MIVA maintains an active and sophisticated monitoring system for screening fraudulent traffic.” These statements could have misled a reasonable investor. Assuming the truth of the other facts alleged, these statements triggered a duty to disclose the system’s grave defects, and the failure to disclose wasn’t cured by any general cautionary or risk-disclosing language, since MIVA offered only general warnings about risks inherent to its business model, not specifically tailored to risks from click fraud. It would be deceptive to withhold information about actual known breaches of click-fraud monitoring systems already touted in the 10-K.
However, the court of appeals still affirmed because plaintiffs failed to plead scienter adequately. What was required was intent to defraud or severe recklessness, meaning highly unreasonable omissions or misrepresentations involving an extreme departure from the standards of ordinary care that present a danger of misleading others that is either known to the defendant or that is so obvious that the defendant must have known of it. The PSLRA requires that the complaint’s allegations create “a strong inference” of scienter, meaning that the inference must be more than plausible or reasonable. It must be at least as compelling as any alternative inference of nonfraudulent intent. Each act or omission must be evaluated separately and for each defendant, though the court’s inquiry must be holistic (it need not ignore the other acts or omissions when evaluating each one individually).
Essentially, plaintiffs didn't plead enough specifics to generate a strong inference of scienter until mid-2004 at the earliest, when there was a meeting to discuss terminating Saveli and Dmitri. This put the earlier statements off-limits. Defendants’ motives to meet Wall Street revenue expectations were insufficient to establish scienter—mere motive and opportunity is insufficient. (It’s tough out there for a securities plaintiff.)
On to the July 26, 2004 public conference call discussing second-quarter results. Defendant Thune, the COO, said that revenue was increasing by June and that “we believe that every one of our divisions can grow revenue from Q2 to Q3, despite the seasonal softness typical in the summer months, when individual Internet usage usually declines.” The future performance statement was non-actionable, and plaintiffs didn’t allege that revenue was not increasing by June.
Plaintiffs argued that this was misleading because the growth came from click fraud, and that by making affirmative claims MIVA had a duty to disclose other facts necessary to avoid an incomplete and misleading picture. However, a company has a duty to disclose only when the natural and normal implication of its statements would be misleading. Thune’s statement would be misleading only if it conveyed a false impression of the quality of MIVA’s click traffic. But a statement about total revenue, which also included MIVA’s recently acquired companies, conveyed no such message. It’s generally okay to tout past success, even if future prospects are less rosy.
On to the remaining two statements from 2005 (detailed above), the issue was whether plaintiffs’ expert report demonstrated genuine issues of material fact on loss causation and damages. The district court held that there were no triable issues of fact because the expert acknowledged that MIVA’s stock price was inflated by 26.44% before the first actionable misrepresentation and remained inflated after. The district court reasoned that because the stock price didn’t change, the otherwise actionable statements couldn’t have caused the plaintiffs’ losses.
This was error. Investors who purchased at inflated prices after the fraudulent statements were made may have sustained substantial losses they wouldn’t have suffered had the defendants revealed the truth at the start of the class period.
Fraud-on-the-market theory hypothesizes that disclosure of confirmatory information--information already known by the market--will not cause a change in the stock price. But publicly disseminated falsehoods will artificially inflate the stock price as long as they remain uncorrected, tainting the total mix of information. When the misinformation is corrected, the market will dissipate the artificial inflation.
Loss causation can frequently be shown circumstantially, when plaintiffs identify (1) a corrective disclosure, (2) a price drop soon thereafter, and (3) an absence of other possible explanations for the price drop. Plaintiffs’ expert report, which the district court assumed was admissible for purposes of the summary judgment motion, offered evidentiary support for both loss causation and damages. The expert conducted an event study, common in such cases, estimating the damages at $22.24 million.
The district court ruled that the inflation preexisted the actionable fraudulent statements, rendering the expert report irrelevant. The court of appeals held that this was a misapprehension of the nature of market fraud. “Inflation creates an ongoing risk of harm. Every investor who purchases at an inflated price--whether at the beginning, middle, or end of the inflationary period--is at risk of losing the inflationary component of his investment when the truth underlying the misrepresentation comes to light.”
Investors who buy and sell during the inflationary period overpaid, but they can recoup by selling at the same inflated price. But investors who buy at inflated prices and hold will suffer economic loss. “Because thousands of shares of stock are purchased each day, the longer that inflation remains within a stock price, the more shares that are purchased at inflated prices, and the more shares that stand to lose when the inflation subsequently dissipates from the price. Clearly then, a falsehood that endures within the marketplace for a longer period of time, all else being equal, will cause greater harm than one that endures for a shorter period of time.”
In conclusion, the court of appeals declined “to erect a per se rule that, once a market is already misinformed about a particular truth, corporations are free to knowingly and intentionally reinforce material misconceptions by repeating falsehoods with impunity.” So, even if the earlier nonactionable statements started the trouble, as long as the market believed that defendants had click fraud under control, the later false statements could cause continuing harm.
On to the remaining two statements from 2005 (detailed above), the issue was whether plaintiffs’ expert report demonstrated genuine issues of material fact on loss causation and damages. The district court held that there were no triable issues of fact because the expert acknowledged that MIVA’s stock price was inflated by 26.44% before the first actionable misrepresentation and remained inflated after. The district court reasoned that because the stock price didn’t change, the otherwise actionable statements couldn’t have caused the plaintiffs’ losses.
This was error. Investors who purchased at inflated prices after the fraudulent statements were made may have sustained substantial losses they wouldn’t have suffered had the defendants revealed the truth at the start of the class period.
Fraud-on-the-market theory hypothesizes that disclosure of confirmatory information--information already known by the market--will not cause a change in the stock price. But publicly disseminated falsehoods will artificially inflate the stock price as long as they remain uncorrected, tainting the total mix of information. When the misinformation is corrected, the market will dissipate the artificial inflation.
Loss causation can frequently be shown circumstantially, when plaintiffs identify (1) a corrective disclosure, (2) a price drop soon thereafter, and (3) an absence of other possible explanations for the price drop. Plaintiffs’ expert report, which the district court assumed was admissible for purposes of the summary judgment motion, offered evidentiary support for both loss causation and damages. The expert conducted an event study, common in such cases, estimating the damages at $22.24 million.
The district court ruled that the inflation preexisted the actionable fraudulent statements, rendering the expert report irrelevant. The court of appeals held that this was a misapprehension of the nature of market fraud. “Inflation creates an ongoing risk of harm. Every investor who purchases at an inflated price--whether at the beginning, middle, or end of the inflationary period--is at risk of losing the inflationary component of his investment when the truth underlying the misrepresentation comes to light.”
Investors who buy and sell during the inflationary period overpaid, but they can recoup by selling at the same inflated price. But investors who buy at inflated prices and hold will suffer economic loss. “Because thousands of shares of stock are purchased each day, the longer that inflation remains within a stock price, the more shares that are purchased at inflated prices, and the more shares that stand to lose when the inflation subsequently dissipates from the price. Clearly then, a falsehood that endures within the marketplace for a longer period of time, all else being equal, will cause greater harm than one that endures for a shorter period of time.”
In conclusion, the court of appeals declined “to erect a per se rule that, once a market is already misinformed about a particular truth, corporations are free to knowingly and intentionally reinforce material misconceptions by repeating falsehoods with impunity.” So, even if the earlier nonactionable statements started the trouble, as long as the market believed that defendants had click fraud under control, the later false statements could cause continuing harm.
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