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From Securities Regulation Daily, October 7, 2016

Most claims against REIT giant and execs can proceed

By Amanda Maine, J.D.

A lawsuit filed by investors against one of the world’s largest real estate investment trust companies and several former executives will go forward, a federal court in Arizona ruled. The company and the executives are accused of artificially inflating the value of the company’s stock and using company assets to pay for improper fees and services to other companies closely associated with the executives (Vanguard Specialized Funds v. VEREIT Inc., October 3, 2016, Silver, R.).

AFFO. American Realty Capital Properties (ARCP), a large real estate investment trust (REIT), used a metric called "adjusted funds from operations" or "AFFO" which was based on its high level of merger and acquisition activity and was regularly cited by the company and its representatives as a reason to invest in the company. ARCP touted its acquisitions in real estate, including its merger with Arizona-based rival Cole Real Estate Investments, which ARCP declared in its SEC filings would result in AFFO growth. Cole investors voted in favor of the merger and exchanged their Cole shares for ARCP shares.

Disclosures in October 2014 and March 2015 revealed that audits and investigations cast doubt on the reliability of ARCP’s financial statements, specifically citing AFFO measurements. A series of executive resignations followed the initial revelation, and in December 2014, the company’s former chief accounting officer filed a defamation complaint against the CEO and the president, alleging that she repeatedly informed them that AFFO had no justification or basis. ARCP investors, some of whom acquired their shares in the Cole merger, sued the executives, the company, and several associated entities on various state and federal grounds, including securities fraud.

State and venue claims. The court declined the defendants’ motion to transfer venue. Although most other litigation relating to ARCP has been filed in the Southern District of New York, the Arizona district court found that SLUSA would likely prohibit the investors form pursuing Arizona state law claims in that that court because it could not have been brought there. The court also proclaimed that at this stage in the litigation, it did not have enough facts to determine whether or not plaintiffs could pursue state law securities claims. It did, however, dismiss all aiding and abetting claims based on Arizona state law.

Loss causation. The defendants urged the court to dismiss federal securities fraud claims on loss causation grounds with regard to alleged misstatements not disclosed in the October 2014 press release announcing that the company’s financial statements should not be relied upon. While the price of ARCP stock fell from $12.38 to $10.00 a share following the initial October 2014 disclosure, the defendants pointed out that following the company’s disclosure in March 2015 that it had overstated AFFO in other quarters, the price actually increased. The court pointed out that the defendants’ argument ignores the company’s own suggestion not to rely on the earlier financial reports, and held that the plaintiffs had adequately pleaded loss causation.

Scienter. The court also concluded that scienter had been adequately pleaded as to most of the defendants. It dismissed the claims against the company’s chief operating officer, however. The COO had resigned less than two months after the initial disclosures, but the court noted that the plaintiffs had not pleaded adequate facts to refute the "natural inference" that she left for performance and not for nefarious reasons. The plaintiffs’ arguments regarding scienter as to the other defendants hold merit, according to the court.

Statutory seller liability. The court rejected, however, the plaintiffs’ allegations regarding the defendants’ statutory seller liability as "solicitors" motivated by financial interests. While the court acknowledged the CEO’s promoting of the Cole merger to investors, including describing it as "an epic transaction," the court found that the allegations against him did not amount to "direct and active participation in the solicitation of an immediate sale." Statutory seller liability allegations against other executives were even more tenuous, and must be dismissed, the court held.

Controlling person liability. The plaintiffs also sued on controlling person grounds three similarly-named entities, which were associated with ARCP or its CEO in some manner, as well as the "operating partner" in which ARCP owned nearly all equity interests. The controlling person claims against the operating partnership entity were dismissed because the securities laws confer liability on whoever controls a person liable under the securities laws, and not the entity through which the person conducts business. However, at this stage in the litigation, the court found that due to the "intensely factual nature of the inquiry," the plaintiffs’ allegations regarding control person liability on the ARCP associated-entities were sufficient to permit discovery.

Other litigation. ARCP, the former CEO, and other executives are also facing both civil and criminal charges.

The case is No. 15-cv-2157.

Attorneys: Beko O. Reblitz-Richardson (Boies, Schiller & Flexner LLP) and Keith Beauchamp (Coppersmith Brockelman PLC) for Vanguard Specialized Funds, Vanguard Index Funds and Vanguard Institutional Index Funds. Antonia M. Apps (Milbank, Tweed, Hadley & McCloy LLP) and David B. Rosenbaum (Osborn Maledon, P.A.) for Vereit Inc. and Vereit Operating Partnership LP.

Companies: Vanguard Specialized Funds; Vanguard Index Funds; Vanguard Institutional Index Funds; Vereit Inc.; Vereit Operating Partnership LP

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