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From Securities Regulation Daily, June 22, 2017

Solar energy company’s peculiar business model and accounting technique render IPO omissions immaterial

By Rebecca Kahn, J.D.

Whether omission of interim financial information in a solar energy company’s IPO registration statement violates the Securities Act is determined by the "total mix" of information available to the investor in the Second Circuit, not by any "extreme departure" as in the First Circuit. As the company’s peculiar business model resulted in wild quarterly fluctuations, failure to disclose the negative pre-IPO financial report did not amount to a material omission, particularly because the company warned investors of such possible fluctuations. Therefore, the Second Circuit affirmed the lower court’s dismissal for failure to state a Securities Act claim (Stadnick v. Vivint Solar, Inc., June 21, 2017, Walker, J.).

In conducting an IPO on October 1, 2014, Vivint Solar, Inc. issued a registration statement, which a purported class of purchasers claimed omitted material information about a massive negative swing in third-quarter earnings which was released the day before the IPO. The complaint alleged that the company misled the market when it failed to disclose its true financial picture in its registration statement and instead waited until the post-IPO release of its third quarter earnings to clarify its position. The lower court rejected the complaint for failing to state a claim for securities law violations, finding that Vivint had provided sufficient information about investment risks and that the third quarter earnings disclosures were not the kind of extreme departures from prior disclosures that would require a more stringent reporting requirement. The complaint failed to state a claim under Item 303 of Regulation S-K regarding the company’s earnings, as it did not show how the registration statement contained an untrue statement or omission of material fact.

Unusual business model. Vivint is a major installer of residential solar energy units. Its business model is to retain ownership of the installed equipment by leasing to its customers. This insures that the company benefits from various tax credits and other government incentives. Vivint allocates income between public shareholders and outside investors (non-controlling interests or NCIs) and calculates shareholder income by subtracting the NCI-allocated portion from the company’s overall income. It uses Hypothetical Liquidation at Book Value (HLBV). This business model and accounting method may show substantial variations of income allocation from quarter to quarter.

IPO. On October 1, 2014, Vivint issued an IPO and accompanying registration statement disclosing financial results for six quarters immediately preceding the third quarter of 2014. These revealed ever-increasing overall net losses and fluctuating NCI losses. Vivint also warned of the impact its business model and accounting practices could have on the allocation of income between NCIs and shareholders. The registration statement identified "key operating metrics" for assessing the company’s performance.

On November 10, 2014, Vivint disclosed its financial results for the quarter ending immediately before the IPO, showing decreased net income for shareholders by $40.8 million. It also reported that the results surpassed analyst expectations measured by the "key operating metrics" and the company’s overall market share increased significantly in the third quarter. The next day, Vivint’s stock price plunged 22.5%.

Robby Shawn Stadnick filed a putative class action alleging violations of Securities Act Sections 11, 12(a)(2), and 15. The lower court dismissed for failure to state a claim and Stadnick appealed, arguing that Vivint was obligated to disclose the third-quarter financial information because performance during that quarter constituted an "extreme departure" under Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996).

"Extreme departure" test rejected. The defendant in Shaw, Digital Equipment, prepared its registration statement on SEC Form S-3, which requires disclosure of "any and all material changes." Shortly after the third quarter’s close, Digital announced an unexpected operating loss of $183 million for the quarter and its stock dropped 20% below the IPO offering price. The Shaw plaintiffs alleged that Digital knew on the IPO date, but failed to disclose that the company’s third quarter performance would be substantially worse than that of previous quarters. The First Circuit concluded that Digital possessed, at the time of the IPO, interim information that created a "substantial likelihood" that its performance during the quarter in question would represent an "extreme departure" from its previous performance. The operating loss was therefore material to the offering and disclosure was required.

The Second Circuit panel rejected this "extreme departure" test and ruled that Vivint’s omissions were not material under the test set forth in DeMaria v. Andersen, 318 F.3d 170 (2d Cir. 2003).

DeMaria remains the operative test in the Second Circuit. DeMaria held that a duty to disclose information arises if a reasonable investor would view the omission as significantly altering the total mix of information made available. The panel found that the DeMaria test did not require Vivint to disclose its third quarter interim information because a reasonable investor would not have viewed Vivint’s omission as significantly altering the ‘total mix’ of information made available. The panel assessed the materiality of Vivint’s omissions by taking into account the performance of all five metrics disclosed by Vivint and the disclosures regarding Vivint’s unique business plan and the HLBV accounting method. When viewed in this context, the panel found that the omissions relating to income and earnings-per-share for the third quarter of 2014 did not render the publicly available information misleading.

Stadnick focused solely on income available to shareholders and earnings-per-share. The panel noted that the company’s performance would be more accurately assessed by looking to Vivint’s total revenue and total income, neither of which were affected by the HLBV method. Prior to the third quarter of 2014, during every quarter but one, the company’s total revenue increased from the previous quarter, and in every single quarter its net losses became larger, which comported with the successful implementation of its business model. Both of these trends continued through the third quarter of 2014. The panel found that the omission was not material even according to the variables identified by Stadnick if examined over the entire period for which Vivint disclosed information.

Most critically, Vivint’s registration statement contained ample warnings and disclosures that explained shareholder revenue and earning fluctuations, namely that: (1) the peculiarities of its business model and the HLBV method render the metrics identified by Stadnick less probative of Vivint’s performance; (2) as a result, the income available for shareholders would likely fluctuate from quarter to quarter; and (3) Vivint anticipated its substantial operating losses to continue.

Stadnick’s Section 15 claims were also dismissed.

The case is No. 16-65-cv.

Attorneys: Adam M. Apton (Levi & Korsinsky, LLP) for Robby Shawn Stadnick. Jay B. Kasner (Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates) for Vivint Solar, Inc. and The Blackstone Group L.P.

Companies: Vivint Solar, Inc.; The Blackstone Group LP

MainStory: TopStory FraudManipulation IPOs PublicCompanyReportingDisclosure ConnecticutNews NewYorkNews VermontNews

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