A hedge fund and the U.S. Securities and Exchange Commission aren’t groups that you would typically expect to see working together as allies. This week is different – Moab Capital Partners is presenting oral arguments to the Supreme Court and has the backing of the SEC (via a friend-of-the-court brief).
Originally published in the January 17th edition of Transacted.
At issue is a reading of U.S. securities law, which Moab thinks should be interpreted in a way that allows investors, in addition to regulators, to sue companies for failing to disclose negative business trends known to management—all part of Moab’s ongoing litigation against Macquarie Infrastructure Corp. (MIC), which the hedge fund says purposefully withheld information from investors.
The Background
Founded in 2006, Moab says it employs an event-driven, value-oriented strategy spanning “arbitrage, equity restructuring, special situations, credit, and distressed strategies.”
In 2018, the fund launched an activist campaign against MIC, calling for an immediate reconstitution of the board and pursuit of strategic alternatives, including a sale of the company.
Moab’s justification was partially based on MIC’s unique structure, which included a management services agreement that paid Macquarie Infrastructure Management, a unit of the eponymous Australian financial services firm, various management and performance fees. Per Moab, those fees totaled more than $500 million over the preceding three years, despite a falling share price and 2018 EBITDA of just $221 million.
But, the origin of this week’s SCOTUS visit was Moab’s allegations that MIC fraudulently withheld information from its shareholders, covering up an upcoming hit to the business brought by a new maritime fuel law that banned the use of sulfur-heavy No. 6 fuel oil. Specifically, that the law would decimate MIC’s fuel storage unit, which owned facilities specifically designed for No. 6 fuel.
Moab says MIC management knew the severity of the situation well in advance, yet continued to provide only a positive narrative on the business’ trajectory.
Then, in February 2018, Macquarie announced it had missed its financial projections and would cut its dividend, disclosing that the percentage of its storage capacity in use had plummeted.
Even then, Macquarie waited until the following day to acknowledge that many of the business’ No. 6 fuel oil customers had previously terminated their contracts. Post-announcement, the company’s share price fell more than 40 percent.
The Legal Question
Moab sued MIC under the claim that, by not disclosing this information in the company’s public filings, MIC ran afoul of Rule 10b-5 of the Securities Exchange Act, which allows private investors to sue a company that knowingly provides false or misleading statements.
The legal question is whether Rule 10b-5 and its right to sue also extends to omissions of information, rather than outright falsehoods, in the section of a company’s public filings where management provides an update on the business, known as Management’s Discussion & Analysis (MD&A).
The MD&A section is governed under the separate Item 303 of Regulation S-K. While Item 303 isn’t specific about what should and shouldn’t be disclosed, the SEC has historically pursued actions against companies that knowingly leave out material information—Item 303 does not, however, grant private investors the same right to sue.
“It comes down to a question of how broad Section 10(b) is as a tool for private enforcement,” Jill Fisch, a professor at the University of Pennsylvania Carey Law School, told Bloomberg Law.
Earlier this year, The Second Circuit Court of Appeals unanimously sided with Moab and vacated a lower court’s earlier dismissal of the case. Now, the Supreme Court will decide.
The SEC Wants a Helping Hand
The SEC is in full agreement with Moab’s interpretation of the law, which mirrors its longstanding position that omissions in the management discussion & analysis portion of a public filing can be the basis for securities fraud liability.
On the topic of a hedge fund-turned-regulator, the SEC calls private suits an “essential supplement” to its own work and, along with the Department of Justice, will participate in this week’s arguments.
Implications of the Upcoming Decision
In an amicus brief on behalf of institutional investors, Richard Bodnar of Rolnick Kramer Sadighi LLP likened Item 303 ommissions to “‘the dog that did not bark in the night,’” in reference to a Sherlock Holmes clue occasionally cited by courts. “The absent disclosure tells investors not to concern themselves with that issue.”
“Item 303 disclosure failures can be particularly harmful for sophisticated investors, who may be comparing trend disclosures across companies in a given sector or industry or over time for a specific issuer,” he added.
That sentiment isn’t universally shared, with other parties warning that a ruling in Moab’s favor could unleash a torrent of new suits brought by investors. “That would cost companies a great deal of money,” Elizabeth Gingold Clark of Alston & Bird told Bloomberg Law. “Securities litigation is very expensive and very protracted.”