Norfolk Cty. Ret. Sys. v. Cmty Health Sys., Inc.: Plaintiffs Plausibly Alleged Securities Fraud

In Norfolk Cty. Ret. Sys. v. Cmty Health Sys., Inc., 877 F.3d 687 (6th Cir. 2017), the United States Court of Appeals for the Sixth Circuit reversed the district court’s judgment in favor of Community Health System shareholders (“Plaintiffs”). The Court of Appeals ruled that under §10(b) of the Securities Exchange Act and Rule 10b-5 promulgated thereunder, Plaintiffs plausibly alleged the value of Community Health Systems’s (“Defendant”) shares fell because of undisclosed practices. Defendant’s profits relied on Medicare fraud, which they failed to disclose. The Plaintiffs allege that the market reacted negatively once those fraudulent practices were revealed, resulting in a loss in the value of their shares.

Defendant runs the largest for-profit hospital system in the country. In 2011, Defendant reported $13.6 billion in revenue, which revenue significantly depended on reimbursements from treating Medicare patients. Defendant is reimbursed far more for inpatient services, and relies on an internal system called the Blue Book to determine if a person needs inpatient or outpatient care. According to the allegations, the Blue Book directed doctors to provide inpatient services for conditions that other hospitals would treat as outpatient cases. Allegedly, Defendant never disclosed the Blue Book practices and attributed its profits to “synergies” and “efficiencies” of its hospital network. In 2011, Defendant initiated a hostile takeover of Tenet Healthcare Corporation (“Tenet”). To win the votes of Tenet’s shareholders, Defendant attributed its success to its “reputation for superior operating performance” and did not mention the Blue Book practices. Defendant made this same statement, and others like it, to the SEC. Tenet sued Defendant, alleging those statements were false and misleading because the Blue Book practices were the real reason for Defendant’s success and further claimed that the Blue Book practices directed Defendant’s hospitals to defraud Medicare. After the Tenet suit was filed, Plaintiffs alleged that Defendant engaged in a series of misrepresentations designed to preserve the fraud’s effect, including assurances that the hospitals would stop using the Blue Book practices by the end of the year, that Defendant’s “business practices are appropriate,” that the Blue Book practices were “fairly close” to other systems used in the industry, and that switching from the Blue Book practices would not hurt revenues. According to the Plaintiff’s allegations, the date Tenet filed its complaint, Defendant’s shares lost more than half their value and Plaintiffs lost a total of $891 million. Plaintiffs claimed that Defendant’s misrepresentations convinced investors that Defendant’s revenues were sustainable when in fact they were not and argued the district court erred in dismissing the complaint for failure to state a plausible claim of securities fraud under Section 10(b) and Rule 10b-5.

To state a claim under Section 10(b) and Rule 10b-5, the plaintiffs must allege the defendants made material misrepresentations or omissions in connection with the sale of a security, that they did so with scienter, that the plaintiffs relied on the misrepresentations or omissions, and that they suffered an economic loss as a result. Plaintiffs must set forth allegations that, if proved, establish a “strong inference” of fraudulent intent. Plaintiff may satisfy the loss causation element through the defendant’s revelation of their own fraud with a “corrective disclosure,” which is a statement that reveals what the defendants themselves previously concealed.

The only element in dispute was whether Plaintiffs sufficiently alleged loss causation. The Court of Appeals concluded that Plaintiff plausibly alleged corrective disclosures in Defendant’s response to Tenet’s complaint. The court held Plaintiffs’ reliance on the subsequent drop in Defendant’s share prices satisfied the loss causation element, therefore Plaintiff plausibly stated a claim for securities fraud.

 Accordingly, the Sixth Circuit reversed the district court’s dismissal and remanded the case.

 The primary materials for this case may be found on the DU Corporate Governance Website.