Attorney: Michael J. Wernke
Pomerantz Monitor May/June 2018
Chief Judge Waverly D. Crenshaw, Jr. of the Middle District of Tennessee recently denied defendants’ motion to dismiss Pomerantz’s securities fraud class action involving Quorum Health Corporation (“Quorum”) and Community Health Systems, Inc. (“CHS”). CHS is one of the nation’s largest operators of hospitals. Quorum, an operator and manager of hospitals, was spun off from CHS in April 2016. The action, brought on behalf of investors in Quorum who purchased Quorum shares after the spinoff, alleges that Quorum, CHS and certain of their officers violated section 10(b) of the Securities Exchange Act as well as section 20(a), the “control person” provision, by issuing financial statements for Quorum that misrepresented its financial condition.
Specifically, our complaint alleges that CHS hatched a scheme to unload its worst-performing hospitals at an inflated price. It set up the new subsidiary, Quorum, to buy these hospitals from CHS for $1.2 billion, which Quorum borrowed. That price was based on fraudulent calculations of “good will” attributable to those hospitals. Goodwill is an intangible asset that that results when one company purchases another for a premium value. The value of a company’s brand name, customer base, and good customer relations are examples of goodwill. That is, when a company like CHS purchases hospitals like those that came to make up Quorum, it must record as goodwill the amount it paid for those hospitals in excess of the fair value of the assets. A company must then periodically test the goodwill and record an “impairment” to the goodwill when it is more likely than not that the fair value of the asset has declined below its carrying amount (or book value). This occurs when “triggering events” lead management to believe that the expected future cash flows of an asset have significantly declined.
The inflated value of Quorum’s goodwill was then reflected in Quorum’s financial statements, which were disseminated to investors when Quorum’s stock started trading as a separate public company.
We allege that the defendants knowingly inflated Quorum’s goodwill and failed to take a necessary impairment. As a result of the defendants’ false statements about Quorum’s goodwill, investors that purchased Quorum stock in the market following the spin-off paid an inflated price. The truth was revealed when Quorum and CHS each announced only a few months after the spin-off was completed (and CHS received its $1.2 billion) that each company was severely impairing its goodwill. As a result, Quorum’s stock price plummeted $4.99, almost 50%, damaging investors.
Defendants’ main argument for dismissal was that their statements of goodwill, which are considered statements of opinion under the law, were not false and misleading when made, or made with the intent to mislead investors. The court rejected these arguments, finding that the multiple “triggering events” or “red flags” indicating that the goodwill was impaired were known to the defendants prior to the spin-off. For example, in the months prior to the spin-off, CHS’s stock price decline 78%, corresponding to a decline in market capitalization of $5.6 billion. The court also noted the extremely poor performance of the hospitals that made up Quorum as an indicator that the goodwill was impaired. Thus, the court held that because the complaint alleged that the defendants’ statements of goodwill did not fairly align with the information they knew, Pomerantz adequately alleged that the defendants knew that their statements of goodwill were false.
This opinion is particularly significant because the court held that the CHS defendants, in addition to the Quorum defendants, were “makers” of the false statements of goodwill in Quorum’s initial financial statements even though the filings were made on behalf of Quorum, not CHS. Normally, only the company and officers whose stock the class purchased are liable for false statements under the federal securities laws. Here, that would be Quorum and its officers. However, the court accepted our argument that CHS and its officers should also be liable for the false statements because Quorum was part of CHS prior to the spin-off and all of Quorum’s financials in the spin-off documents were calculated by CHS.