Contractual Promises For The Future Which Are Breached Are Not Material Misrepresentations Under Securities Law

All securities fraud lawyers know it can be tough to make it past a 12(b)(6) motion in securities fraud cases, because of the intense scrutiny all complaint allegations get under the law and procedural rules. That’s why its important to first make sure you properly identify the material misrepresentations upon which your client relied, since this is the cornerstone of the case. Unfortunately, what we’re learning is that promises of future behavior that investors may rely upon, if they are part of contractual language, will not constitute the first critical element of securities fraud cases.

The recent case of Reese v. BP Exploration (Alaska), Inc., decided on June 29, 2011, by the Ninth Circuit illustrates this point well, since many of the claims brought against the company failed because the court determined no material misrepresentation was properly alleged. The appeal originated with a securities fraud action involving British Petroleum Exploration of Alaska (BPXA). In fall 2006 BPXA was in charge of supervising its pipeline and oil production facilities in Prudhoe Bay Alaska. During that time two separate pipeline leaks resulted from the buildup of bacterial colonies in the pipeline due to sediment accumulation. In the resulting action under the Clear Water Act brought by the U.S. government BPXA admitted to being aware of the sediment buildup before the spills. The class of Plaintiffs represented by Claude A. Reese, were those individuals who purchased shares of BP in the time frame leading up to the spill, who collectively suffered billions of dollars of capital loss when the stock plummeted in the spill’s aftermath. The Plaintiffs alleged that BPXA had given them assurances that such spills, which had occurred before, were a thing of the past due to new safety protocols. Based on that assurance the Plaintiffs filed a securities fraud suit against BPXA.

The Plaintiffs claimed that BPXA made false and misleading statements about its

operations in Prudhoe Bay through the SEC filings of the BP Prudhoe Bay Royalty
Trust, a trust created to distribute royalty interest from oil production in Prudhoe Bay to
purchasers of Trust units traded on the New York Stock Exchange. When BPXA created
the trust, it executed an Overriding Royalty Agreement to govern the details of the
interest distribution. Pursuant to the Overriding Agreement, BPXA contracted to operate
its production in Prudhoe Bay according to a “prudent operating standard.” Then during
each quarter the Trust attached the Overriding Agreement, with its “prudent operating
standard” clause to its SEC filings.

The Plaintiffs claim that this act when taken with the admitted negligent operation of the Prudhoe Bay pipeline constituted a material misrepresentation and the grounds for a securities fraud action. The Court of Appeals rejected this claim by the Plaintiffs using the general “reasonable investor test,” which holds that a statement is misleading in the context of securities fraud if “it would give a reasonable investor the impression of a state of affairs that differs in a material way from the ones that actually exist.” For the Court of Appeals the Trust’s Overriding Agreement, with its prudent operating procedure clause, constituted only a contractual promise to perform services, not a material guarantee that such services would be performed in the future. They reasoned that a breach of a contractual promise of future action does not constitute a material misrepresentation that will support the allegation of fraud. Thusly, the Court of Appeals affirmed the District Court’s partial dismissal of the Plaintiff’s claim based on a failure to show a material misrepresentation.

The case provides a valuable lesson in the standards to which investors will be held when engaging in securities trading. Recent trends in securities law focus on the doctrine of “investor beware” and increasingly hold investors to a high standard of due diligence in their investment activity. Here the court held that investors should not assume that a contractual promise of a company to act in a certain manner is a guarantee of such action, relying on the contractual doctrine of efficient breach, which assumes that people will sometimes intentionally breach their contractual agreements for no other reason than financial gain. While the Court of Appeals left open the issue of whether or not the Plaintiffs could recover contractual remedies from BPXA, their ruling illustrates the proactive environment of investing that all Plaintiffs should be aware is required.