Opinion ID: 1253901
Heading Depth: 4
Heading Rank: 2

Heading: Accounting for the Mahonia Transactions as Trades Rather than as Loans

Text: Plaintiffs contend that JPMC's accounting of disguised loans as trading activities rather than as loans constitutes a false statement. The district court found that the Mahonia transactions were indeed mischaracterized on JPMC's financial disclosures, JP Morgan Chase I, 363 F.Supp.2d at 626. However, the district court also held that treating the prepaid transactions as trades rather than as loans was immaterial. Id. at 630. Plaintiffs allege that the misclassification of the loans was material in light of the qualitative factors set out in SAB No. 99. First, according to the complaint, this accounting and reporting misstatement concealed an unlawful transaction because it hid JPMC's collaboration with Enron's illegal activities. Allegedly, the disclosure of the true nature of the prepay transactions would have exposed JPMC's role in the Enron accounting debacle. SAC ¶¶ 249-54. Accordingly, the misstatement was material because its purpose was to deceive investors and conceal misconduct. SAC ¶¶ 249, 254. Second, according to the complaint, the misstatement was material because, after JPMC's actions became public, JPMC stock immediately fell nearly nineteen percent. SAC ¶¶ 251, 588, 603, 606. Third, the complaint alleges that the misstatement was material because it related to JPMC's relationship with Enron, a relationship which Plaintiffs argue constituted a significant aspect of JPMC's operations and profitability because Enron was JPMC's single largest client. SAC ¶¶ 51, 54, 702-19, 726. Accordingly, Plaintiffs contend that three of SAB No. 99's qualitative factors point to the materiality of the alleged misstatement. However, the classification of the loans as trading assets was immaterial in this case. Under the legal standard set forth in Ganino, both quantitative and qualitative factors must be considered in determining materiality. Here, the quantitative factor strongly supports JPMC's argument that the classification error, if it was one, was immaterial. Although $2 billion in prepay transactions may sound staggering, the number must be placed in context reclassifying $2 billion out of one category of trading assets (derivative receivables) totalling $76 billion into another category (loan assets) totalling $212 billion does not alter JPMC's total assets of $715 billion. J.App. 406 (JMPC Annual Report 2000). Moreover, the underlying assets in either classification carry some default risk. As the district court said about this same information, [c]hanging the accounting treatment of approximately 0.3% of JPM Chase's total assets from trades to loans would not have been material to investors. JP Morgan Chase I, 363 F.Supp.2d at 631. While Ganino held that bright-line numerical tests for materiality are inappropriate, it did not exclude analysis based on, or even emphasis of, quantitative considerations. Ganino, 228 F.3d at 164. According to Ganino, an alleged misrepresentation relating to less than two percent of defendant's assets, when taken in context, could be immaterial as a matter of law. Id.; see also Parnes v. Gateway 2000, Inc., 122 F.3d 539, 547 (8th Cir.1997) (finding alleged misrepresentations with regard to two percent of total assets were immaterial as a matter of law); In re Westinghouse Sec. Litig., 90 F.3d 696, 715 (3d Cir.1996) (stating that a misstatement was immaterial where only one percent of assets was allegedly misclassified). And as the SEC stated in SAB No. 99, [t]he use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that ... a deviation of less than the specified percentage with respect to a particular item on the registrant's financial statements is unlikely to be material. SEC Staff Accounting Bulletin No. 99, 64 Fed.Reg. at 45,151. Here, the five percent numerical threshold is a good starting place for assessing the materiality of the alleged misstatement. In this case, the alleged misrepresentation does not even come close to that threshold. An accounting classification decision that affects less than one-third of a percent of total assets does not suggest materiality. However, this preliminary inquiry under the quantitative factor must be supplemented. See Ganino, 228 F.3d at 163. We go on to consider qualitative factors that might contribute to a finding of materiality. Contrary to Plaintiffs' assertions, however, the qualitative factors do not adequately demonstrate the materiality of the decision to classify the prepay transactions as loans. On appeal, Plaintiffs point to three factors set forth in SAB No. 99 as supporting their argument of materiality. The first qualitative factor is whether the misstatement concealed an unlawful transaction. Plaintiffs have not shown that this factor is present. Although they allege that the transaction should have been described differently, see, e.g., SAC ¶ 261, there is no allegation that the transaction itself was illegal. The second qualitative factor, the misstatements' relation to a significant aspect of JPMC's operations, also favors JPMC. While Plaintiffs allege that Enron is a key client of JPMC, it appears clear that JPMC's transactions with Enron were not a significant aspect of JPMC's operations, considering the fact that JPMC earned less than .1% of its revenues from Enron-related transactions each year. See SAC ¶ 54 and J.App. 405 (showing that while JPMC earned $30.1 million and $29.8 million in relationship revenues from Enron in 1999 and 2000 respectively, it earned $29.484 billion and $31.557 billion in total net revenues in those years). Finally, the third qualitative factor that Plaintiffs rely on is the market reaction to the public disclosures of JPMC's role in the Enron collapse. SAB No. 99, while alluding to market reactions as a valid consideration in analyzing materiality, warned that market volatility alone is too blunt an instrument to be depended on in considering whether a fact is material. SEC Staff Accounting Bulletin No. 99, 64 Fed.Reg. at 45,152 (internal quotation marks omitted). Indeed, SAB No. 99 limits the usefulness of this factor to instances where management expects that a known misstatement may result in a significant positive or negative market reaction. Id. Plaintiffs have not alleged facts that would permit the inference that JPMC expected that the alleged misclassification of the loans might result in a significant market reaction. For this reason, the market reaction to Enron's collapse and JPMC's involvement in this collapse does not point towards qualitative materiality under SAB No. 99. These qualitative factors are intended to allow for a finding of materiality if the quantitative size of the misstatement is small, but the effect of the misstatement is large. See Ganino, 228 F.3d at 163. Here, Plaintiffs have failed to allege properly that despite the relatively small size of the allegedly misstated transactions, reporting these transactions as loans instead of trades would have made a qualitative difference in JPMC's financial statements. To be sure, misclassification of assets does matter (as Plaintiffs point out, it has implications for ratio analysis), but the tenor of the SAC is that JPMC knew that the prepays were worthless all alongan argument that is not only implausible, but also counter-intuitive. Plaintiffs also argue that, had the transactions been reported properly, the subterfuge that JPMC and Enron created would have been exposed, leading to the public becoming aware of JPMC's involvement with Enron's misdeeds. See SAC ¶¶ 249, 254. As set forth in the complaint, this allegation is wholly conclusory. While Plaintiffs make the assertion that the proper accounting would have revealed JPMC's collusion with Enron, that hardly suggests how the whole arrangement with Enron would have come to light. [9] And, given that assets in either category carry some default risk, we cannot reasonably infer that there was a substantial likelihood that JPMC's reporting of the transactions as loans rather than as trades would have been viewed by a reasonable investor as having significantly altered the total mix of information made available.