(Article from Securities Law Alert, August 2015)
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On August 18, 2015, the Tenth Circuit affirmed dismissal of a securities fraud action alleging that ZAGG, Inc. had failed to disclose the number of company shares pledged as collateral in a margin account by the company’s then-CEO, in violation of Item 403(b) of Regulation S-K. In re ZAGG, Inc. Sec. Litig., 2015 WL 4901893 (10th Cir. 2015) (Tymkovich, J.) (ZAGG II). The court agreed with defendants that “the bare identification of a securities regulation violation is not enough,” standing alone, to raise a strong inference of scienter.
Background
Item 403(b) of Regulation S-K requires companies to disclose “the amount of shares that are pledged as security” in accounts held by the company’s directors and officers. 17 C.F.R. § 229.403(b). Plaintiffs asserted that Robert Pedersen, ZAGG’s former CEO and Chairman, had “failed to disclose in several of ZAGG’s SEC filings the fact that he had pledged nearly half of his ZAGG shares, amounting to approximately 9 percent of the company, as collateral in a margin account.” ZAGG’s SEC filings during the class period “revealed Pedersen’s total share of ownership but did not . . . indicat[e] the amount of his shares pledged as security” as required under Item 403(b).
Between December 2011 and August 2012, Pedersen sold ZAGG shares on three separate occasions in order to meet margin calls. Each time, Pedersen filed a Form 4 disclosing the sale. On August 17, 2012, ZAGG announced that Pedersen was stepping down as CEO and Chairman. The company also “filed a Form 8-K with the SEC stating that the company had implemented a policy prohibiting officers, directors, and 10 percent shareholders from pledging ZAGG securities on margin.”
Plaintiffs subsequently brought suit alleging that “the company’s SEC filings [had] omitted material information regarding Pedersen’s pledged shares,” and that this omission “resulted in the artificial inflation of ZAGG’s share price.” Defendants moved to dismiss. On February 7, 2014, the District of Utah dismissed plaintiffs’ complaint on scienter grounds. In re ZAGG Sec. Litig., 2014 WL 505152 (D. Utah. 2014) (Benson, J.). The court found plaintiffs had neither “allege[d] any facts [showing] that Pedersen knew that his failure to reveal his pledges would likely mislead investors,” nor pled “any particularized facts that might give rise to a strong inference that the pledged shares were ‘so obviously material’ that Pedersen must have been aware that [his] non-disclosure would likely mislead investors.” Plaintiffs appealed.
Tenth Circuit Finds a Failure to Comply with a Securities Regulation Disclosure Obligation Insufficient to Raise an Inference of Scienter Absent Particularized Allegations Showing Defendant Knew of or Recklessly Disregarded the Disclosure Requirement
On appeal, the Tenth Circuit found it “undisputed that ZAGG’s annual reports and proxy statements filed during the class period should have disclosed both Pedersen’s total ownership and ‘by footnote or otherwise, the amount of shares that [were] pledged as security.’” ZAGG II, 2015 WL 4901893 (quoting 17 C.F.R. § 229.403(b)). The court held, however, that “the fact of [an item 403(b)regulation disclosure] violation [was] insufficient” to raise an inference of scienter “without some other facts evidencing Pedersen signed the filings with the knowledge that they omitted a required disclosure.”
The court rejected plaintiffs’ contention that it was “implausible that Pedersen did not know of [Item 403(b)’s] requirement to disclose his pledged shares.” The court explained that plaintiffs’ argument “assume[d] that Pedersen [had] read and prepared the disclosures, and knew the omission would mislead investors.” The court found plaintiffs had alleged no particularized facts showing that “Pedersen appreciated [this] risk at the time the disclosures were made.” The court further found that “Pedersen’s position in the company [was] also an insufficient basis from which to impute his knowledge of the reporting violation.” Finally, the court deemed “unpersuasive” the fact that Pedersen had “executed Sarbanes-Oxley (SOX) certifications stating that he [had] reviewed the filings and the information contained therein was accurate.” The court determined that plaintiffs had not alleged any facts showing that Pedersen knew these “sworn SOX statements were false at the time they were made.”
Plaintiffs alternatively claimed that Pedersen had “acted with a reckless disregard of a substantial likelihood of misleading investors” in failing to comply with Item 403(b)’s disclosure requirements. The Tenth Circuit explained that “recklessness in [the securities fraud] context is a particularly high standard, . . . something closer to a state of mind approximating actual intent.” The court found that it could not “say that . . . a failure to comply with Item 403(b)[ ] . . . [was] evidence of conduct that was an extreme departure from the standards of ordinary care, . . . or akin to conscious disregard,” particularly given that Pedersen had “personally disclosed the margin account after each margin call.”
Tenth Circuit Finds Company’s Subsequent Margin Account Policy Changes Did Not Support an Inference of Scienter
The Tenth Circuit further determined that “neither Pedersen’s forced resignation nor ZAGG’s implementation of a new policy prohibiting officers, directors, and 10 percent shareholders from pledging company securities in margin accounts help[ed] to establish an earlier intent to defraud.” The court found that ZAGG’s margin account policy changes and Pedersen’s forced resignation were “at most an acknowledgement that the company [had] identified a better way of doing things moving forward, not an indicator that fraudulent intent existed at the time the alleged omissions occurred.”
The court found that any inference of scienter was not “at least as compelling” as “the plausible, nonculpable inference that Pedersen did not know Item 403(b)’s requirement and . . . believed he [had] appropriately disclosed the margin account . . . following each margin call.” The Tenth Circuit therefore affirmed dismissal of plaintiffs’ complaint for failure to allege scienter.