(Article from Securities Law Alert, December 2015)
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First Circuit: (1) Materiality and Scienter Analyses Are Linked, and (2) a Statement’s Marginal Materiality Can Weigh Against a Finding of Scienter
In a decision dated February 6, 2015, the First Circuit stated that “the materiality and scienter inquiries are linked.” Fire & Police Pension Ass’n of Colorado v. Abiomed, Inc., 778 F.3d 228 (1st Cir. 2015) (Lynch, C.J.). The court reaffirmed that “‘[t]he question of whether a plaintiff has pled facts supporting a strong inference of scienter has an obvious connection to the question of the extent to which the omitted information is material’” (quoting City of Dearborn Heights Act 345 Police & Fire Ret. Sys. v. Waters Corp., 632 F.3d 751 (1st Cir. 2011)). The First Circuit reasoned that “‘[i]f it is questionable whether a fact is material or its materiality is marginal, that tends to undercut the argument that defendants acted with the requisite intent or extreme recklessness in not disclosing the fact’” (quoting Waters Corp., 632 F.3d 751).
On December 8, 2015, the First Circuit applied the same reasoning in holding that a “thin materiality showing” could not “support a finding of scienter” in an SEC action against two former employees of State Street Bank and Trust Company. Flannery v. SEC, 2015 WL 8121647 (1st Cir. 2015) (Lynch, J.).
Second Circuit: 10b5-1 Plan Stock Trades May Support an Inference of Scienter If Plan Participation Commenced After the Alleged Fraud Began
On July 24, 2015, in a securities fraud action against Green Mountain Coffee Roasters, Inc. and certain of its executives, the Second Circuit rejected defendants’ contention that the executives’ stock sales did “not support an inference of scienter because they were made pursuant to . . . pre-determined 10b5-1 trading plans.” Emps.’ Ret. Sys. of Gov’t. of V.I. v. Blanford, 794 F.3d 297 (2d Cir. 2015) (Chin, J.). The court underscored the allegation that defendants began participating in these plans “long after . . . Green Mountain’s fraudulent growth scheme [allegedly] began.” The court held that “[w]hen executives enter into a trading plan during the [c]lass [p]eriod and the [c]omplaint sufficiently alleges that the purpose of the plan was to take advantage of an inflated stock price, the plan provides no defense to scienter allegations.”
In the case before it, the Second Circuit found that defendants had allegedly “made positive public statements about Green Mountain’s growth that drove up its stock price immediately before” scheduled sales of stock in their 10b5-1 trading plans. Although the sales “were made pursuant to their 10b5-1 trading plans,” the court found it significant that defendants “knew the dates of their scheduled sales [were] imminent when they made allegedly misleading statements to investors.”
Ninth Circuit: Adverse Interest Exception to Imputing an Executive’s Scienter to the Corporation Does Not Apply If (1) the Executive Acted with Apparent Authority; and (2) an Innocent Third Party Relied on the Executive’s Misrepresentations
On October 23, 2015, the Ninth Circuit held that fraudulent misrepresentations made by Ron Chan, the founder and CEO of ChinaCast Education Corporation, could be imputed to ChinaCast even though Chan had acted adversely to ChinaCast’s interests by “embezzl[ing] millions” from the company. In re ChinaCast Educ. Corp. Sec. Litig., 2015 WL 6405680 (9th Cir. 2015) (McKeown, J.). The Ninth Circuit determined that the adverse interest exception to the general rule imputing an executive’s scienter to the corporation did not apply because the complaint alleged that (1) “Chan [had] acted with apparent authority on behalf of the corporation” and (2) “third-party shareholders [had] understandably relied on Chan’s representations, which were made with the imprimatur of the corporation that selected him to speak on its behalf and sign SEC filings.” The Ninth Circuit found that “the adverse interest exception itself has an exception: the principal is charged with even the faithless agent’s knowledge when an innocent third-party relies on representations made with apparent authority.”
Tenth Circuit: Failure to Comply with a Securities Regulation Disclosure Requirement Is Insufficient, Standing Alone, to Raise a Strong Inference of Scienter
On August 18, 2015, the Tenth Circuit found that “the bare identification of a securities regulation violation is not enough,” standing alone, to raise a strong inference of scienter. In re ZAGG, Inc. Sec. Litig., 797 F.3d 1194 (10th Cir. 2015) (Tymkovich, J.).
The court 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 Robert Pedersen, the company’s then-CEO, in violation of Item 403(b) of Regulation S-K. The Tenth Circuit held that the fact of the Item 403(b) disclosure violation was “insufficient” to raise a strong inference of Pedersen’s scienter absent “some other facts evidencing [that] Pedersen [had] signed the filings with the knowledge that they omitted a required disclosure.” The court also rejected plaintiffs’ contention that the disclosure violation 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: Allegations of GAAP Violations and Claims That Defendants “Must Have Known” of the Fraud Are Insufficient, Standing Alone, to Allege Scienter Under the PSLRA’s Heightened Pleading Standards
On January 16, 2015, the Tenth Circuit reaffirmed that “‘allegations of GAAP violations or accounting irregularities, standing alone, are insufficient to state a securities fraud claim.’” In re Gold Resource Corp. Sec. Litig., 776 F.3d 1103 (10th Cir. 2015) (Seymour, J.) (quoting City of Philadelphia v. Fleming Cos., Inc., 264 F.3d 1245 (10th Cir. 2001)). The court held that such allegations may only “‘be sufficient to state a claim’” where they are “‘coupled with evidence that the violations or irregularities were the result of the defendant’s fraudulent intent to mislead investors’” (quoting Fleming, 264 F.3d 1245).
The Tenth Circuit further ruled that plaintiffs in the case before it could not meet the scienter pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”) merely by alleging that defendants “must have known” of the alleged fraud or financial discrepancy at issue in light of the size of the misstatement or the significance of the product line at issue. The Tenth Circuit emphasized that “plaintiffs’ view of the situation fail[ed] to take account of other plausible inferences” as required under the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007). The court noted that one such “plausible inference” is that a “prudent executive” might “want to investigate and confirm [a] claimed discrepancy before disclosing it publicly.” The Tenth Circuit explained that “‘[k]nowing enough to launch an investigation . . . is a very great distance from convincing proof of intent to deceive’” (quoting Higginbotham v. Baxter Int’l, Inc., 495 F.3d 753 (7th Cir. 2007)).
Eleventh Circuit: Allegations That a Corporate Executive “Must Have Known” of an Alleged Fraud Given Her Role at the Company Are Insufficient to Plead Scienter Absent Other Particularized Allegations Supporting the Executive’s Knowledge
On March 25, 2015, the Eleventh Circuit affirmed dismissal of a securities fraud action against Jiango Pharmaceuticals’ CFO and auditor on scienter grounds. Brophy v. Jiangbo Pharm., 781 F.3d 1296 (11th Cir. 2015) (Pryor, J.). The court rejected plaintiffs’ attempt to establish scienter on the part of Elsa Sung, Jiangbo’s former CFO, by claiming that “the disparity between Jiangbo’s actual and reported cash balances” was so large “that it would have been difficult or impossible for Ms. Sung’s not to have known about it in her capacity as CFO.”
The Eleventh Circuit found that plaintiffs essentially wanted the court to “rely solely on Ms. Sung’s position as CFO to overlook [the] omissions and ambiguities in the complaint.” In support of this argument, plaintiffs “cite[d] cases in which courts [have] recognized a strong inference of scienter based in part on a senior financial executive’s oversight of the processes that produce a company’s financial statements.” The court deemed those cases inapposite because they all “involve[d] particularized allegations that the executives knew or were severely reckless in disregarding how those processes were distorted by fraud.” Here, however, plaintiffs had “allege[d] no particularized facts that directly show[ed] [that] Ms. Sung intended to deceive shareholders or knew about or was severely reckless with respect to deficiencies in reporting.” The court determined that “[t]he seriousness of Jiangbo’s errors and Ms. Sung’s proximity to those errors at most impl[ied] negligence, which is not enough to establish scienter.”