(Article from Securities Law Alert, January 2016)
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On January 13, 2016, the Fifth Circuit affirmed dismissal of a securities fraud action against Diodes, a semiconductor company, and two of its corporate officers for failure to raise a strong inference of scienter. Local 731 I.B. of T. Excavators and Pavers Pension Trust Fund v. Diodes, 2016 WL 157822 (5th Cir. 2016) (Jones, J.). The court rejected plaintiffs’ contention that “more disclosure was required” as to the reasons for a labor shortage where defendants had accurately disclosed both the timing and financial impact of that shortage. The court explained that “[m]ost reasonable investors would rather receive an accurate ‘bottom line’ assessment of a disclosed company problem than all of its assumptions and nuances.” The court further held that it could not infer scienter based on the officers’ positions at the company absent “special circumstances,” which the court found were not present.
Court Finds No Basis for Plaintiffs’ Contention That Diodes’ CEO and CFO Must Have Known That the Labor Shortage Was Due to Diodes’ Workplace Policies
In the case before the court, defendants had “repeatedly warned investors of a labor shortage that would affect [the company’s] output in the first two quarters of 2011” and also “accurately warned [of] the precise impact this labor shortage would have on [the company’s] financial results.” Plaintiffs nevertheless claimed that defendants’ disclosures were materially misleading because defendants did not disclose that the labor shortage was “due principally to Diodes’s own harsh labor practices that alienated workers and caused them to quit.”
Plaintiffs did not allege any “facts indicating that [Diodes’ CEO and CFO] knew that the labor shortage was principally caused by Diodes’s workplace policies.” Instead, plaintiffs contended that “a strong inference of scienter [could] be drawn simply from the magnitude of disruption caused by the company’s labor policies, which, from their top executive positions, [Diodes’s CEO and CFO] must or should have known about.”
Plaintiffs acknowledged that under Fifth Circuit case law, “‘an officer’s position with a company does not suffice to create an inference of scienter’” (quoting Nathenson v. Zonagen, 267 F.3d 400 (5th Cir. 2001)). However, plaintiffs argued that courts in the Fifth Circuit have held that “special circumstances, ‘taken together with an officer’s position, may support a strong inference of scienter’” (quoting Dorsey v. Portfolio Equities, 540 F.3d 333 (5th Cir. 2008)).
The Fifth Circuit in Diodes explained that these “‘special circumstances’ cases exhibit some combination of four considerations that might tip the scales in favor of an inference of scienter.” First, the court noted that “the smaller the company the more likely it is that corporate executives would be familiar with the intricacies of day to day operations.” A second factor is whether the transaction in question was “critical to the company’s continued vitality.” A third factor is whether “the misrepresented or omitted information at issue would have been readily apparent to the speaker.” Finally, a fourth factor is whether “the defendant’s statements were internally inconsistent with one another.”
The Fifth Circuit determined that “[n]one of these considerations [was] present here.” The court pointed out that “Diodes is a large company with over 4,000 employees at locations across the world.” The court found it “not at all clear that Diode’s top executives in Dallas would have been aware of labor policies at the Shanghai facility, much less the chatter on the factory floor and the varying reasons for employee attrition.” There was no allegation that the labor shortage “jeopardized the company’s existence.” As to the causes of the labor shortage, the court found that the impact of Diodes's workplace policies on the labor force would not necessarily have been “readily apparent” to Diodes’s CEO and CFO given that there were also other factors at play (the Chinese New Year and new Chinese government policies). Finally, the court noted that “defendants’ statements [on the labor shortage] were both consistent and accurate.”
The court therefore concluded that it could not infer scienter based solely on the executives’ positions at Diodes.
Court Finds Diodes’s Early Product Shipments Do Not Suggest Scienter
Plaintiffs also contended that “Diodes's early shipments of orders without prior customer authorization” “indicate[d] that Diodes [had] intended to conceal the true impact of the labor problems from the public and to deceive investors by artificially pushing forward its earnings.”
The Fifth Circuit found that this “argument [was] beset with difficulties, not the least of which is that early shipping is a legal practice that may be supported by any number of legitimate reasons, and usually does not support a strong inference of scienter.” The court also deemed plaintiffs’ theory illogical because “shipping orders early would tend to enhance the labor shortage problem, not disguise it.” The court explained that “shipping orders early would deplete the inventory” and “Diodes’s ensuing inability to keep up with orders would [then] quickly become apparent, and its revenue and gross profit margin would decrease.”
Court Finds Stock Sales by Diodes's CEO Insufficient to Support a Finding of Scienter
The Fifth Circuit then turned to plaintiffs’ contention that stock sales by Diodes's CEO prior to the company’s disclosure of the impending labor shortage supported an inference of scienter. The court explained that “insider trading, by itself, cannot create a strong inference of scienter, but it may meaningfully enhance the strength of the inference of scienter.” The court underscored that “even unusual sales by one insider do not give rise to [an inference of] scienter when other defendants do not sell some or all of their shares during the [c]lass [p]eriod.”
The Fifth Circuit agreed that Diodes's CEO’s stock sales “might be considered suspicious” when “[v]iewed in isolation” because they were “out of line with his prior trades, which were infrequent and in much smaller amounts.” However, the court concluded that the CEO’s stock sales could not support an inference of scienter because “[t]he sales represented a small portion of his investment in the company” and there were no allegations of other suspicious insider sales during the same time period.
Based on the “[t]otality of the circumstances,” the Fifth Circuit found that plaintiffs had failed to allege facts giving rise to “a strong inference of scienter.”