(Article from Securities Law Alert, March 2018)
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On March 8, 2018, the Ninth Circuit affirmed dismissal of a securities fraud action against a solar energy company arising out of an accounting error. Webb v. SolarCity Corp., 2018 WL 1189422 (9th Cir. 2018) (Smith, Jr., J.). The Ninth Circuit held that generalized allegations of a motive to boost a company’s financial performance in the months before and after an IPO are insufficient to meet the high bar for pleading scienter. The court further held that plaintiffs could not rely on the core operations theory to allege scienter because the accounting error at issue involved only a small division of the company.
The Ninth Circuit began its analysis by emphasizing that the scienter pleading standard set by the Supreme Court in Tellabs v. Makor Issues & Rights, 551 U.S. 308 (2007) “is not easy to satisfy.” The court explained that plaintiffs must “plead an inference of scienter that is ‘cogent and at least as compelling as any opposing inference one could draw from the facts alleged.’” Id. (quoting Tellabs, 551 U.S. 308).
The Ninth Circuit found plaintiffs’ IPO-related motive allegations “unhelpful” towards pleading scienter. The court noted that plaintiffs’ allegations were neither “specific” nor “particularized,” but instead spoke to the type of “routine corporate objectives” that it has rejected in the past. The court explained that “[s]urely every company that goes public wants to maximize its apparent profitability prior to its IPO and to maintain a high share price afterward in order to finance acquisitions and expand.”
The Ninth Circuit also rejected plaintiffs’ effort to rely on the core operations doctrine to plead defendants’ knowledge of the accounting error. While plaintiffs alleged that defendants “had a hands-on style and general accounting acumen,” there were no allegations that defendants “were involved in accounting decisions as minute as the calculation” at issue. The court further found plaintiffs alleged no facts supporting an inference that it would have been “absurd” for defendants to have missed the impact of the accounting error. The court noted that the division affected by the accounting error accounted for “a relatively minor portion of the company’s overall business.” Moreover, the court observed that the error “was so subtle that it appears that even the company’s specialized accounting division and professional auditors missed it.” Finally, the court found it significant that the accounting error “only misstated the degree of the company’s unprofitability.” The court determined that these factors, taken together, precluded it “from holding that the falsity of the erroneous financials was necessarily ‘immediately obvious’” to defendants.
Based on a holistic consideration of plaintiffs’ scienter allegations, the Ninth Circuit concluded that plaintiffs’ “narrative of fraud is simply not as plausible as a nonfraudulent alternative.”[1] The court found that at most, plaintiffs “paint[ed] a picture of a mismanaged organization in need of closer financial oversight that made a minute error at a critical stage in its development.”
[1] The Ninth Circuit rejected plaintiffs’ contention that the district court had erred by considering each scienter allegation individually before conducting a holistic analysis. While the Ninth Circuit noted that it has recognized the “potential pitfalls” of such an approach, the court stated that “such an analytical process is permitted under [its] precedents.”