Securities — If Group Pleading Is Dead, Is Collective or Corporate Scienter Alive? Circuit Split
Rahman v. Kid Brands, Inc., 2012 U.S. Dist. LEXIS 31406 (D.N.J. Mar. 8, 2012):
In Winer Family Trust, the Third Circuit was asked to consider, inter alia, whether plaintiff former shareholders of Pennexx Foods could assert liability on the part of individual defendant directors and officers of Pennexx and Smithfield Foods on the basis of said individual defendants' "access to, control over, and ability to edit and withhold dissemination of Pennexx's press releases and SEC filings." 503 F.3d at 334-35. The Third Circuit defined group pleading doctrine as a "judicial presumption that statements in group-published documents including annual reports and press releases are attributable to officers and directors who have day-to-day control or involvement in regular company operations. Under the doctrine, where defendants are insiders with such control or involvement, their specific connection to fraudulent statements in group-published documents is unnecessary. . . . Accordingly, the group pleading doctrine allows a plaintiff to plead that defendants made a misstatement or omission of a material fact without pleading particular facts associating the defendants to the alleged fraud." Id., at 335. After reviewing the purposes of the PSLRA and the reasoning in Tellabs regarding the substantial heightening of pleading requirements in securities class action lawsuits, the Third Circuit held that a "presumption of particularity is inconsistent with the PSLRA's requirement that scienter be pleaded with respect to 'each act or omission' by 'the defendant' . . . . The PSLRA requires plaintiffs to specify the role of each defendant, demonstrating each defendant's involvement in misstatements and omissions. . . . [T]he group pleading doctrine is no longer viable in private securities actions after the enactment of the PSLRA." Id., at 335-37 (quoting 15 U.S.C. § 78u-4(b)).
However, while the Third Circuit has clearly rejected the group pleading doctrine, it has not definitively decided whether the close but distinguishable assertion of collective or corporate scienter is viable after the PSLRA and Tellabs. Collective or corporate scienter could, for example, be imputed to a corporation either through respondeat superior or agency theories of liability, or through an inference based on dramatic announcements or oversights that corporate officials could not but know to be false, even if no individual defendant can be named regarding the concoction and dissemination of the fraud. There is a Circuit split as to whether the imputation of liability under traditional, common law understandings of tort liability are viable even if group pleading doctrine has been rejected. The Second, Sixth, Seventh and Ninth Circuits have upheld some version of collective or corporate scienter absent the naming of individual defendants in securities fraud actions, while the Fifth and Eleventh Circuits have rejected the viability of such a scienter showing. Since the Third Circuit has not yet definitively ruled on the issue, Defendants ask the Court to follow the Fifth Circuit's approach to scienter in Section 10(b) pleadings, requiring at least one individual corporate officer making any misleading statement to have the requisite level of scienter. *** After reviewing the relevant case law on collective and corporate scienter, including recent decisions by the Third Circuit, the Court disagrees with Defendants that all forms of imputation of liability to corporations available under tort law are no longer available to private securities fraud plaintiffs after the enactment of the PSLRA, but nevertheless finds that Plaintiff's Amended Complaint does not adequately plead scienter within the available scope of such imputations.
Defendants encourage the Court to follow the Fifth and Eleventh Circuits in holding that plaintiffs must plead that at least one individual acting on behalf of the corporation made a false statement with the requisite state of mind. See Southland Securities Corp. v. INSpire Insurance Solutions, Inc., 365 F.3d 353,366-67 (5th Cir. 2004); Phillips v. Scientific-Atlanta. Inc., 374 F.3d 1015, 1018 (11th Cir. 2004). In Southland, corporate defendant INSpire Insurance Solutions, its original parent company, Millers Mutual Fire Insurance Company, and various corporate officers were alleged to have committed securities fraud in violation of Section 10(b), Rule 10b-5 and Section 20(a) by engaging in a scheme to deceive investors about the company's performance for the purpose of inflating the price of INSpire stock for their own financial benefit. Southland, 365 F.3d at 359-60. The court found that, for "purposes of determining whether a statement made by the corporation was made by it with the requisite Section 10(b) scienter we believe it appropriate to look to the state of mind of the individual corporate official or officials who make or issue the statement . . . rather than generally to the collective knowledge of all the corporation's officers and employees acquired in the course of their employment." Id., at 366. The Eleventh Circuit also rejected collective scienter in Phillips, where, without addressing the validity of group pleading doctrine, it held that "scienter must be found with respect to each defendant and with respect to each alleged violation of the statute. . . . Although the plain language [of the PSLRA] is less compelling with respect to alleging the scienter of each defendant, the statute does use the singular term 'the defendant,' and we believe that the most plausible reading in light of congressional intent is that a plaintiff, to proceed beyond the pleading stage, must allege facts sufficiently demonstrating each defendant's state of mind regarding his or her alleged violations." Phillips, 374 F.3d at 1018.
However, the Second, Sixth, Seventh, and Ninth Circuits have approved the viability of collective scienter doctrine while nevertheless upholding the strict pleading requirements of the PSLRA. In Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital, the Second Circuit was asked to consider the circumstances under which a plaintiff could plead the requisite scienter against a corporate defendant without successfully pleading scienter against a specifically-named individual defendant. 531 F.3d 190, 192 (2nd Cir. 2008). In that case, plaintiff Teamsters Local 445 had purchased bonds issued as asset-backed securities which were secured by mortgage loans sold by defendant Dynex Capital's subsidiary, Merit Securities Corp. Id. According to the complaint, after the bonds were issued, the value of the collateral began a sharp decline when increasing numbers of borrowers defaulted on their mortgage loans, creating substantial losses for bond investors. Id. In October 2003, Dynex disclosed that it had understated repossession rates on the bond collateral, and in February 2005, plaintiff filed a securities fraud action for alleged violations of Sections 10(b) and 20(a), naming Dynex and Merit as corporate defendants as well as Thomas Potts and Stephen Benedetti, who served as the president and principal executive officer of Dynex and the president and CEO of Merit, respectively. Id., at 193. The district court held that plaintiff had failed to adequately plead scienter with respect to individual defendants Potts and Benedetti, but nevertheless found that scienter was adequately pled as to corporate defendants Dynex and Merit "because plaintiff's allegations constituted strong circumstantial evidence of recklessness, a sufficiently culpable mental state." Id., at 194-95. In reviewing the reasoning of the district court, the Second Circuit cautioned against "improperly conflat[ing] pleading rules and liability rules. To prove liability against a corporation, of course, a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation." Id., at 195. The court found that when the defendant is a corporate entity, pursuant to the PSLRA,
the pleaded facts must create a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter. In most cases, the most straightforward way to raise such an inference for a corporate defendant will be to plead it for an individual defendant. But it is possible to raise the required inference with regard to a corporate defendant without doing so with regard to a specific individual defendant. . . . Congress has imposed strict requirements on securities fraud pleading, but we do not believe they have imposed the rule urged by defendants, that in no case can corporate scienter be pleaded in the absence of successfully pleading scienter as to an expressly named officer.
Id., at 195-96.
The Sixth Circuit considered the same question in City of Monroe Employees Ret. Sys. v. Bridgestone. 399 F.3d 651 (6th Cir. 2005). In that case, plaintiff purchased Firestone-Bridgestone common stock or American Depository Receipts for Bridgestone common stock, and brought a securities fraud action on its behalf and others similarly situated based on defendant Firestone-Bridgestone's alleged public attribution of known defective tire failures to consumers' failures to properly inflate or take care of their tires. Id., at 656. A government investigation revealed corporate fault in the adhesion-boosting compound of the rubber used in the tires, and the company was fined by the National Highway Traffic Safety Administration, following which Firestone-Bridgestone instituted a recall which allegedly injured Firestone-Bridgestone's corporate image, brand, and financial performance. Id. The complaint then detailed a series of incidents which the company attempted to suppress information about, including various government investigations, foreign and domestic, regarding tire failures. Id., at 657-664. On appeal, the Sixth Circuit reviewed the district court's granting of defendant Firestone-Bridgestone's motion to dismiss, inter alia, on grounds that plaintiff failed to sufficiently plead scienter on the part of the corporate defendants Firestone and Bridgestone as well as individual defendant Firestone CEO and Bridgestone Executive Vice-President. Id., at 684. Without deciding the viability of group pleading doctrine, the court found that plaintiff's complaint failed to allege scienter as to any individual defendant, but nevertheless found that scienter could be imputed to Firestone and Bridgestone, and that, "while an individual officer's knowledge may be attributed to the corporation, liability for the corporation's act does not, absent independent evidence, generally flow from the corporation to the corporate officer." Id., at 689-90.
On remand from the Supreme Court, the Seventh Circuit issued a much-cited opinion in Tellabs II which held that scienter was sufficiently pled as to corporate defendant Tellabs in conformity with the requirements of the PSLRA. 513 F.3d at 712. Judge Posner found at least three routes to pleading corporate scienter, two of which included traditional forms of imputing liability under tort law: respondeat superior and agency liability. See id., at 707-708 ("The Supreme Court has declined to incorporate common law principles root and branch into section 10(b) of the Securities Exchange Act (and hence into Rule 10b-5), and specifically has rejected aider and abettor liability. But the doctrines of respondeat superior and apparent authority remain applicable to suits for securities fraud. Tellabs does not argue the contrary.")(citations omitted). With respect to the third route of liability, the court considered critical the question of "how likely it [wa]s that the allegedly false statements . . . were the result of merely careless mistakes at the management level based on false information fed it from below, rather than of an intent to deceive or a reckless indifference to whether the statements were misleading." Id., at 709. The court then set forward a model hypothetical to gauge such a likelihood, utilized as a standard in subsequent cases for imputing corporate scienter:
[I]t is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud. Suppose General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero. There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false. . . . The fact that a gamble — concealing bad news in the hope that it will be overtaken by good news — fails is not inconsistent with its having been considered, though because of the risk a reckless, gamble.
Id., at 710. On this basis, the court found that it was exceedingly unlikely that the CEO of Tellabs, at the top of the corporate pyramid, was unaware of problems at his company regarding false and misleading statements concerning two major switching systems used in fiber optic cable networks, specifically, projecting excessive demand for said switching systems when the fiber-optics bubble burst. Id., at 711.
In Glazer Capital Mgmt., LP v. Magistri, the Ninth Circuit considered the viability of pleading collective scienter when InVision Technologies, Inc. ("Invision"), its CEO, and its Chief Financial Officer were alleged to have violated Section 10(b) in their misstatements regarding doubts about the corporation's potential merger agreement with General Electric due to discovery of InVision's potential violations of the Foreign Corrupt Practices Act of 1997. 549 F.3d 736 (9th Cir. 2008). While the court generally found that corporate scienter relies heavily on the awareness of directors and officers that statements were fraudulent when made, it nevertheless found that, under certain facts, corporate scienter pleading was appropriate: "In Nordstrom. Inc. v. Chubb & Son. Inc., we touched on the issue [of collective scienter] indirectly in the context of an insurance dispute. 54 F.3d 1424 (9th Cir. 1995). . . . Nordstrom merely held that, on the facts of the case, it was impossible to allege corporate scienter without also implicating the directors and officers. Nordstrom does not foreclose the possibility that, in certain circumstances, some form of collective scienter pleading might be appropriate. For instance, as outlined in the hypothetical posed in [Tellabs II], there could be circumstances in which a company's public statements were so important and so dramatically false that they would create a strong inference that at least some corporate officials knew of the falsity upon publication." Id., at 744.
While the Third Circuit has not decided which approach it agrees with, it has indicated that it may be possible to plead scienter against a corporation without pleading scienter against an individual, but the facts alleged would need to be similar to those in Bridgestone and Tellabs II. Specifically, in City of Roseville Employees' Retirement Sys. v. Horizon Lines. Inc., the court cited Judge Posner's hypothetical in Tellabs II and generalized that the alleged wrongdoing to so assert collective scienter would need be "extraordinary." 442 Fed. Appx. 672, 676 (3d Cir. 2011). In Horizon Lines, plaintiff retirement fund brought claims against a parent and subsidiary shipping company as well as individual defendants--executive and management officers at the company--for securities fraud arising out of alleged price fixing in Horizon's shipping business from the United States to Puerto Rico. Id., at 673. After finding that the plaintiff failed to sufficiently plead scienter as to the senior executives at Horizon, the Third Circuit considered "whether plaintiff may otherwise plead scienter as to Horizon, and if so, whether it has done so." Id., at 676. The Court noted that the district court, in finding that plaintiff had not so pled, applied the Fifth Circuit approach in Southland Securities: "Because there was no individual at Horizon who made actionable statements with scienter, the Court concluded that plaintiff had not pled scienter against Horizon." Id. However, the Third Circuit considered the approaches of the Sixth and Seventh Circuits in Bridgestone and Tellabs II as viable, and declined to definitively accept the Fifth Circuit individual defendant scienter requirement: "Although the price-fixing conspiracy at Horizon was long-lasting and affected a substantial portion of Horizon's business, the facts pled here are a far cry from those in Bridgestone or in the Seventh Circuit's hypothetical, and we need not decide whether we agree with either approach. Even if, however, it were possible to plead scienter against a corporation without pleading scienter against an individual, the facts alleged here would not survive a motion to dismiss." Id., at 676-77.
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