Commercial Litigation and Arbitration

Securities — Corporate Scienter — Must Misrepresentation Be Made by Someone Harboring Scienter, Or May Someone Else Have It? If the Latter, How High in the Hierarchy Must the Speaker Be? Circuit Split — New Sixth Circuit Standard

In re Omnicare, Inc. Secs. Litig., 2014 U.S. App. LEXIS 19326 (6th Cir. Oct. 10, 2014):

B. Element Two: Scienter

To satisfy Element Two, plaintiffs must plead facts showing that defendants had a "'mental state embracing intent to deceive, manipulate or defraud.'" In re Comshare, 183 F.3d at 548 (quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 (1976)). In the past, we have read this language to require plaintiffs to allege facts showing that defendants acted with at least recklessness. Helwig v. Vencor, Inc., 251 F.3d 540, 550 (6th Cir. 2001) (en banc). However, when plaintiffs accuse defendants of misrepresenting or omitting soft information, as KBC does in this case, plaintiffs must plead facts showing that the defendants knowingly misrepresented or omitted facts to deceive, manipulate, or defraud the public. Omnicare II, 719 F.3d at 505; Omnicare I, 583 F.3d at 945-46.

In run-of-the-mill fraud cases, KBC could allege this mental state "generally," Rule 9(b), but in securities-fraud actions, Congress has imposed a higher standard, requiring plaintiffs to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind," 15 U.S.C. § 78u-4(b)(2). Interpreting this language, the Supreme Court has created a three-part test for lower courts to apply in assessing the sufficiency of a plaintiff's scienter allegations. See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322-23 (2007). First, a court must "accept all factual allegations in the complaint as [*35]  true." Id. at 322. Second, a court "must consider the complaint in its entirety" and decide "whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard." Id. at 322-23. Third, assuming that plaintiff's allegations create a "powerful or cogent" inference of scienter, id. at 323, a court must compare this inference with other competing possibilities, allowing the complaint to go forward "only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged," id. at 324. See also Frank v. Dana Corp., 547 F.3d 564, 570-71 (6th Cir. 2008) (adopting this approach).

When the defendant is an individual, we examine the facts and apply this test in a rather straightforward manner, considering factors such as whether there was:

(1) insider trading at a suspicious time or in an unusual amount; (2) divergence between internal reports and external statements on the same subject; (3) closeness in time of an allegedly fraudulent statement or omission and the later disclosure of inconsistent information; (4) evidence of bribery [*36]  by a top company official; (5) existence of an ancillary lawsuit charging fraud by a company and the company's quick settlement of that suit; (6) disregard of the most current factual information before making statements; (7) disclosure of accounting information in such a way that its negative implications could only be understood by someone with a high degree of sophistication; (8) the personal interest of certain directors in not informing disinterested directors of an impending sale of stock; and (9) the self-interested motivation of defendants in the form of saving their salaries or jobs.

Helwig, 251 F.3d at 552. The more of these factors that are present, the stronger the inference that the defendant made his statement with the requisite state of mind.

This analysis can become much more complicated when the defendant is a corporation because there is the additional question of whose knowledge and state of mind matters. For liability to attach to the corporation, must the person misrepresenting a material fact in the name of the corporation have also done so with scienter, or is it enough that some person in the corporate structure had the requisite state of mind? If the latter conception is correct, how [*37]  high in the hierarchy of the corporation must the person with scienter be, and what must his relationship be to the statement? Our sister circuits have answered these questions differently; scholars disagree; and we have been less than precise in our prior pronouncements. Therefore, we try once more to survey the terrain and explain where we stand on the doctrine of collective corporate scienter.

1. The Lay of the Land

In 2004, the Fifth and Eleventh Circuits adopted a narrow view in keeping with common-law-fraud principles, allowing scienter to be imputed to the corporation only under a theory of respondeat superior. These circuits "look to the state of mind of the individual corporate official or officials who make or issue the statement (or order or approve it or its making or issuance, or who furnish information or language for inclusion therein, or the like) rather than generally to the collective knowledge of all of the corporation's officers and employees acquired in the course of their employment." Southland Sec. Corp. v. Inspire Ins. Solutions, Inc., 365 F.3d 353, 366 (5th Cir. 2004); see also Phillips v. Scientific-Atlanta, Inc., 374 F.3d 1015, 1018-19 (11th Cir. 2004) (implicitly adopting this approach). For support, these circuits cite general common-law fraud principles and cases [*38]  from other circuits noting that "'there is no case law [as of 2004] supporting an independent collective scienter theory.'" Southland, 365 F.3d at 366 (quoting Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424, 1435 (9th Cir. 1995)).

A year later, a panel of this court took a very different approach, allowing the knowledge of a corporate officer to be imputed to the corporation even though that officer did not issue the false or misleading statement. See City of Monroe, 399 F.3d at 688-90. In that case, the plaintiffs alleged that the corporation made several material misrepresentations in its annual report, and we held that these statements were actionable. Id. at 680-81. Plaintiffs also alleged that the CEO had actual knowledge that these statements were false or misleading, and we held that this knowledge could be attributed to the corporation, even though the complaint failed to link the CEO to the issuance of the statements. Id. at 688-89. As a result, we decided that the plaintiffs' suit could go forward against the corporation, our having concluded that plaintiffs adequately pleaded Element One and Element Two. Id. at 689. Importantly, because the plaintiffs did not claim that the CEO issued the misrepresentations, we dismissed the suit against the CEO in his personal capacity. Id. at 690. In adopting this more expansive view of collective corporate [*39]  scienter, we cited a securities-regulation treatise and analogized from a Tenth Circuit case. See id. at 688 (citing 2 Thomas Lee Hazen, Treatise on the Law of Securities Regulation § 12.8[4], at 444 (4th ed. 2002); Adams v. Kinder-Morgan, Inc., 340 F.3d 1083, 1106 (10th Cir. 2003)).

Several years later, the Second, Seventh, and Ninth Circuits weighed in, though none of these circuits sided fully with either camp in this circuit split. The Seventh Circuit recognized that "it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud." Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702, 710 (7th Cir. 2008). The court reasoned: "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." Id. In this case, however, it was unnecessary to rely upon an expansive view of collective corporate scienter because the court held that the plaintiffs adequately pleaded that the CEO knowingly misrepresented [*40]  material facts with the intent to defraud and that his individual liability could be imputed to the corporation. Id. at 711.

Somewhat similarly, the Second Circuit agreed that plaintiffs could plead collective corporate scienter, at least in some cases, and overcome the PSLRA's requirements. The court stated: "we do not believe that [Congress] imposed the rule . . . that in no case can corporate scienter be pleaded in the absence of successfully pleading scienter as to an expressly named officer." Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190, 196 (2d Cir. 2008). That said, the court concluded that the plaintiffs "fail[ed] to allege the existence of information that would demonstrate that the statements made to investors were misleading" and, thus, that the plaintiffs failed to state a valid claim. Id. at 197.

Finally, the Ninth Circuit added to this middle position, stating that it "had at that time [2002] not categorically rejected the concept of 'collective scienter'" and that "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." Glazer Capital Mgmt., LP v. Magistri, 549 F.3d 736, 744 (9th Cir. 2008) (citing Makor Issues, 513 F.3d at 710). Importantly, the Ninth Circuit pared back [*41]  Nordstrom, which the Fifth Circuit had relied upon, writing that "Nordstrom does not foreclose the possibility that, in certain circumstances, some form of collective scienter pleading might be appropriate." Id. The court nevertheless concluded that Glazer Capital was not such a case and required the plaintiff "to plead scienter with respect to those individuals who actually made the false statements . . . ." Id. at 745. Surprisingly, none of the 2008 decisions cited or discussed City of Monroe.

2. Merits of the Approaches

Since Southland and City of Monroe were decided, courts and commentators have debated the merits of the two approaches. Most agree that neither — when taken to the extreme — is ideal, though there is no consensus about how to calibrate the middle ground. Slanting too far toward the Fifth Circuit's approach risks running counter to the goals and purposes of the 1934 Act-which include fostering "an attitude of full disclosure by publicly traded corporations, rather than a philosophy of caveat emptor for securities buyers." Heather F. Crow, Riding the Fence on Collective Scienter: Allowing Plaintiffs to Clear the PSLRA Pleading [*42]  Hurdle, 71 La. L. Rev. 313, 317 (2010) (citing SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963)). For instance, "in situations where a corporate policy, procedure, or sub rosa encouragement of illegal or tortious behavior results in the commission of an offense, but there is no single identifiable culpable actor, [the Fifth Circuit's approach] would not place the requisite culpability on the corporation." Patricia S. Abril & Ann Morales Olazábal, The Locus of Corporate Scienter, 2006 Colum. Bus. L. Rev. 81, 113-14 (2006);see also Craig L. Griffin, Note, Corporate Scienter Under the Securities Exchange Act of 1934, 1989 BYU L. Rev. 1227, 1244 ("A requirement that corporate liability may lie only where all culpable knowledge exists in a single individual would allow a corporation to engage freely in conscious ignorance by keeping lines of communication between different departments closed.").

In contrast, reading our decision in City of Monroe too broadly could expose corporations to liability far beyond what Congress has authorized. In that case, we stated that "'knowledge of a corporate officer or agent acting within the scope of [his] authority is attributable to the corporation.'" City of Monroe, 399 F.3d at 688 (quoting 2 Thomas Lee Hazen, Treatise on the Law of Securities Regulation § 12.8[4], at 444 (4th ed. 2002)) (alteration in original; emphasis added). If the [*43]  scienter of any agent can be imputed to the corporation, then it is possible that a company could be liable for a statement made regarding a product so long as a low-level employee, perhaps in another country, knew something to the contrary. See Kevin O'Riordan, Note, Clear Support or Cause for Suspicion? A Critique of Collective Scienter in Securities Litigation, 91 Minn. L. Rev. 1596, 1613-14 (2007) (citing cases). Such a result runs contrary to the PSLRA, which increased the scienter pleading requirements to prevent strike suits. Id. at 1614.

3. Our Standard

Given that neither approach is ideal, a middle ground is necessary. In addition, our prior decision in City of Monroe, if read in an overly broad manner, potentially supports a theory of scienter at odds with the PSLRA. Therefore, going forward, we adopt the following formulation of the rule:

The state(s) of mind of any of the following are probative for purposes of determining whether a misrepresentation made by a corporation was made by it with the requisite scienter under Section 10(b): . . .

a. The individual agent who uttered or issued the misrepresentation;

b. Any individual agent who authorized, requested, commanded, furnished information [*44]  for, prepared (including suggesting or contributing language for inclusion therein or omission therefrom), reviewed, or approved the statement in which the misrepresentation was made before its utterance or issuance;

c. Any high managerial agent or member of the board of directors who ratified, recklessly disregarded, or tolerated the misrepresentation after its utterance or issuance . . . .

Abril & Olazábal, Locus, supra, at 135 (emphasis deleted).2 We think that this clarification of the rule not only remains true to our prior statements, but also goes a long way toward solving the flaws of the two approaches discussed above.

2      Abril and Olazábal append another prong to this test-the corporation itself. See Abril & Olazábal, Locus, supra, at 135. At this point, we see no need to expand our rule to include this highly theoretical portion of their test.

First, this rule is consistent with our prior pronouncement in City of Monroe, though it qualifies some of that opinion's overly broad language. We recognize that "'[a] panel of this Court cannot overrule the decision of another panel. The prior decision remains controlling authority unless an inconsistent decision of the United States Supreme Court requires modification of the decision or this Court sitting en banc overrules the prior decision.'" Darrah v. City of Oak Park, 255 F.3d 301, 309 (6th Cir. 2001) (quoting Salmi v. Sec'y of Health & Human Servs., 774 F.2d 685, 689 (6th Cir. 1985)). Admittedly, some of the language in City of Monroe suggests that the knowledge of any agent of the company could be imputed to the corporation, but that case turned on the CEO's knowledge, a person included in Part C of our rule. See City of Monroe, 399 F.3d at 688. The broader language of the opinion is not necessary to arrive at that panel's conclusion and is, thus, dicta. See United States v. Wells, 473 F.3d 640, 647-48 n.5 (6th Cir. 2007) (rephrasing a prior panel's statement when it used overly broad language to decide a narrower point). Moreover, the result of that case would not change under our clarification of the standard. The CEO's knowledge, after all, would be imputed to the corporation under our formulation of the standard. Therefore, under these conditions, our precedents and procedures justify our formulation of this circuit's collective-scienter standard.

Second, this formulation of the rule largely prevents corporations from evading liability through tacit encouragement and willful ignorance, as they potentially could under a strict respondeat superior approach. Under our formulation of the rule, a corporation is not insulated if lower-level employees, contributing [*46]  to the misstatement, knowingly provide false information to their superiors with the intent to defraud the public. As a result, corporations that willfully permit or encourage the shielding of bad news from management will potentially be liable. And therefore, the ultimate purpose of the 1934 Act will be served.

Third, our formulation protects corporations from liability-or strike suits-when one individual unknowingly makes a false statement that another individual, unrelated to the preparation or issuance of the statement, knew to be false or misleading. By allowing courts to examine only the states of mind of lower-level employees connected to the statements, our formulation prevents plaintiffs from abusing the broad dicta in City of Monroe and running afoul of the PSLRA.


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