From time to time, D&O Developments will take a closer look at an important issue decided in an appellate opinion.  In this post, I analyze In re ChinaCast Education Corp. Securities Litigation, 809 F.3d 471 (9th Cir. 2015), in which the Ninth Circuit reversed the dismissal of a securities class action against ChinaCast Education Corporation, a for-profit e-learning provider in China.  ChinaCast’s founder and CEO, Ron Chan, had bilked the company out of millions and, due to his failure to disclose the underlying fraud, made false and misleading statements in conference calls, press releases, and SEC filings.  Even though Chan’s conduct was contrary to ChinaCast’s interests, the court ruled that his fraudulent intent could be imputed to the company because he acted with apparent authority on the company’s behalf.

At first blush, the Ninth Circuit’s holding seems fair: why shouldn’t the company be liable for the false statements of its CEO?  Yet the holding reads the scienter element out of Section 10(b), and thus expands the scope of liability under that section, contrary to the Supreme Court’s direction that its implied right of action be narrowly construed.  The Ninth Circuit compounded its legal error with an incomplete analysis of public policy considerations.  Holding a defrauded corporation liable for the fraud committed against it by its officers simply re-victimizes the corporation, and rewards class-period purchasers of stock at the expense of current shareholders.

Factual and Procedural Background

At least on appeal, the parties didn’t dispute the details of the fraud.  ChinaCast was a successful, promising business.  But its March 2011 10-K filing disclosed that the company’s outside auditor, a Deloitte affiliate, had identified “serious internal control weaknesses” with respect to ChinaCast’s financial oversight.  Within a few months of that report, Chan began the process of sending some $120 million in company money to outside accounts that he or close associates controlled.  He also used millions of dollars of ChinaCast money to secure loans that had nothing to do with the business, and engaged in other unauthorized and illegal transfers of company assets to third parties.

All the while, Chan made statements about the company’s success and financial security in press releases and on investor calls, and signed SEC disclosures that didn’t mention his looting.  Though the board of directors uncovered Chan’s actions in spring 2012, removed him as CEO, and publicly disclosed that he and other senior officers had engaged in illegal conduct, the damage was done. Chan’s actions ruined the company financially.

Purchasers of ChinaCast stock sued Chan, ChinaCast, its Chief Financial Officer, and the company’s independent directors in the Central District of California in September 2012.  The district court dismissed the complaint with prejudice as to ChinaCast and the independent directors, holding that the complaint had not adequately alleged scienter.  Specifically, the district court reasoned that Chan’s rogue conduct could not be held against the company or its directors because he acted only in his own self-interest and there was nothing to suggest the company benefitted from his actions—what the law of agency calls the “adverse interest exception” to the general principle of holding companies responsible for their agents’ actions.  Id. at 474.  (Chan and the CFO had not been served and were not the subject of the motion to dismiss ruling.)

The Ninth Circuit’s Ruling

The Ninth Circuit reversed, holding that common law agency principles permitted ChinaCast to be held accountable for Chan’s fraud.  The panel explained that ordinarily, actions within the scope of an officer’s apparent authority are imputed to the company.  While there is an adverse interest exception to this principle, the exception itself has an exception, which the district court failed to recognize: an agent’s rogue conduct is imputed to the principal (the company) to protect innocent third parties who dealt with the principal in good faith.  When ChinaCast permitted Chan to speak on investor calls and through the press, the company gave him its stamp of approval.  Innocent shareholders understandably relied on those statements, and protecting their interests requires that Chan’s conduct be imputed to the company.  In this case, the company and board did nothing to beef up their oversight processes despite Deloitte’s warning about serious internal risks, and failed to adequately monitor Chan, who, as CEO, should have been subject to careful scrutiny.

The panel relied on a 2013 decision of the Third Circuit, which had rejected a corporate defendant’s adverse interest argument, and allowed a complaint to go forward where the company’s Ponzi-scheming employee acted within the scope of his apparent authority.  Id. at 477 (citing Belmont v. MB Inv. Partners, Inc., 708 F.3d 470, 496 (3d Cir. 2013)).

The opinion closed by acknowledging the consequences of its reasoning:

Assuming a well-pled complaint, we recognize that, as a practical matter, having a clean hands plaintiff eliminates the adverse interest exception in fraud on the market suits because a bona fide plaintiff will always be an innocent third party.

Id. at 479.  But the panel further concluded that this result is consistent with the securities laws’ purposes of protecting investors and promoting confidence in securities markets.  Id.

The ChinaCast Holding Is Inconsistent with Section 10(b)

Resort to agency law for guidance on federal securities law questions can be appropriate, if it doesn’t conflict with the underlying securities law.  But the Ninth Circuit’s agency-law analysis, even if correct, reads the scienter element out of Section 10(b).  Under the types of facts present in ChinaCast, the company can only disclose the underlying fraud through those who know about it.  But when the looter himself is the only one who knows about the fraud, the company is incapable of disclosing it—the looter has essentially gagged the company.  In such a situation, to say that the company “knew,” by imputing the looter’s state of mind to the company, is a dangerous fiction:  a company can’t defraud purchasers of its stock by omitting information of which it had no knowledge or ability to disclose other than through the looter.  Moreover, the company doesn’t benefit from being defrauded.  To the contrary, it is not only directly harmed by the theft, but may also develop legal liabilities due to the looting, and its interest is in preventing further looting and pursuing remedies against the wrongdoer to address those legal liabilities.

In making this error, the Ninth Circuit relied on “the public policy goals of both securities and agency law—namely, fair risk allocation and ensuring close and careful oversight of high-ranking corporate officials to deter securities fraud,” as a basis for refusing to apply the adverse interest exception.  ChinaCast, 809 F.3d at 478-79.  But expanding Section 10(b) liability on such grounds is not allowed.  The Supreme Court has consistently warned against expanding the scope of Section 10(b)’s implied private right of action without a clear statement from Congress.  See, e.g., Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2301-02 (2011); Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148, 165 (2008).  This principle is especially relevant in the context of corporate scienter.  Under Section 10(b), liability is foreclosed absent scienter, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976), and of course, scienter is required as to each defendant, including the company.

In contrast to Section 10(b), Congress has explicitly lowered the burden for plaintiffs in other provisions of the securities laws.  For example, Section 11 claims impose strict liability on issuers for misstatements in a registration statement.  See Ernst & Ernst, 425 U.S. at 200 (contrasting Section 10(b) to other liability provisions in the securities laws, including Section 11).  Congress designed Section 11’s lower burden “to assure compliance with the disclosure provisions of the Act by imposing a stringent standard of liability on the parties who play a direct role in a registered offering.”  Herman & MacLean v. Huddleston, 459 U.S. 375, 381-82 (1983).  Thus, where Congress intends to allocate risk among market participants, it does so explicitly, and there has been no similar allocation in the Section 10(b) context.

Moreover, the Ninth Circuit incorrectly calibrated its fairness analysis.  If an executive loots the company in secret and then prevents it from fulfilling its obligations under the securities laws to make accurate public disclosures, imposing liability on the company would further harm and thus re-victimize the company and its shareholders.  Indeed, holding the company liable rewards only class-period purchasers of stock, who may or may not be current shareholders, at the expense of the company and its current shareholders.

It is important for courts to remain faithful to the structure of the securities laws in cases that present facts similar to ChinaCast.  Although such cases are thankfully rare, they are cases in which there are many victims of the fraud—including the corporation itself, as well as innocent officers and directors.

In Doshi v. Gen’l Cable Corp., ___ F.3d ___, 2016 WL 2991006 (6th Cir. May 24, 2016), the Sixth Circuit affirmed a district court order dismissing a securities fraud class action against a company and two of its executives, on the grounds that the complaint failed to plead facts sufficient to create a strong inference of scienter on the part of either the company or the individual defendants. In its holding, the Sixth Circuit refused to impute the state of mind of a senior non-defendant executive to the company for the purposes of scienter, because that executive had not made any false or misleading public statements.

Plaintiff alleged that General Cable and its CEO and CFO had violated Sections 10(b) and 20(a) of the Exchange Act, as well as Rule 10b-5, by acting at least recklessly in issuing or approving materially false public financial statements. Defendants countered that the misstatements were a product of accounting errors and theft in General Cable’s Brazilian operations, and that they had promptly remediated these problems upon learning of them. The district court granted defendants’ motion to dismiss, on the grounds that plaintiff had failed to plead scienter, and denied plaintiff’s request to file an amended complaint as futile.

In evaluating the district court’s rulings, the Sixth Circuit emphasized the standards set forth in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), which requires that allegations of scienter be assessed “holistically,” and that courts weigh the strength of scienter allegations against “plausible opposing inferences” of innocent conduct. Doshi, 2016 WL 991006 at *4 (quoting Tellabs, 551 U.S. at 323, 326). In performing the Tellabs holistic review, the Sixth Circuit examined the nine factors listed in its decision in Helwig v. Vencor, Inc., 251 F.3d 540, 552 (6th Cir. 2001) (en banc). These factors, which are not exhaustive, include the following:

(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 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.

Doshi, 2016 WL 2991006 at *4 (citing Helwig, 251 F.3d at 552).

Plaintiff’s scienter arguments as to General Cable turned in large part on the conduct of a non-defendant executive named Mathias Sandoval, who headed the “Rest of World” (“ROW”) division that included the company’s operations in Brazil. While the Sixth Circuit accepted plaintiff’s theory that Sandoval’s knowledge of the theft and accounting errors in Brazil could be imputed to General Cable, it cited its decision in Omnicare in refusing to impute Sandoval’s scienter to General Cable, because plaintiff had not alleged that Sandoval had drafted, reviewed, or approved General Cable’s erroneous public statements—in other words, that Sandoval had “made” a statement. Doshi, 2016 WL 2991006 at *5 (citing In re Omnicare, Inc. Sec. Litig., 769 F.3d 455, 476, 481 (6th Cir. 2014)). The court then concluded that seven out of the nine Helwig factors weighed against an inference of scienter on the part of the company. Although “one could infer that General Cable acted recklessly by issuing its public financial statements,” the court concluded, the facts alleged in plaintiff’s complaint established a stronger countervailing inference that the materially false statements were a product of theft and errors by local managers in Brazil and the legitimate freedom accorded to ROW to report financial data. Id. at *7.

Having concluded that plaintiff’s complaint failed to create a strong inference that General Cable acted with scienter, the Sixth Circuit turned to the two individual executive defendants. Although the court allowed that a holistic review of the facts lent “some support to an inference that [the executive defendants] consciously disregarded the obvious risks that each issued or authorized false public financial statements,” it once again concluded based on the Helwig factors that there was no strong inference of scienter, and that at most the alleged facts supported an inference that the two executives had been negligent in issuing or authorizing false statements. Id.

In considering plaintiff’s request to file an amended complaint, the Sixth Circuit evaluated plaintiff’s new proffered allegations, which included, inter alia, assertions that General Cable had disclosed FCPA violations in foreign countries that were not Brazil, and that the executive defendants could have lost previously-issued incentive compensation by disclosing the misstatements. The Sixth Circuit held that the district court had correctly decided that these proposed amendments would have been futile, given that the FCPA violations were unrelated to the theft and errors in Brazil, and the new incentive compensation allegations were too general to support a strong inference of scienter.

The Second Circuit has issued another confirmation of the high bar for imposing liability on external auditors under the securities laws, and of the importance of the protections created for opinions by the Supreme Court in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015). The unpublished decision, Querub v. Moore Stephens Hong Kong, __ Fed. App’x __, 2016 WL 2942415 (2d Cir. May 20, 2016), affirmed the dismissal at summary judgment of a securities claim against a Hong Kong auditor that issued “clean opinions” for the financial statements of a China-based coal supplier.

Puda, a China-based, U.S.-listed company, owned a 90% stake in Shanxi—a company that supplied coal for steel manufacturing. Id. at *1. But in 2009, Puda’s chairman transferred ownership of Shanxi to himself. Id. While shareholder meeting minutes and some filings with Chinese regulatory authorities reflected the transfer, Puda’s 2009 and 2010 financial statements included Shanxi’s assets and revenues. Id. A Hong Kong auditor—Moore Stephens—issued clean opinions for Puda’s 2009 and 2010 financial statements under Public Company Accounting Oversight Board (“PCAOB”) standards. After learning of the Shanxi transfer in 2011, Moore Stephens resigned as Puda’s auditor and stated that its opinions on the 2009 and 2010 statements could no longer be relied upon. Id.

In assessing the securities claims brought by investors against Moore Stephens, the Second Circuit examined three issues. First, the court held that the district court had appropriately struck the plaintiffs’ expert witness: the witness lacked expertise or experience in PCAOB accounting standards—the auditing standard at issue—and so was not qualified as an expert. Id. at *2. Second, the court ruled that the plaintiffs could not establish that Moore Stephens had acted with sufficient recklessness to support liability. Id. at *3. Even if expert testimony on the PCAOB standards were not required, the “red flags” that plaintiffs claimed showed recklessness showed only “fraud by hindsight.” Id. Finally, the court explained that “[a]udit reports, labeled ‘opinions’ and involving considerable subjective judgment, are statements of opinion subject to the Omnicare standard . . . .” Because there was no evidence that Moore Stephens either didn’t believe its “clean audit opinions” or that it omitted material facts about those opinions, the court ruled that plaintiffs’ claims could not survive. Id.

On April 12, 2016, the Eighth Circuit became the first court of appeals to interpret and apply Halliburton Co. v. Erica P. John Fund, Inc., 134 S.Ct. 2398 (2014) (“Halliburton II”), in which the Supreme Court held that direct and indirect evidence of a lack of price impact may be presented by Rule 10b-5 defendants at the class certification stage to rebut the “fraud-on-the-market” presumption established by Basic v. Levinson, 485 U.S. 224, 241–47 (1988).

In IBEW Local 98 Pension Fund, et al. v. Best Buy Co., Inc., et al., 818 F.3d 775 (8th Cir. 2016), the majority of a divided three-judge panel held that a district court had abused its discretion in certifying a class under Rule 23, where the defendants had provided “overwhelming evidence” that statements challenged by the plaintiffs had not affected the price of Best Buy’s common stock.

Legal Background: Basic and Halliburton II

Until 1988, when the Supreme Court decided Basic, Rule 23’s commonality requirement was a major impediment to certification in securities cases, because the reliance element of a Rule 10b-5 claim often implicated facts specific to individual investors. Basic transformed the landscape of securities litigation by allowing entire classes of investors to invoke a “fraud-on-the-market” presumption of reliance, eliminating the need for each investor to demonstrate actual reliance. The Basic presumption is based on the theory that because the price of any stock traded on an efficient market reflects all public information, anyone who purchases such a stock when its price has been inflated by a material misrepresentation can be presumed to have relied upon that misrepresentation. 485 U.S. at 246–47.

In Halliburton II, the Supreme Court was given an opportunity to overrule or modify Basic but declined to do so, emphasizing instead that the “fraud on the market” presumption is rebuttable, and holding that “defendants must be afforded an opportunity before class certification to defeat the presumption through evidence that an alleged misrepresentation did not actually affect the market price of the stock”—a chance to show, in other words, that there was no “price impact.” 134 S.Ct. at 2416-17.

Factual Background and the District Court’s Decision

In Best Buy, plaintiffs alleged that the company and three of its executives made false or misleading statements in a press release issued at 8:00 a.m. on September 14, 2010, and an analyst conference call held at 10:00 a.m. the same day. Specifically, plaintiffs initially challenged three statements: one from the 8:00 a.m. press release increasing Best Buy’s earnings-per-share (EPS) guidance for FY 2011, and two from the 10:00 a.m. conference call, that “we are on track to deliver and exceed our annual EPS guidance” and “our earnings are essentially in line with our original expectations for the year.” Best Buy, 818 F.3d at 777-78. The district court allowed the plaintiffs to proceed based on the latter two statements, but dismissed their claim as to the press release statement, holding that increasing the EPS guidance was a forward-looking statement protected by the Safe Harbor provision of the Reform Act. Id. at 778.

With the press release statement out of the case, plaintiffs moved for class certification, relying on Basic’s fraud-on-the-market presumption to satisfy the commonality requirement. The district court stayed the plaintiffs’ motion pending the outcome of Halliburton II, then granted the motion, certifying a class of all Best Buy purchasers between the 10:00 a.m. conference call on September 14 and the release of the “corrective” earnings report three months later. Id. at 777. In doing so, the district court held that defendants had failed to rebut the Basic presumption, because while they had shown that the price of the stock did not increase after the conference call, they failed to show that the conference call statements did not artificially maintain the stock’s price. Id. at 782.

The Eighth Circuit’s Opinion

On interlocutory appeal, the Eighth Circuit focused on whether the district court had properly evaluated the price impact evidence offered by the defendants to rebut the Basic presumption—and in particular, whether the district court was correct to conclude that plaintiffs could continue to rely on the presumption even though defendants had shown that there was no “front-end” price impact immediately following the conference call.

An expert offered by plaintiffs before the district court had opined that although the forward-looking EPS guidance in the 8:00 a.m. press release led to an immediate increase in the stock price, the challenged statements in the conference call two hours later had no additional price impact. This expert also concluded that the “economic substance” of the EPS guidance in the press release was “virtually the same” that of the alleged misstatements in the conference call, and that investors gave the EPS guidance “great weight.” A defense expert agreed. Id.

In the Eighth Circuit’s majority opinion, Judge Loken held that this expert testimony constituted “overwhelming evidence of no ‘front-end’ price impact.” Id. at 782. Although the price of Best Buy stock did decline following the December 14 “corrective” earnings report, which the plaintiffs cited as evidence to support their price maintenance theory, plaintiffs’ own expert’s opinion showed that “the allegedly ‘inflated price’ was established by the non-fraudulent press release,” thereby severing “[any] link between the alleged conference call misrepresentations and the stock price at which plaintiffs purchased.” Id. at 782-83. In the absence of any additional evidence of price impact, Judge Loken concluded, the plaintiffs had failed to satisfy Rule 23, and the district court had abused its discretion in certifying the class. Id. at 783.

Judge Murphy, writing in dissent, argued that the majority had “ignore[d]” plaintiffs’ price maintenance theory, which supported an unrebutted fraud-on-the-market presumption of reliance sufficient to support class certification. Where plaintiffs rely on such a theory, she wrote, the defendant must rebut the Basic presumption “by providing evidence showing that the alleged misrepresentations had not counteracted a price decline that would otherwise have occurred”—and yet the Best Buy defendants had offered no such evidence. Id. at 784.

Judge Murphy also noted that the Seventh and Eleventh Circuits have recognized claims based on an allegation that false statements averted the decline of an artificially-inflated stock price. Id. at *8 (citing FindWhat Inv’r Grp. v., 658 F.3d 1282, 1313-15 (11th Cir. 2011) and Schleicher v. Wendt, 618 F.3d 679, 683-84 (7th Cir. 2010)).

Although it is not clear that the Best Buy majority sought to foreclose price maintenance arguments as a general matter, the court’s rejection of plaintiffs’ theory does at least raise the possibility of a circuit split regarding their viability.

In another entry in the large field of securities fraud suits involving Chinese companies traded on U.S. exchanges, the Second Circuit affirmed in an unpublished memorandum the dismissal of investors’ claims against an auditor for failing to detect and disclose that a company’s CEO was pilfering the company’s coffers for personal gain.

In Special Situations Fund III QP, L.P. v. Deloitte Touche Tohmatsu CPA, Ltd., __ Fed. App’x __, 2016 WL 1392280, at *1 (2d Cir. Apr. 8, 2016), a group of investors sought relief after ChinaCast, the company in which they had invested, disclosed that its CEO and other executives had engaged in fraud by embezzling funds. The suit accused Deloitte, ChinaCast’s independent auditor, of several violations, including a claim under Section 10(b) of the Exchange Act for giving ChinaCast a clean bill of health in audit opinions from 2007 to 2010 in connection with Deloitte’s review of ChinaCast’s SEC filings, and a claim under Section 18 of the Exchange Act for Deloitte’s filing its allegedly misleading audit opinions with the SEC. Id. The Second Circuit concluded that the Section 10(b) claim did not adequately allege Deloitte’s scienter, and—applying the Supreme Court’s landmark decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015)—that the plaintiffs did not adequately allege that Deloitte’s opinions were false or misleading.

The court held that to satisfy the scienter requirement for a non-fiduciary accountant like Deloitte, the plaintiffs had to allege facts showing “such recklessness [as to be] an extreme departure from the standards of ordinary care” and in fact come close to “an actual intent to aid in the fraud being perpetrated by the company.” Id. (quoting Rothman v. Gregor, 220 F.3d 81, 98 (2d Cir. 2000)). Applying this high standard, the court ruled that the alleged “red flags” Deloitte recklessly disregarded were inadequate to show scienter. These red flags included large transactions and assets on ChinaCast’s books that the plaintiffs contended Deloitte would have discovered with a more thorough audit, and certain transactions between ChinaCast subsidiaries and third parties that the plaintiffs alleged were suspicious. Id. at *2. But the court decided that these records were red flags only in hindsight, because there was no allegation that Deloitte was required to perform the investigation that the plaintiffs claim would have revealed the suspicious transactions, and the records that Deloitte had access to at the time of its audits suggested that the subsidiary transactions were not unusual. Id.

Deloitte’s audit opinions were also protected under Omnicare. The plaintiffs did not allege facts that would show either that Deloitte held a subjective belief inconsistent with the opinions, or else that any of the challenged statements of opinion omitted “material facts about the issuer’s inquiry into or knowledge concerning [the] statement of opinion . . . [which would] conflict with what a reasonable investor would take from the statement [of opinion] itself.” Id. at *3 (quoting Omnicare, 135 S. Ct. at 1329) (first alteration added). The court also affirmed the dismissal of other claims based on the underlying Section 10(b) and Section 18 claims. Id.

On March 19, 2016, the Second Circuit revived securities fraud claims brought by investors against SAIC, Inc., and individual defendants, alleging material misstatements and omissions in SAIC’s public filings related to its exposure to liability for employee fraud. Though a win for the plaintiffs in this particular case, the ruling provided useful ammunition for the defense bar in future cases, because the Second Circuit found that in order to bring a Section 10(b) action for failure to disclose “known trends and uncertainties” that may materially affect a company’s financial position under SEC Regulation S-K, Item 303, plaintiffs must allege the company’s “actual knowledge” of these trends or uncertainties—not merely that they “should have known” of them.

In Indiana Public Retirement System v. SAIC, Inc., 818 F.3d 85, 88–89 (2d Cir. 2016), plaintiffs brought putative class claims against SAIC, which provides defense, intelligence, logistics, and other services mainly to government agencies. According to the plaintiffs’ proposed amended complaint, in 2000 SAIC became the main contractor on a New York City project to develop and implement a timekeeping program—CityTime—for City employees. Id. at 89. Two years into the project, a deputy program manager at SAIC, along with a SAIC engineer, participated in an elaborate kickback scheme with a company called Technodyne, which involved the two SAIC employees receiving payments for each hour a Technodyne consultant or subcontractor worked on the CityTime project. Id. Due to the kickback scheme, as well as an amendment to SAIC’s contract with the City that made the City responsible for the risk of any cost overruns, SAIC billed the City over $600 million—ten times the City’s initial budget for the project. Id. By late 2010, SAIC had placed the employee heading the project—and participating in the kickback scheme—on leave, and hired an outside law firm to conduct an internal investigation of the possible fraud. Meanwhile, City officials announced that they were reevaluating SAIC’s role in CityTime and considering whether to seek recovery of the City’s payments to SAIC. Id. In early March 2011, the internal investigation reported the improper timekeeping practices to the company. Id.

Despite this report, SAIC did not disclose any potential liability related to the CityTime project in its March 2011 Form 10-K. It was not until June 2011, after a criminal investigation had been launched against the SAIC employee and the City had indicated its intent to pursue recovery, that SAIC begin to disclose the potential risk in a series of SEC filings and press releases. Id. at 89–90.

Plaintiffs alleged, among other things, that SAIC’s March and June 2011 SEC filings had failed to disclose SAIC’s potential liability related to the CityTime project or known trends or uncertainties associated with the fraud, even though SAIC was required to do so under Financial Accounting Standard No. 5 (“FAS 5”) and Item 303. Id. at 91. In several orders, the Southern District of New York dismissed the plaintiffs’ claims, ultimately denying them leave to file a proposed amended complaint dealing only with the FAS 5 and Item 303 claims related to SAIC’s March 2011 (and later) SEC filings. Id. at *91–92. On appeal, the Second Circuit considered SAIC’s alleged failure to comply with FAS 5 by not disclosing appropriate loss contingencies related to CityTime and its alleged failure to comply with Item 303 by not disclosing a known trend or uncertainly reasonably expected to have a material financial impact, as well allegations that SAIC had made misleading statements related to its commitment to integrity in a 2011 report to shareholders, and whether or not it had acted with scienter. Id. at 88.

The court reasoned that because before the March 2011 filing SAIC had received the report of its internal investigation, received a grand jury subpoena for the production of documents related to CityTime, agreed to pay its employees’ legal fees associated with criminal proceedings, and was aware that the City was reevaluating SAIC’s role in CityTime, the proposed complaint “adequately alleged that SAIC violated FAS 5 by failing to disclose a loss contingency in its March 2011 [filing] arising from the City’s manifest awareness of a possible material claim against SAIC.” Id. at 93–94.

Before Indiana Public Retirement, the Second Circuit had “never directly addressed whether Item 303 requires that a company actually know or merely should have known of the relevant trend, event, or uncertainty in order to be liable for failing to disclose it.” Id. at 95. The court reasoned that the plain language of Item 303 requires the registrant’s “actual knowledge of the relevant trend or uncertainty.” Id. The court further held that the SEC’s interpretation of Item 303, which advises that trends or uncertainties must be “presently known to management,” bolstered the plain language reading. Id. Here, the proposed amended complaint supported a strong inference that SAIC actually knew about the CityTime fraud and its potential liability before the March 2011 SEC filing, and that the claim could therefore survive. Id. at 95–96.

The court ruled that the proposed amended pleading similarly alleged sufficient facts to show scienter: “the allegations support the inference that SAIC acted with at least a reckless disregard of a known or obvious duty to disclose” when it omitted the information about the CityTime fraud from its March 2011 filings. Id. at 96. The court affirmed, however, the district court’s dismissal of plaintiffs’ other claims. Id. at 97–98.

Issued just shy of the one-year anniversary of the Supreme Court’s Omnicare decision in Omnicare, the Second Circuit’s ruling in Tongue v. Sanofi, 816 F.3d 199 (2d Cir. 2016), is the most significant post-Omnicare ruling thus far. The Sanofi court not only correctly applied the Court’s rulings on the standard for evaluating statements of opinion, but also appropriately highlighted the Court’s emphasis on the importance of context in evaluating allegedly false statements.

Other circuit court decisions have recognized the impact of Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), and the Fifth Circuit has specifically noted its importance in emphasizing that statements of both fact and opinion must be evaluated in the context in which they are made. See Owens v. Jastrow, 789 F.3d. 529 (2015) (affirming dismissal of complaint for failure to plead scienter). With Sanofi, however, the Second Circuit became the first appeals court to discuss Omnicare in detail, and to examine the changes that it brought about in the previously governing law.

The case centered around statements about Lemtrada, a drug in development for the treatment of multiple sclerosis. Sanofi, 816 F.3d at 203-04. Sanofi and its predecessor had conducted “single-blind” clinical trials for Lemtrada (studies in which either the researcher or the patient does not know which drug was administered), despite the fact that the U.S. Food and Drug Administration had repeatedly expressed concerns about these trials, and recommended “double-blind” clinical studies (studies in which both the researcher and the patient do not know which drug was administered). Id.

The plaintiffs alleged that Sanofi’s failure to disclose the FDA’s repeated warnings that a single-blind study might not be adequate for approval caused various statements made by the company to be misleading, including its projection that the FDA would approve the drug, its expressions of confidence about the anticipated launch date of the drug, and its view that the results of the clinical trials were “unprecedented” and “nothing short of stunning.” Id. at 204-06. Although the FDA eventually approved Lemtrada without further clinical trials, the agency initially refused approval based in large part on the single-blind studies concern, causing a large drop in the price of Sanofi stock. Id. at 206-07.

In an opinion issued before Omnicare, the district court dismissed the claims, in part because it found that plaintiffs had failed to plead that the challenged statements of opinion were subjectively false, under the standard previously employed by the Second Circuit in Fait v. Regions Financial Corp, 655 F.3d 105 (2d Cir. 2011). The Second Circuit stated that it saw “no reason to disturb the conclusions of the district court,” but wrote to clarify the impact of Omnicare on prior Second Circuit law. Id. at 209.

The court acknowledged that Omnicare affirmed the previous standard that a statement of opinion may be false “if either ‘the speaker did not hold the belief she professed’ or ‘the supporting fact she supplied were untrue.’” Id. at 210. However, it noted that Omnicare went beyond the standard outlined by Fait in holding that “opinions, though sincerely held and otherwise true as a matter of fact, may nonetheless be actionable if the speaker omits information whose omission makes the statement misleading to a reasonable investor.” Id.

The Second Circuit highlighted the Omnicare Court’s focus on context, taking note of its statement that “an omission that renders misleading a statement of opinion when viewed in a vacuum may not do so once that statement is considered, as is appropriate, in a broader frame.” Id. Since Sanofi’s offering materials “made numerous caveats to the reliability of the projections,” a reasonable investor would have considered the opinions in light of those qualifications. Id. at 211. Similarly, the Second Circuit recognized that reasonable investors would be aware that Sanofi would be engaging in continuous dialogue with the FDA that was not being disclosed, that Sanofi had clearly disclosed that it was conducting single-blind trials for Lemtrada, and that the FDA had generally made clear through public statements that it preferred double-blind trials. In this broader context, the court found that Sanofi’s optimistic statements about the future of Lemtrada were not misleading even in the context of Sanofi’s failure to disclose the FDA’s specific warnings regarding single-blind trials. Id. at 213.

Under the Omnicare standards, the Second Circuit thus found nothing false or misleading about the challenged statements, holding that Omnicare imposes no obligation to disclose facts merely because they tended to undermine the defendants’ optimistic projections. In particular, the Second Circuit found that “Omnicare does not impose liability merely because an issuer failed to disclose information that ran counter to an opinion expressed in a registration statement.” Id. at 212. It also reasoned that “defendants’ statements about the effectiveness of [the drug] cannot be misleading merely because the FDA disagreed with the conclusion—so long as Defendants conducted a ‘meaningful’ inquiry and in fact held that view, the statements did not mislead in a manner that is actionable.” Id. at 214.

In Rand-Heart of New York, Inc. v. Dolan, 812 F.3d 1172 (8th Cir. 2016), the Eighth Circuit Court of Appeals found that the Reform Act’s Safe Harbor did not protect comments made by a CEO during an earnings call, finding that he had actual knowledge that his comments would be misleading when he did not disclose a significant decline in future revenue from a major customer.

The Eighth Circuit reversed a district court’s dismissal of the claims against James Dolan, the CEO of Dolan Company, finding that plaintiffs had adequately alleged that Dolan acted with scienter during an earnings call with analysts, and that he was not protected by the Reform Act’s Safe Harbor, because the company’s cautionary language was not sufficiently meaningful and Dolan had actual knowledge that his statements were misleading. However, the Court ruled in Dolan’s favor on a loss causation issue, holding that the company’s first corrective disclosure was complete, and that plaintiffs therefore could not claim damages from a second large stock price decline two months later.

Factual Background

The litigation relates to Dolan Company’s subsidiary DiscoverReady, a company that performed litigation support services primarily for Bank of America. In spring 2013, Bank of America expressed concern to Dolan and DiscoverReady management regarding Dolan Company’s financial health, suspended discussions of a pending colocation agreement with DiscoverReady, and indicated it would cease sending new work to DiscoverReady until the financial concerns were resolved. Dolan reported this news to Dolan Company’s board, which then authorized the sale of DiscoverReady. Id. at 1174-75.

Approximately two months later, on August 1, 2013, Dolan Company announced its second quarter financial results.  Among other things, it reported 18% revenue growth for DiscoverReady. It also reported on certain cash flow and borrowing issues that could impact its profitability, but nothing specific to DiscoverReady. The same day, James Dolan spoke with stock analysts. He said that Dolan Company expected double-digit growth from DiscoverReady for 2013, but that third quarter revenue would be lower than the previous year. He added: “We make this comment not to dampen enthusiasm about our growth prospects for DiscoverReady, but to set proper expectations for a business that may experience lumpiness on a quarter-to-quarter basis.” When asked to elaborate on the “lumpiness,” Dolan added some additional vague commentary, but refused to elaborate on any specifics. Id. at 1175.

On November 12, 2013, Dolan Company filed its third quarter Form 10-Q, which reported that revenue decline “exceeded our expectations,” largely due to “a reduction in new work from [DiscoverReady’s] largest customer, a reduction that we identified towards the end of the quarter.” Dolan Company’s stock price traded at $2.08 on November 11, and fell to $1.05 on November 12, and to $0.90 on November 13. On January 2, 2014, Dolan Company issued a final press release announcing the appointment of a Chief Restructuring Officer and a Continuing Listing Standards Notice from the NYSE. On that news the company’s stock fell an additional 20%. In March, the company filed for Chapter 11 bankruptcy protection. Id. at 1175-76.

Eighth Circuit’s Scienter Analysis

In analyzing the complaint’s scienter allegations, the Court agreed with the district court that there was no allegation of Dolan’s motive. However, plaintiffs could still survive the motion to dismiss by alleging that Dolan was “severely reckless,” which, under Eighth Circuit precedent, is defined as “highly unreasonable omissions or misrepresentations involving an extreme departure from the standards of ordinary care, and presenting the danger of misleading buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it.” Id. at 1177 (quoting In re K-Tel Intern., 300 F.3d 881, 893 (8th Cir. 2002)).

Applying the “severely reckless” standard, the Court held that plaintiffs had not adequately pleaded that Dolan possessed scienter in failing to disclose that Bank of America had suspended discussions of a co-location agreement with Dolan Company, and had demanded that Dolan Company restructure, finding that the inference of scienter was negated by Dolan’s warnings regarding the company’s precarious financial state during the August 1 analyst call. Id. However, the Court concluded that Dolan was severely reckless in failing to disclose that Bank of America had stopped sending new work to DiscoverReady; the company’s financial instability was, at the least, “so obvious that [Dolan] must have been aware of it.” Id. at 1178. As a result, the Court ruled that plaintiffs had met their burden of pleading Dolan’s scienter.

Court’s Findings on Safe Harbor

Dolan asserted that his August 1 statements about “double-digit” growth and “lumpiness” were protected by the Reform Act’s Safe Harbor, which provides that a forward-looking statement is not actionable if it is accompanied by meaningful cautionary language or the defendant does not have actual knowledge of the statement’s falsity. See 15 U.S. C. § 78u-5(c)(1). The Court found that Dolan’s Safe Harbor defense failed on both grounds. First, the court held that Dolan had actual knowledge that his statements about DiscoverReady’s expected performance were misleading. Rand-Heart of New York, Inc., 812 F.3d at 1178. Second, the cautionary language was not meaningful because it consisted of boilerplate, generally applicable risk factors. For example, one excerpt of cautionary language on which Dolan relied stated: “Our failure to comply with the covenants in our debt instruments could result in an event of default that could adversely affect our financial condition and ability to operate our business as planned if we are not successful in obtaining a waiver of our failure to comply with our covenants.” Id.

Eighth Circuit Opinion on Loss Causation

Finally, the Court addressed plaintiffs’ assertion that the fraud was not fully revealed until the January 2 press release announcing the new restructuring officer, which disclosure was followed by a 20% stock price decline. But the Court found that the January 2 press release merely elaborated on the previous corrective disclosures, and did not serve as a separate corrective disclosure. Id. at 1180. The fact that this disclosure was followed by an additional stock price decline does not necessarily mean that decline was caused by the previous misrepresentation.  The 20% stock price decline in January could have been caused by any number of other market forces. As the Court concluded, “not every bit of bad news that has a negative effect on the price of a security necessarily has a corrective effect for purposes of loss causation.” Id. (quoting Meyer v. Greene, 710 F.3d 1189, 1202 (11th Cir. 2013)).

The Ninth Circuit Court of Appeals clarified an important question surrounding the “corrective disclosure” pleading requirement in Lloyd v. CVB Financial Corporation, 811 F.3d 1200 (9th Cir. 2016), finding that disclosure of an SEC investigation can constitute a partial corrective disclosure, but only if there is a follow-on disclosure that specifically corrects a prior misstatement.

The Lloyd loss causation holding, while clarifying the law to some degree, requires a fact-specific inquiry. In order to find loss causation in an analogous situation, courts would need to piece together several facts: (1) disclosure of a government investigation resulting in a stock drop; (2) market perception that the investigation related to a previous misstatement; (3) a follow-on disclosure confirming the previous misstatement; and (4) a minimal market reaction to the follow-on confirming disclosure.

Factual Background and Procedural History

The litigation arose from pre-recession loans that issuer defendant CVB Financial Corporation (“CVB”) made to the Garrett Group (“Garrett”), a commercial real estate company. In 2008, Garrett informed CVB that it would be laying off employees and reducing salaries, and that it could not make loan payments due to CVB. CVB agreed to restructure the loans, and loaned an additional $10 million to avoid a Garrett default. In 2009, CVB refinanced Garrett’s loans again, providing an additional $53 million and agreeing to other loan modifications. Despite these efforts, in 2010 Garrett again informed CVB that it was unable to fulfill its payment obligations and was then considering filing bankruptcy. Id. at 1203.

During this time, Garrett was CVB’s largest borrower and the loans in question were material to CVB’s balance sheet. Despite Garrett’s struggles and the materiality of the loans, CVB stated in its SEC filings that it was “not aware” of any “known credit problems of the borrower [that] would cause serious doubts” about Garrett’s ability to repay the loans. In July 2010, the SEC served CVB with a subpoena seeking information about its underwriting and loan loss methodologies. The next month, in its Form 10-Q, CVB disclosed the subpoena and that the SEC inquiry regarded CVB’s underwriting and allowance for credit and loan losses and related areas. The next day CVB’s stock fell 22%. Analysts following CVB noted that the subpoena was likely related to the Garrett loans. One month later, CVB finally wrote down $34 million in Garrett loans and reclassified the remaining $48 million of Garrett loans as non-performing. Following this disclosure, CVB’s stock price dropped only six cents to $6.99. Id. at 1204-05.

Plaintiffs brought a securities class action alleging Section 10(b) and Rule 10b-5 claims. The district court concluded that the challenged statements were not made with scienter and did not cause the plaintiffs’ alleged losses, and granted CVB’s motion to dismiss the complaint.

Ninth Circuit’s Ruling

The complaint alleged four types of CVB misstatements: (1) touting of loan underwriting and quality of loan portfolio; (2) a statement that the deteriorating real estate market “could” harm its borrowers’ ability to repay; (3) violations of GAAP in financial statements; and (4) assurances in SEC filings that it was “not aware of any other loans . . . for which known credit problems of the borrower would cause serious doubts as to the ability of such borrowers to comply with their loan repayment terms.” Id. at 1206.

The Ninth Circuit quickly concluded that the first three categories of alleged misstatements were not actionable, finding that the first category of statements were vague puffery, the second category was not misleading when placed in context, and the third category of GAAP failures, without more, did not establish scienter. Id. at 1206-07. However, with respect to the last category, the court concluded that some of these statements were false and made with knowledge or recklessness, and reversed the district court’s decision. The court found that the complaint had adequately alleged that CVB, prior to making those statements, had been alerted to facts that “would cause serious doubts” about Garrett’s ability to repay its loans.  Id. at 1207-09.

Finding one category of misstatements actionable, the court then moved to the question of loss causation, examining Supreme Court and Ninth Circuit law in this area. Under the Supreme Court’s decision in Halliburton, the “burden of pleading loss causation is typically satisfied by allegations that the defendant revealed the truth through ‘corrective disclosures’ which ‘caused the company’s stock price to drop and investors to lose money.’” Id. at 1209 (quoting Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014)). The court also revisited an open question from its recent decision in Loos v. Immersion Corporation, in which it held that “the announcement of an investigation, standing alone and without any subsequent disclosure of actual wrongdoing, does not reveal to the market the pertinent truth of anything, and therefore does not qualify as a corrective disclosure.” Id. at 1209-10 (quoting 762 F.3d 880, 890 n.3 (9th Cir. 2014)).

However, the court noted that the Loos court had reserved judgment on the question of whether the announcement of an investigation, such as CVB’s announcement of the SEC subpoena, could “form the basis for a viable loss causation theory” if the plaintiff also alleged a subsequent corrective disclosure. Lloyd, 811 F.3d at 1210. The Lloyd court then answered that question in the affirmative.

The disclosure of the SEC subpoena in July resulted in a 20% stock drop. Under Loos, the court found, that disclosure alone would not qualify as a corrective disclosure. However, just one month later, CVB disclosed that it had written off millions in Garrett’s loans. This second “bombshell” disclosure resulted in hardly any market reaction. However, the court concluded from this chain of events that investors correctly understood that the disclosure of the SEC subpoena was a partial corrective disclosure acknowledging the falsity of the prior “no serious doubts” statements. Id. at 1210-11. These two disclosures, when viewed together, constituted a sufficient corrective disclosure. The court reasoned: “Indeed, any other rule would allow a defendant to escape liability by first announcing a government investigation and then waiting until the market reacted before revealing that prior representations under investigation were false.” Id. at 1210. In making its ruling, the Court noted its holding was consistent with the Fifth Circuit’s decision in Public Employees’ Retirement System of Mississippi v. Amedisys, Inc., 769 F.3d 313 (5th Cir. 2014).

The Second Circuit affirmed the dismissal of a securities fraud claim against an outside, independent auditor for failure to adequately allege scienter, emphasizing that the standards for pleading scienter against independent auditors are “extremely demanding.”

In an unpublished decision in Zech Capital LLC v. Ernst & Young Hua Ming, 636 Fed. Appx. 582 (2nd Cir. 2016), plaintiff asserted that an Ernst & Young (“E&Y”) subsidiary violated Section 10(b) in connection with the audit of a SinoTech Energy Limited’s (“SinoTech”) IPO, alleging that E&Y facilitated SinoTech’s deception of its investors related to a $180 million IPO. Specifically, plaintiff contended that E&Y was aware of SinoTech’s weak internal controls, or should have been aware of those weaknesses, because if it had conducted an appropriate audit E&Y would have found a high percentage of SinoTech’s assets and reported revenue were “completely fictitious.”

The court rebuffed plaintiff’s assertions, finding the logic flawed and the allegations anemic. The court reiterated its earlier decisions which held that in order to allege scienter against outside auditors, the wrongful conduct must “approximate an actual intent to aid in the fraud being perpetrated by the audited company,” such as “conduct[ing] an audit so deficient as to amount to no audit at all, or disregard signs of fraud so obvious that the defendant must have been aware of them.”  Zech, 636 Fed. Appx. at 582 (citation omitted).

The court went on to fault plaintiff’s deductive allegations of scienter as failing to meet this demanding standard. There were no allegations that E&Y conducted the audit with intent to defraud, and that nothing alleged by plaintiff amounted to “red flags” that would put E&Y on notice of wrongdoing.

Plaintiff alleged that if E&Y had conducted an acceptable audit, it would have uncovered the fraud, but since E&Y did not uncover the fraud, then E&Y’s audit must have been insufficient. This theory, in and of itself, failed to allege any facts indicative of a strong inference of scienter. There were no allegations that the auditing procedures were reckless, as opposed to merely highly negligent. And there were no allegations that E&Y ignored “obvious signs of fraud” or “failed to review or check information that [it] had a duty to monitor.”  Id. at 584-85 (citation omitted).

Finally, the court weighed inferences as required by Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), under which the court must “take into account plausible opposing inferences” and consider “nonculpable explanations for the defendant’s conduct, as well as inferences favoring the plaintiff.”  Id. at 585 (quoting Tellabs). In reviewing all permissible inferences, the court found it more likely that E&Y was negligence rather than reckless, and affirmed the judgment of the lower court.

The case, standing together with others reviewing allegations of securities fraud brought against independent auditors, illustrates that allegations of sloppy auditing are simply not enough to get over the high bar required to maintain a claim against an independent auditor.