The 11th Circuit ignored the potential application of the Supreme Court’s 2015 decision in Omnicare, and instead reached back to its own precedent dating from 1979, in holding that plaintiffs are foreclosed from bringing a claim that a company misled shareholders about its real motivations for engaging in a stock repurchase program.

In its per curiam unpublished opinion in Henningsen v. ADT Corp. (“ADT”), 2016 WL 4660814 (11th Cir. 2016), the 11th Circuit affirmed the dismissal of Section 10(b) claims against ADT and its CEO, and against Corvex Management LP, and its founder, Keith Meister.

Plaintiffs alleged that Corvex had acquired more than five percent of ADT’s stock in 2012, and that after that point, Meister was outspoken in his criticism of the Company, alleging that its stock was undervalued and urging management to take on more debt so it could repurchase shares, with a goal of increasing ADT’s stock price.

The complaint alleged that Meister threatened to call a shareholder vote to replace the board if the directors did not offer him a board position and agree to take out loans for significant stock buybacks.  ADT announced a plan to repurchase $2 billion of its common stock over three years after an initial meeting with Meister.  Soon afterward, Meister was given a position on the ADT board, and the Company continued to borrow more money to repurchase more stock, ultimately causing credit rating agencies to downgrade ADT’s credit rating and ADT’s share price to drop.  After this downturn, the complaint alleges that Meister pushed for ADT to repurchase more shares on an even more accelerated timeframe, and that the directors acquiesced after Meister promised to leave the board if they agreed with his plan.

In November 2013, ADT announced that it was repurchasing Corvex’s shares and that Meister was resigning from the board.  ADT stock price dropped 6% on this news, and dropped another 30% in the following months.  Plaintiffs filed suit, claiming that ADT and Corvex had misrepresented various issues and problems at the Company, and that they had misled shareholders by concealing that they had engaged in aggressive share repurchases to appease Meister and Corvex, instead characterizing the repurchase plan as “thoughtful,” “effective,” and “optimal.” Id. at *5.

The district court dismissed most of the claims for failure to sufficiently plead falsity and scienter, and rejected the “motivation” claim because it was barred by 11th Circuit precedent, namely Alabama Farm Bureau Mutual Casualty Co. v. American Fidelity Life Insurance Co., 606 F.2d 602, 610 (5th Cir. 1979).  The 11th Circuit affirmed.

In Alabama Farm, the court held that a company does not engage in “deception” under the securities laws by failing to “disclose [its] motives in entering a transaction,” and that Section 10(b) does not require “the disclosure of an individuals’ motives or subjective beliefs.” ADT, 2016 WL 4660814, at *4 (quoting Alabama Farm, 606 F.2d at 610).

In ADT, 11th Circuit found that this precedent foreclosed plaintiffs’ claims that the “ADT Defendants misled investors by having one motive, while offering up another, for participating in an otherwise accurately-disclosed stock repurchase plan.”  The court reasoned that information about the Company’s motives was not material as long as the Company had accurately disclosed “material financial or other information concerning the nature, scope, or mechanics of the stock repurchase transaction.” Id. at *4.

The court rejected plaintiffs’ argument that such a bright-line test for materiality is no longer good law after the Supreme Court’s decisions in Basic Inc. v. Levinson, 485 U.S. 224 (1988) and Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011).  Even in light of these Supreme Court decisions expressing concern such bright-line tests might exclude information important to a reasonable shareholder, the court found that “no reasonable shareholder would have considered the alleged omissions” regarding ADT’s true motivations “significant to the decision about whether to trade ADT securities given the other disclosures regarding the stock repurchase program and ADT’s corporate financing.” Id.

Finally, the court declined to give meaningful consideration to plaintiffs’ claims that ADT and its CEO had misled its shareholders by calling the repurchase program “thoughtful,” “effective,” and “optimal,” among other descriptors.  The court did not consider the applicability to these claims of the Supreme Court’s decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), which sets forth the criteria for deciding whether a statement of opinion was false or misleading. Instead, the court relied on pre-Omnicare precedent to dismiss these statements as nonactionable “puffery,” thus sidestepping the question of whether plaintiffs might have adequately alleged that they were false statements of opinion under the Omnicare standard. Id. at *5.

The Third Circuit engaged in a searching analysis of plaintiffs’ falsity and scienter allegations and found them insufficient under the exacting standards of the Reform Act, upholding the district court’s dismissal of the complaint in OFI Asset Management v. Cooper Tire & Rubber, — F.3d —, 2016 WL 4434404 (3d Cir. 2016).

In its ruling, the Third Circuit also had some harsh words for plaintiffs’ “kitchen sink” pleading style, finding that it “has been a hindrance at every stage of these proceedings.”  Id. at *7.

The case is tied to Cooper’s failed merger with Apollo Tyres.  Cooper was valuable to Apollo largely due of its manufacturing facility in China (“CCT’), of which it owned 65%, with the remaining 35% owned by a Chinese company.  The merger fell through after workers at CCT went on strike, denied Cooper officials access to the facility, refused to provide Cooper with financial information, and stopped producing Cooper-branded tires.  At the same time, the merger announcement led to a labor dispute in Cooper’s U.S. manufacturing facilities, with a labor arbitrator eventually finding in favor of the union and barring Cooper from selling two of its U.S. plants to Apollo.

Plaintiffs alleged that Cooper made a number of false or misleading statements under Section 10(b) and 14(a) in connection with the failed merger, including in the merger agreement, the proxy statement, its financial statements, and two 8-Ks containing news about the merger.  The claim was dismissed by the district court in Delaware for failure to adequately allege falsity and scienter.

Prior to oral argument, the district court had ordered plaintiffs to submit a letter identifying the five most compelling examples of allegedly false statements, with three factual allegations demonstrating the falsity of each statement and three allegations supporting scienter as to each of the statements.  Upon appeal, plaintiffs’ first objection was as to the court’s process, arguing that the court abused its discretion by considering only five “artificially selected” allegedly false statements, and failing to rule on the whole of plaintiffs’ complaint.

The Third Circuit considered plaintiffs’ “umbrage. . . unfounded.” Far from harming OFI’s case, the court found that the district judge had tried to “give OFI an assist,” by offering it a chance to frame the issues in its complaint more clearly.  Asking OFI to bring some order and clarity to its 100-page, 245-paragraph complaint was well within the district judge’s discretion to manage complex disputes, and does not show that the judge failed to consider the allegations as a whole.  Id. at *6.

Held the Third Circuit: “As pled, the Complaint presents an extraordinary challenge for application of the highly particularized pleading standard demanded by the PSLRA. This is true not only due to the length of the Complaint, but also its lack of clarity. . . . Now that OFI has come to us with the same kind of broad averments that drove the District Court to demand specificity, we find ourselves more than sympathetic to the Court’s position.”  Id. at *6.

After holding that the district court had not abused its discretion in managing the case, the Third Circuit went on to explore in detail each of the allegedly false statements, finding that none of them were sufficient to maintain a claim.  In doing so, the court considered the context of each allegedly false or misleading statement, and examined whether the allegations of falsity as to each were sufficiently specific, rejecting those allegations that lacked the particularity required of the Reform Act or which failed to show how a statement was misleading rather than simply incomplete.

As to a number of forward-looking statements, the Third Circuit held that its allegations of falsity failed to account for the Reform Act’s Safe Harbor.  Because the statements had been accompanied by meaningful cautionary statements, the court held that the Safe Harbor immunized them from liability—and thus they were not actionable even if plaintiffs could show that they were false and made with scienter.  Id. at *15.

In regard to one isolated statement, the court also found that even if OFI had sufficiently pleaded technical falsity, it nevertheless failed to raise a strong inference of scienter, because the “plausible opposing inferences” were more likely, “including that the statement was simply imprecise or received little attention due to the context in which it was made[.]”  Id. at 12.

Wrote the court: “OFI’s post hoc scouring of countless pages of documents for a stray and inartfully phrased comment that can be argued to be technically false seems like just the sort of litigation maneuver the PSLRA was meant to eliminate. One purpose of the statute was to prevent disappointed investors from treating every imprecise statement during a transaction as an invitation to file a lawsuit.”  Id. at *13.

The Sixth Circuit has joined a majority of the other circuit courts in recognizing that loss causation can be shown through a “materialization of the risk” theory,” reversing the dismissal of a case against Freddie Mac stemming from the 2007 mortgage crisis.

In Ohio Public Employees Retirement Sys. v. Federal Home Loan Mortgage Corp. (“Freddie Mac”), — F.3d. —, 2016 WL 3916011 (6th Cir. 2016), the Sixth Circuit found that under “the clear weight of persuasive authority,” plaintiffs could adequately plead loss causation by alleging that a risk that had been fraudulently concealed caused harm to a company and a resultant stock drop — even if there was no corrective disclosure that revealed that the company’s statements had been false or misleading. Id. at *7.

Plaintiffs brought the action against Freddie Mac in January 2008, alleging that starting on August 1, 2006, the mortgage-holding giant had made false or misleading statements that concealed from purchasers of its stock its growing investment in loan portfolios comprised of risky mortgages, as well as the fact that it circumvented its traditional underwriting standards to purchase these portfolios.

Although Freddie Mac had given the market warnings about potential credit risk, plaintiffs alleged that it had made misleading statements highlighting its rigorous underwriting requirements and declaring that it had “basically no subprime exposure.” Id. at *7-8.

Plaintiffs allege that the market began to learn the truth behind these misrepresentations on November 20, 2007, when Freddie Mac released an earnings statement that revealed that more than a fourth of its loan portfolio was at high risk of substantial losses, and disclosed that it had incurred a record $2 billion in losses during the previous quarter. The company’s stock price dropped 29% on this news. However, it was not until 2008 that news articles and analyst reports suggested that Freddie Mac’s prior statements regarding its portfolio may have been false.

The complaint had previously withstood three motions to dismiss, but in 2013 the district judge in the Northern District of Ohio recused himself from the case and it was reassigned. The new district judge gave defendants leave to file a fourth motion to dismiss, which the court granted in 2014.

In finding the materialization of the risk theory sufficient to plead a Section 10(b) claim, the Sixth Circuit noted that it was an issue of first impression in the circuit, and referred to decisions from nine other circuit courts that recognize the theory.  It cited to the Second Circuit in holding that alternate theories of loss causation that do not include a corrective disclosure are sufficient if they allege that the stock drop was caused by events that were “within the zone of risk concealed by the misrepresentations and omissions.”  Id. at *6 (citing Lentell v. Merrill Lynch & Co., 396 F.3d 161, 172 (2d Cir. 2005)).

The court noted: “We are mindful of the dangerous incentive that is created when the success of any loss causation argument is made contingent upon a defendant’s acknowledgment that it misled investors. Our sister circuits are too and have recognized that defendants accused of securities fraud should not escape liability by simply avoiding a corrective disclosure.”  Id. at *7.

Emphasizing that allegations of loss causation do not need to meet heightened pleading under the Reform Act, the court found that plaintiffs had sufficiently alleged that their investment losses were caused when the allegedly concealed risky mortgages and compromised underwriting standards resulted in substantial defaults and record losses for the company. The court found that the disclosure of these losses on November 20, 2007 “well within the ‘zone of risk’ that Freddie Mac allegedly concealed,” and therefore were sufficient to support a “plausible claim” of loss causation under the standard of Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)). Id. at *8-9.

In Anderson v. Spirit Aerosystems Holdings, Inc., — F.3d —, 2016 WL 3607032 (10th Cir. 2016), the Tenth Circuit provided a blueprint for how to analyze securities class action scienter allegations, looking carefully at allegations made by confidential witnesses, examining the challenged statements in context, evaluating plaintiffs’ motive allegations, and weighing conflicting inferences of innocence and scienter.

In rejecting the scienter allegations as inadequate, the court also analyzed what has come to be known as the “core operations inference,” considering whether the court should attribute knowledge of wrongdoing to top level executives based on their position within the company, and the fact that the plaintiffs claim that their allegations implicate the “core operations” of the company.

Plaintiffs filed a class action against Spirit Aerosystems Holdings, Inc. (“Spirit”), and four executives, alleging violations of Section 10(b) and Rule 10b-5. Spirit supplies parts for Gulfstream aircraft and had periodically reported to the public about its progress on various projects, including cost overruns, production delays, and risks, while also expressing confidence about its ability to meet deadlines and ultimately break even. When Spirit later announced that it expected to lose hundreds of millions of dollars on three projects, its stock price fell and litigation ensued.

Plaintiffs alleged that top executives must have known that problems with the three projects would result in the company failing to meet economic forecasts. They claimed that the executives misrepresented and/or omitted cost overruns and production delays because they knew, or must have known, that the overruns or delays were going to impact materially impact revenue.

But the court rejected these “core operations” allegations because they were based solely on defendants’ positions within the company and their involvement with certain projects. The court cited to the Ninth Circuit’s decision in South Ferry LP, No. 2 v. Killinger, 542 F.3d 776, 784 (9th Cir. 2008), in finding that such allegations will fail to meet the scienter requirement unless there are detailed allegations about an executive’s actual knowledge of information that belied the truth of the public statements. Id. at *10.

The court held: “Based on the plaintiffs’ allegations of the defendants’ involvement in Spirit’s core operations, we can infer only that the four executives were overly optimistic about Spirit’s ability to achieve the forecasted production schedules and cost reductions. The plaintiffs have not provided a good reason to believe that the executives knew that the projects were unlikely to meet forecasts.”

The court also found that plaintiffs failed to demonstrate scienter through (1) allegations that the defendants were “motivated to mislead in order to buy time in the hope that a difficult financial situation ‘would right itself,’” (2) information from confidential witnesses, or (3) implementation of a recovery plan.

The court began its analysis of plaintiffs’ motive allegations by stating the Tenth Circuit’s legal standard: although motive is not required to plead scienter, the absence of a motive allegation is relevant in evaluating scienter. With respect to plaintiffs’ particular alleged motive, the court found, as an initial matter, that the argument had not been properly preserved. But even if it were considered, it would not suffice, because it is nothing more than a generalized corporate motive. In the absence of a particularized motive to obfuscate, the allegations were insufficient to support an inference of scienter.

The court next rejected the confidential-witness allegations, because they did not support the inference that the executives knew of specific contemporaneous facts that were inconsistent with their challenged statements. The court noted that most of the CWs did not work closely with the executives, and the allegations from the one witness who did concerned only claims of general corporate mismanagement, of a kind that was insufficient to establish scienter. Id. at *7.

Finally, the court analyzed plaintiffs’ allegations that the existence of a recovery plan tended to establish scienter. The court started with the assumption that certain statements were false or misleading, and then weighed the dual explanations to determine whether those misrepresentations were made with scienter. The defendants argued the statements were made from an honest belief that the recovery plan would reduce costs and accelerate production. The court, relying on In re Zagg, Inc., Sec. Litig., 797 F.3d 1194, 1198-99 (10th Cir. 2015), determined it was more likely than not that the executives had identified a better way of handling the project and not that the recovery plan suggested scienter. The court concluded that the “innocent inference” was more cogent and compelling than an inference of scienter. Id. at *8.

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.