Core Operations Inference

In this putative class action, investors alleged that Biogen executives misled the public about the impact on sales of the company’s multiple sclerosis drug Tecfidera after one patient’s death. Plaintiffs alleged violations of Sections 10(b) and 20(a) of the Securities Exchange Act by Biogen and three Biogen executives. The First Circuit affirmed the District Court’s dismissal of the investors’ amended complaint for failure to meet the heightened pleading requirements of the Private Securities Litigation Reform Act, as well as the District Court’s denial of investors’ motion to vacate the dismissal and for leave to file a second amended complaint.

Tecfidera accounted for one-third of Biogen’s revenues prior to the announcement of the patient death during an earnings call in October 2014. Following the announcement and an FDA warning to the public about the patient death, Biogen eventually revised its estimate of overall 2015 revenue growth, “based largely on revised expectations for the growth of Tecfidera.” Biogen’s stock plummeted over 20 percent in one day following the announcement of the revised revenue growth estimate.

Plaintiffs’ amended complaint set forth numerous allegedly misleading statements made by defendants regarding the material impact of the patient death on Tecfidera sales, “alleg[ing] in substance that Biogen executives made statements about future Tecfidera sales that were misleading because they were unduly optimistic.”

To support their claims that the statements were made with scienter and were misleading, plaintiffs relied on the statements of several confidential witnesses. Of the 20 misrepresentations alleged in the complaint, the District Court found that only three of defendants’ statements appeared to be “plausibly misleading” based on the complaint’s allegations. The court found that the remainder of the statements were either protected by the Reform Act’s safe harbor for forward-looking statements, or constituted immaterial expressions of corporate optimism or puffery. With respect to the three “plausibly misleading” statements, the court commented that “[e]ven assuming that defendants made a materially false or misleading statement, plaintiffs have not sufficiently alleged that defendants made those statements with ‘conscious intent to defraud or a high degree of recklessness.’” The District Court also found that the record gave rise to inferences in the defendants’ favor. In granting the motion to dismiss, the court noted that, “[b]ased on the complaint as a whole, plaintiffs’ asserted inference of scienter may be plausible, but it is not strong, cogent, or compelling” as required by the Reform Act’s heightened pleading standards.

In affirming the dismissal, the First Circuit adopted the District Court’s analysis regarding the falsity of defendants’ statements, focusing on the complaint’s allegations of scienter with respect to the three “plausibly misleading” statements. The First Circuit found that the confidential witness statements, a substantial basis for the complaint’s allegations as to scienter, “very often made about events occurring after the defendants’ statements at issue, are so lacking in connecting detail that they cannot give rise to a strong inference of scienter.”  Elaborating on this conclusion, the First Circuit found that the allegations were “insufficiently particular, do not make misleading the defendants’ public disclosures, and do not speak with specificity as to why the defendants’ alleged misstatements were untrue or misleading.” In particular, the confidential witness statements did “not even begin to quantify the magnitude” of the decline in Tecfidera sales, “explain with any precision” the specific cause of the decline, or contain contemporaneous facts that “purport to contradict” Biogen’s financial reports during the class period. The allegations suffered from “a significant timing problem” in that the majority of the confidential witness statements and other alleged “evidentiary admissions” did not address how the defendants’ statements were “knowingly or recklessly misleading at the time they were made.” Indeed, the First Circuit found that the witness statements were “consistent with the defendants’ public disclosures,” and that the defendants repeatedly warned investors about the growth risks throughout the class period.

The court also rejected plaintiffs’ scienter allegations based on the “core operations” inference of scienter and the individual defendants’ motive. First, the court rejected the “core operations” allegations as “inapt” because plaintiffs did not plead “materially” contradictory “reasonably accessible data within the company” at the time the statements were made. As for motive, the court agreed that that the “most cogent inferences from the record favor the defendants,” including the defendants’ compensation structure, which was tied in part to revenue growth, as well as the fact that the individual defendants increased their Biogen stock holdings during the class period, thereby suffering losses as a result of the decline in share price. The court underscored the importance of “evaluating the complaint as a whole, including ‘plausible opposing inferences’,” as a part of the scienter analysis.

In a matter of first impression in the Ninth Circuit, the court applied the Supreme Court’s Omnicare standard for pleading the falsity of a statement of opinion to a Section 10(b) claim in City of Dearborn Heights Act 345 Police & Fire Retirement System v. Align Technology, Inc., — F.3d —, 2017 WL 1753276 (9th Cir. May 5, 2017).

The litigation arose from Align’s $187.6 million acquisition of Cadent Holdings, Inc. in April 2011, and Align’s alleged failures to properly assess and write off the goodwill associated with the acquisition. Align’s statements regarding the fair value of goodwill, of course, were quintessential statements of opinion, because they were inherently subjective. In Omincare, the Supreme Court set the standard for pleading the falsity of an opinion claim under Section 11. Many practitioners, including Lane Powell’s securities litigation team, had opined—and the Second Circuit and other courts had held—that the rationale of Omnicare should equally apply to Section 10(b) claims, since the falsity element is the same. In Align, the Ninth Circuit agreed, and partially overturned a previous Ninth Circuit case that permitted plaintiffs to plead falsity by alleging that “there is no reasonable basis” for the defendant’s opinion.

Align’s accounting for the acquisition resulted in $135.5 million of goodwill, $76.9 million of which was attributable to one of Cadent’s business units (the “SCCS unit”). The plaintiffs alleged that the purchase price, and thus the goodwill, was inflated due to Cadent’s channel stuffing practices prior to the acquisition, and that the defendants must have known as much after performing their due diligence. Following the acquisition, the SCCS unit’s financial results suffered due to numerous factors. Nevertheless, at the end of 2011, Align found no impairment of its recorded goodwill. Align did not perform any interim goodwill testing in the first or second quarters of 2012. Id. at *2-3.

On October 17, 2012, Align finally announced it would be conducting an interim goodwill impairment test for the SCCS unit, which it said was triggered by the unit’s poor financial performance in the third quarter of 2012 and the termination of a distribution deal in Europe. That announcement led to a 20% hit to Align’s stock price. On November 9, 2012, Align announced a goodwill impairment charge of $24.7 million, and it announced subsequent goodwill charges in the following two quarters. Id. at *3. The plaintiffs alleged that the defendants made seven false and misleading statements concerning the goodwill valuation between January 30, 2012 and August 2, 2012. The plaintiffs’ allegation was that defendants deliberately overvalued the SCCS goodwill, thereby injecting falsity into statements concerning the goodwill estimates and the related financial statements. The district court dismissed the complaint with prejudice for failing to adequately plead falsity and scienter. Id. at *4.

At issue in the Ninth Circuit was whether the plaintiffs had adequately pled that Align’s statements were false. The first question was what analytic framework applied. The plaintiffs did not dispute that five of the seven statements at issue were pure statements of opinion. However, with respect to two statements, the plaintiffs alleged the opinions contained “embedded statements of fact.” Those statements were that “there were no facts and circumstances that indicated that the fair value of the reporting units may be less than their current carrying amount,” and that “no impairment needed to be recorded as the fair value of our reporting units were significantly in excess of the carrying value.” The Court held that the former statement was an opinion with an embedded statement of fact, but that the latter was an opinion. Id. at *5.

The Court also addressed the proper pleading standard for falsity of opinion statements. The panel concluded that Omnicare established three different standards depending on a plaintiff’s theory:

  1. Material misrepresentation. Plaintiffs must allege both subjective and objective falsity, i.e., that the speaker both did not hold the belief she professed, and that the belief was objectively untrue.
  2. Materially misleading statement of fact embedded in an opinion statement. Plaintiffs must allege that the embedded fact is untrue.
  3. Misleading opinion due to an omission of fact. Plaintiffs must allege that facts forming the basis for the issuer’s opinion, the omission of which makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context.

Importantly, the Ninth Circuit extended this Omnicare holding from the Section 11 context to the Section 10(b) and Rule 10b-5 claims at issue in Align. Id. at *7. In doing so, the Ninth Circuit joined the Second Circuit in extending Omnicare in this regard. See Tongue v. Sanofi, 816 F.3d 199, 209-10 (2d Cir. 2016). Finally, the court overruled part of its previous holding in Miller v. Gammie, 335 F.3d 889, 900 (9th Cir. 2003) (en banc), which allowed for pleading falsity by alleging that there was “no reasonable basis for the belief” under a material misrepresentation theory. City of Dearborn Heights, 2017 WL 1753276, at *7.

Applying this pleading standard to the Align facts, the Ninth Circuit concluded that the plaintiffs had not met their pleading burden. Because the plaintiffs did not allege the actual assumptions the defendants relied upon in conducting their goodwill analysis, the court could not infer that the defendants intentionally disregarded the relevant events and circumstances. Accordingly, six of the seven statements that relied on the material misrepresentation theory failed to allege subjective falsity and were properly dismissed. Likewise, the failure to allege the actual assumptions used by the defendants prevented plaintiffs from pleading objective falsity as to the one statement of fact embedded in an opinion statement. Id. at *8-10.

After concluding that the plaintiffs failed to allege falsity, the Ninth Circuit went on to hold that plaintiffs had not alleged scienter against the defendants, providing a second ground for dismissing the complaint. At most, the plaintiffs alleged that the defendants violated generally accepted accounting principles, but such a failure does not establish scienter. Likewise, the stock sale allegations, core operations inference, the temporal proximity between the challenged statements and the goodwill write-downs, the CFO’s resignation, and the magnitude of the goodwill write-downs did not create an inference of scienter. Id. at *10-13.

Judge Kleinfeld concurred in the judgment. He would have upheld the district court’s dismissal based on scienter alone, leaving the weightier issue of falsity described above to a future case where such a decision was necessary. Id. at *13-14 (Kleinfeld, J., concurring in the judgment).

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.