On July 7, the Second Circuit affirmed in part and vacated in part an order by Judge Rakoff of the S.D.N.Y. certifying two classes in the In re Petrobras Securities litigation, — F.3d –, 2017 WL 2883874 (2d Cir., July 7, 2017). In doing so, the Second Circuit joined several other circuits in declining to adopt a “heightened” version of the implied class certification requirement of ascertainability, which arose in the Third Circuit. Having rejected defendants’ arguments on this point, however, the Second Circuit applied Morrison v. National Australia Bank, 561 U.S. 247 (2010), in assessing whether the plaintiffs had met the predominance standard for class certification, and held that they had failed to do so, because individual questions of transactional domesticity—which under Morrison must often be considered when the territorial scope of the securities laws is at issueprevailed over common ones.

Petrobras is a multinational oil and gas company based in Brazil and majority-owned by the Brazilian government. Plaintiffs in Petrobras were holders of Petrobras equity and debt securities, who alleged that value of these securities fell dramatically following the revelation of a long-term money-laundering and kickback scheme at the company. Defendants included Petrobras and a number of its executives. In re Petrobras, 2017 WL 28883874 at *1.

The district court certified two classes of plaintiffs, the first asserting claims under the Exchange Act, and the second asserting claims under the Securities Act. On appeal, defendants challenged class certification on the grounds that (1) these classes were not sufficiently “ascertainable”; and (2) plaintiffs had not met the Rule 23(b)(3) requirement “that questions of law or fact common to class members predominate over any questions affecting only individual members.” In an opinion written by Judge Garaufis of the E.D.N.Y. (sitting by designation), and joined by Judges Hall and Livingston, the Second Circuit rejected defendants’ acertainability argument, but sided with them on their predominance argument. Id. Specifically, the court of appeals found that the district court had “erred in conducting its predominance analysis without considering the need for individualized Morrison inquiries.” Id. at *6.

The ascertainability requirement for class certification does not appear in Rule 23 itself, but is instead an “implied” mandate that a class be “sufficiently definite so that it is administratively feasible for the court to determine whether a particular individual is a member.” Id. at *5 (quoting Brecher v. Republic of Argentina, 806 F.3d 22 (2d Cir. 2015)). In several opinions, including Byrd v. Aaron’s Inc., 784 F.3d 154 (3d Cir. 2015), the Third Circuit has interpreted the ascertainability requirement as requiring a showing of administrative feasibility at the class certification stage—that is, a showing by plaintiffs that there will be an administratively feasible means of determining whether class members fall within the class definition. Petrobras, 2017 WL 2883874 at *11.

In Petrobras, the Second Circuit joined the Sixth, Seventh, Eighth and Ninth Circuits in rejecting this “heightened” ascertainability standard, and clarified its own ruling in Brecher, holding that ascertainability should not be evaluated with reference to administrative feasibility, but rather whether the proposed class is “defined by objective criteria.” Id. at *10. In Petrobras, this “modest threshold requirement” was met, because the proposed classes were concretely defined to include “persons who acquired specific securities during a specific time period, as long as those acquisitions occurred in ‘domestic transactions.’” Id. at *12.

Having rejected defendants’ arguments regarding ascertainability, however, the Second Circuit nonetheless vacated the district court’s certification order on the ground that it did not adequately consider domestic territoriality as defined by Morrison in evaluating the Rule 23 predominance requirement.

In Morrison, the Supreme Court held that the US securities laws are presumed to apply only to (1) transactions in securities listed on domestic exchanges; and (2) “domestic transactions” in other securities. In a subsequent case, Absolute Activist v. Ficeto, 677 F.3d 60 (2d Cir. 2012), the Second Circuit elaborated on the second prong of Morrison, holding that transactions in securities not listed on domestic exchanges are “domestic” if “irrevocable liability is incurred or title passes within the United States”; and also ruled that transactional domesticity is a “merits” question of the kind that can considered in a Rule 12(b)(6) motion.

In Petrobras, there was no doubt that the equity transactions at issue fell within Morrison’s first prong, given that the Petrobras equity securities were traded on the NYSE. There was also no doubt that the debt transactions did not fall within the first prong, since the debt securities did not trade on any U.S. exchange, and were instead traded on various over-the-counter markets. The hard question in Petrobras was whether the over-the-counter debt securities transactions fell into the category of “domestic transactions” notwithstanding the fact that they were not conducted on domestic exchanges—a question rendered more difficult by the fact that these transactions differed in their particulars. Id. at 3.

The district court did consider Morrison-based challenges to plaintiffs’ claims before issuing its class certification order, dismissing two named plaintiffs from the case after finding that their over-the-counter debt securities transactions did not qualify as domestic under Morrison and Absolute Activist. Id. at *7-8. But the Second Circuit nonetheless found that the district court did not adequately address Morrison in the certification context. Id. at *14-16.

Generally speaking, a plaintiffs seeking to demonstrate that a particular over-the-counter transaction was domestic may offer “evidence ‘including, but not limited to, facts concerning the formation of the contracts, the placement or purchase orders, the passing of title, or the exchange of money.’” Id. at *14 (quoting Absolute Activist, 677 F.3d at 70). As the Second Circuit observed in Petrobras, “these transaction-specific facts are not obviously ‘susceptible to [ ] class-wide proof.’” Id. (quoting Tyson Foods v. Bouaphakeo, 136 S.Ct. 1036, 1045-46 (2016)).

The district court approved two class representatives with claims based on over-the-counter transactions in debt securities. For each of these two plaintiffs, domesticity was not seriously at issue, as they placed their purchase orders in the United States and procured their securities directly from U.S. underwriters. But the Second Circuit described these two class representatives as “the easy case,” and concluded that the district court’s certification order “offers no indication that [it] considered the ways in which evidence of domesticity might vary in nature or availability across the many permutations of transactions in Petrobras Securities.” Id. at *15.

According to the Second Circuit, these likely intra-class differences give rise to a predominance problem, because “the investigation of domesticity appears to be an ‘individual question’ requiring putative class members to ‘present evidence that varies from member to member.’” Id. at *14 (quoting Tyson Foods, 136 S.Ct. at 1045). In this case, the Second Circuit concluded, “it cannot be said that the class members’ Morrison inquiries will ‘prevail or fail in unison.’” Id. at *16. On this basis, the Second Circuit vacated the district court’s certification of the two classes insofar as they included all otherwise-eligible members who acquired their Petrobras securities in “domestic transactions”—allowing, however, that the district court might, on remand, properly certify one or more classes that would capture some or all of the members of the vacated classes. Id. at *16.

Finally, the Second Circuit also addressed a ruling by the district court, with respect to the Exchange Act class, that plaintiffs were entitled to a presumption of reliance under the “fraud on the market” theory established in Basic v. Levinson, 485 U.S. 224 (1998). While the defendants pointed to the fact that plaintiffs provided no empirical data showing that the price of the relevant Petrobras securities moved up and down predictably in response to news about the company, the Second Circuit noted that such data may suffice but is not necessary to show market efficiency, and held that the district court properly considered other forms of direct and indirect evidence in ruling that the Basic presumption applied for purposes of class certification. Id. at *20.

The Second Circuit, affirming the Southern District of New York’s dismissal of a ’33 Act securities class action, reaffirmed that the Circuit’s operative test for determining the materiality of omissions is the test set forth in DeMaria v. Andersen, 318 F.3d 170 (2d Cir. 2003), and explicitly rejected the First Circuit’s test in Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996).  In refusing to adopt Shaw’s standard—known as the “extreme departure” test—the court endorsed a test that it determined to be the “classic materiality standard in the omission context” and rejected the test that it found to “leave too many open questions” and to be “analytically counterproductive.”

Stadnick v. Vivint Solar, Inc. is a putative class action alleging violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 based on Vivint Solar’s alleged failure to disclose financial results for the quarter that ended the day before Vivint’s IPO, as well as Vivint’s alleged misstatements regarding the company’s expansion in Hawaii for failing to disclose the impact of the state’s evolving regulatory scheme.

The company’s unique business model and accounting methods are key to the case and the court’s analysis.  Vivint’s business model operates by leasing solar energy panels to its customers and maintaining ownership of the underlying panels.  This model allows Vivint to capitalize on the tax credits associated with solar energy.  Vivint finances its company through outside investors, who invest the capital necessary to purchase tranches of solar energy systems.  The outside investors then receive title to the system they financed and receive most of the monthly lease payments until the system is paid off.  At that time, Vivint then starts to receive most of the revenue.  Based on this set up, Vivint’s income is accordingly allocated between its public shareholders and its outside investors.  To properly calculate this income, Vivint employs an accounting method that allocates the income between the shareholders and outside investors.  Due to Vivint’s business model and this accounting method, Vivint shows significant income fluctuations from quarter to quarter.  Vivint experienced one such dramatic income swing in the quarter directly preceding its IPO.

Vivint issued its IPO on October 1, 2014.  In its registration statement, Vivint set forth the financial results from the previous quarters and warned investors that its business model and accounting practices could impact the allocation of income between shareholders and outside investors.  It also listed the “key operating metrics” for evaluating the company’s financial performance.

Vivint disclosed the financial results for the third quarter on November 10, 2014.  In that disclosure, Vivint revealed a significant decline in income to shareholders.  Specifically, the net income to shareholders was measured at negative $35.3 million, down from $5.5 million in the previous quarter.  However, the results showed that despite this loss, Vivint’s “key operating metrics,” which the company previously had set forth as its measure for evaluating the company’s financial success, were strong.  For example, the company’s installations were up 137 percent from the previous year and its market share increased from 9 percent to 16 percent in that quarter.

The plaintiff brought suit following the decline in stock as a result of the third-quarter earnings announcement.  The plaintiff raised two omissions as the basis for his suit: (1) Vivint’s failure to disclose the third-quarter financial information and (2) Vivint’s failure to disclose the adverse impact of the regulatory oversight in Hawaii.

The Second Circuit focused primarily on this first argument, and used this case as an opportunity to clarify the Second Circuit’s operative test for material omissions.  The plaintiff urged the court to adopt the First Circuit’s “extreme departure” test in Shaw v. Digital Equipment Corp.  In Shaw, the First Circuit held that an omission was actionable under Section 11 if there was “substantial likelihood” that the withheld information would represent an “extreme departure” from the previous financial performance.  Adopting this test would be its own extreme departure—pun intended—from the Second Circuit’s test in DeMaria v. Andersen, which looked instead to whether the information would “significantly alter[] the ‘total mix’ of information available.”  Vivint proved to be an ideal opportunity for the Second Circuit to re-exam its standards as it provides a situation in which the income swings were great enough to be reasonably seen as an “extreme departure,” but the company’s clear formula for evaluating its own performance makes clear that other factors more accurately reflect the company’s true financial health.

The court undertook an analysis of the “extreme departure” test, and affirmatively rejected that test.  The court noted that the DeMaria test used the “classic materiality standard in the omission context.”  Focusing on how the First Circuit test would allow a plaintiff to meet their burden based on two narrow metrics—which would not properly give the entire picture—the court had harsh words for the First Circuit’s test, calling it “analytically counterproductive” and “unsound[],” and noting that it “confuses the analysis.”  Once reaffirming that the Second Circuit would continue to rely on the DeMaria test, the court concluded that Vivint’s omission was not material because shareholder income and earnings-per-share are not the best indicators of Vivint’s financial performance.  The court also noted that the registration statement clearly set forth that Vivint’s unique business model meant that shareholder revenue and earnings would fluctuate.

Plaintiff’s second argument was rejected without much analysis—the court even noted this argument was “tack[ed] onto his complaint”—as the court concluded that the plaintiff failed to show that the regulatory changes adversely affected Vivint’s Hawaiian operations and that Vivint had sufficiently warned investors that such changes could impact their Hawaiian presence.

In a 91-page opinion covering several important securities-litigation issues, the Second Circuit upheld the district court’s partial judgment against Vivendi following a three-month jury trial that resulted in the jury finding Vivendi liable under Section 10(b) and Rule 10b-5.

As I was preparing to summarize the opinion for this blog, I read a summary by Wiley Rein’s David Topol and Jennifer Williams in Kevin LaCroix’s blog, The D&O Diary.  Their post is excellent and comprehensive.  So instead of publishing a separate summary, I obtained their permission to refer readers of this blog to their post:

Vivendi: A Victory for Plaintiffs on the Price Maintenance Theory and on Loss Causation .

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.

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.

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.