Fourth Circuit On Scienter

Although the U.S. Court of Appeals for the Fourth Circuit established its pleading standards for scienter (i.e., fraudulent intent) in securities fraud cases over a year ago, it has not had a subsequent opportunity to apply these standards. Moreover, the Hanger Orthopedic decision did not address the common scienter allegations of insider stock sales and violations of generally accepted accounting principles (“GAAP”).

The Fourth Circuit’s decision in In re PEC Solutions, Inc. Sec. Litig., 2005 WL 646070 (March 18, 2005), although unpublished, offers some guidance on how the court will evaluate the existence of a “strong inference” of scienter as required under the PSLRA. In PEC Solutions, plaintiffs alleged that scienter was demonstrated by, among other things, the stock trading of the individual defendants and a failure of the company to take a reserve against non-payment of a contract in violation of GAAP.

As to the stock sales, the court found that they were “nearly de minimus” given that the individual defendants only sold between 1.17% and 13% of their holdings during the class period. Moreover, the individual defendants exercised stock options during the class period, but did not sell the underlying stock, and actually lost hundreds of millions of dollars in stock value due to the price drop. The court concluded that “[i]f this all give rise to a ‘strong inference’ of anything, it is that no scienter exists.”

Turning to the alleged GAAP violation, the court noted that “it is certainly possible that some egregious GAAP violations may help support an inference of scienter for pleading purposes.” The supposed lack of a reserve, however, added “nothing new” to the scienter allegations because the complaint had failed to plead facts establishing that PEC believed it would not be paid for its work.

Holding: Dismissal affirmed.

Quote of note: “”But this alleged GAAP violation adds nothing new; rather it simply rides around in circles on the inadequate coattails of the scienter pleading. For if PEC was to take a reserve only when it believed non-payment was ‘probable’ . . . and that ‘the amount of the loss can be reasonably estimated,’ we are brought back to Appellants’ previous problem that they have not pled facts that give rise to a strong inference that PEC ever believed it would not get paid by Pearson while making the public statements that the [Complaint] challenges.”

Disclosure: The author of The 10b-5 Daily argued the case before the appellate court on behalf of the defendants. Note that the case has also received some attention for the results of the court’s spell-checking.

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