Control Person Puzzle

In a typical securities class action, the dismissal of the claims against the individual defendants leads to the dismissal of the claims against the company. In the absence of an underlying Rule 10b-5 violation, there also can be no control person liability. But consider this scenario: the suit is stayed against the controlled entity because it is in bankruptcy. Can the control person claims continue against the individual defendants even if the Rule 10b-5 claims against them have been dismissed? The U.S. Court of Appeals for the First Circuit says yes, but how the district court is supposed to implement the decision is unclear.

In In re Stone & Webster, Inc. Sec. Litig., 414 F.3d 187 (1st Cir. 2005), the court affirmed the dismissal of the Rule 10b-5 claims against the CEO and CFO of Stone & Webster (the only individual defendants in the case) based on the failure to adequately plead scienter (i.e., fraudulent intent). The Section 20(a) claims for control person liability against the CEO and CFO, however, were allowed to continue. The CEO and CFO petitioned for rehearing on this issue, arguing that the dismissal of the underlying Rule 10b-5 claims necessitated the dismissal of the Section 20(a) claims.

In a separate opinion, the court denied the petition. See In re Stone & Webster, Inc. Sec. Litig., 2005 WL 2216319 (Sept. 13, 2005). The claims against the company had not been dismissed. Instead, they had been stayed when the company filed for bankruptcy protection. The court held that the dismissal of the Rule 10b-5 claims against the CEO and CFO “is in no way incompatible with the establishment of their secondary liability under Sec. 20(a) as controlling persons of Stone & Webster, predicated on Stone & Webster having violated Rule 10b-5.”

On remand, however, the district court appears to be presented with a difficult puzzle. Whether a defendant corporation has acted with scienter is normally determined by looking “to the state of mind of the individual corporate official or officials who make or issue the statement . . . rather than generally to the collective knowledge of all the corporation’s officers and employees acquired in the course of their employment.” Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353 (5th Cir. 2004). The CEO and CFO were the only individual defendants in the case. If the case is not going to proceed against them, how can the corporation be found to have acted with scienter? The opinion refers to the possibility that “the acts of other agents might also serve as predicates for the Sec. 20(a) liability,” but this seems like merely a theoretical assertion if all of the individual defendants have been dismissed. Stay tuned.

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