Core Operations

There is a recent appellate trend of finding “must have known” allegations sufficient to establish a strong inference of scienter in situations where the underlying events are deemed to be highly important to the corporation (e.g., Dynex Capital (2nd Cir.), Tellabs II (7th Cir.), and Applied Signal (9th Cir.)).

In South Ferry LP v. Killinger, 2008 WL 4138237 (9th Cir. Sept. 9, 2008), the court examined exactly when “a scienter theory that infers that facts critical to a business’s ‘core operations’ or an important transaction are known to a company’s key officers” establishes a strong inference of scienter. The court found that these allegations may help to satisfy the pleading standard in three circumstances.

(1) “[T]he allegations may be used in any form along with other allegations that, when read together, raise an inference of scienter that is ‘cogent and compelling, thus strong in light of other explanations.'” (citing Tellabs)

(2) The “allegations may independently satisfy the [scienter pleading standard] where they are particular and suggest that defendants had actual access to the disputed information.”

(3) The “allegations may conceivably satisfy the [scienter pleading] standard in a more bare form, without accompanying particularized allegations, in rare circumstances where the nature of the relevant fact is of such prominence that it would be ‘absurd’ to suggest that management was without knowledge of the matter.”

Although the first two tests are uncontroversial, the “absurdity” test appears difficult to apply in a consistent fashion. The court cited the Applied Signal case, where the defendants allegedly failed to disclose stop-work orders from the company’s largest customers even though they had a devastating effect on revenues, as one of the “exceedingly rare” cases where the core operations inference, without more, was sufficient. But whether lower courts will find that the core operations inference is sufficient only in “exceedingly rare” cases remains to be seen.
Holding: Remanded for further proceedings consistent with the opinion.

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