Not Sufficiently Colorful

An interesting motion to dismiss decision in the S.D.N.Y. – Dobina v. Weatherford Int’l Ltd., 2012 WL 5458148 (S.D.N.Y. Nov. 7, 2012) – touches upon several scienter pleading issues.

(1) Corporate Acquisitions – Does the artificial inflation of the company’s stock price to facilitate acquisitions establish a “motive” that can contribute to a demonstration of scienter (i.e., fraudulent intent)? The Second Circuit has held that there must be a “unique connection between the fraud and the acquisition,” but has “provided little guidance as to what this ‘unique connection’ must be.” The court found that, at a minimum, this requirement “demands more than alleging simply that the Company acquired companies during the class period with the use of stock.” Moreover, it is arguable that “any such motive to raise the stock price in order to fund acquisitions more cheaply would inure to the benefit of all shareholders, and thus would not demonstrate intent to defraud.”

(2) Core Operations Theory – Should knowledge of the falsity of statements about the “core operations” of a company be imputed to its key officers? The court noted that “it remains an open question whether the theory has survived the passage of the PSLRA.” Even if it applied the core operations theory, however, the court found that because it “may make such an inference does not mean that such an inference necessarily would be the most compelling [as required by the S. Ct.’s Tellabs decision].” As to the Weatherford defendants, the more compelling inference of scienter was “that the Company made an error in its tax accounting treatment in 2007 that persisted on its books, compounding over time, and leading to incorrect financial reporting that propagated up to management.”

(3) Auditor Scienter – Auditor scienter in the Second Circuit “turns on alleging that the auditor repeatedly failed to scrutinize serious signs of fraud” (i.e., ignored red flags). The court found that the plaintiffs’ allegations about what E&Y (Weatherford’s auditor) ignored, however, were either “not red flags at all” or “not sufficiently colorful.” In particular, the mere “size and nature of the fraud” could not establish that “E&Y should have found it.”

Holding: Complaint dismissed, except for claims against two officers based on statements about the quality of internal controls (and related control claims).

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