What Lower-Level Employees Know

A corporation’s scienter (i.e., fraudulent intent) may be imputed in a securities fraud case, under Second Circuit precedent, from (a) the scienter of an individual defendant who made the alleged misstatement, (b) the scienter of officers or directors who were involved in the dissemination of the fraud, or (c) in rare circumstances, from a statement that is so obviously incorrect that it can be inferred that the makers must have known that it was false.

In Jackson v. Abernathy, 960 F.3d 94 (2d Cir. May 27, 2020) (per curiam), the plaintiffs alleged that the company told investors that its surgical gowns were highly-rated for their protectiveness, but in fact the gowns had failed numerous quality control tests. The plaintiffs argued that the company’s scienter could be imputed based on (a) the knowledge of three lower-level employees, who testified in a different litigation that they were aware that the surgical gowns had failed quality control tests, and/or (b) the surgical gowns were a key company product, so senior management must have known about the test failures. The Second Circuit found that these allegations were insufficient to adequately plead the company’s scienter.

First, as to the lower-level employees, the Second Circuit concluded that the employees did not act with scienter because they took steps to raise warnings about problems with the gowns. Moreover, the complaint failed to plead any facts establishing that these employees were involved with the misstatements or had adequately conveyed their warnings to senior management. The court therefore was left to “only guess what role those employees played in crafting or reviewing the challenged statements and whether it would otherwise be fair to charge the [company] with their knowledge.”

Second, as to the allegation that the gowns were a key product, the Second Circuit found that this “naked assertion, without more, is plainly insufficient to raise a strong inference of collective corporate scienter.”

Holding: Affirming lower court decision that amended complaint would be futile.

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