Category Archives: Motion To Dismiss Monitor

In its Tellabs decision, the U.S. Supreme Court created an “at least as compelling” standard for weighing competing inferences of scienter in securities fraud cases. The fact that a draw goes to the plaintiff was criticized by Justice Scalia in his concurrence, although he noted that his preferred “more plausible” standard would be unlikely to have much of a practical effect because “[h]ow often is it that inferences are precisely in equipoise?” Beware of rhetorical questions.

In In Re Paincare Holdings Sec. Litig., 2008 WL 348781 (M.D. Fla. Feb. 7, 2008), the court considered an amended complaint filed after a dismissal without prejudice. The magistrate judge (whose order was adopted by the court), found that scienter had been adequately plead because “the inference of scienter is equal to the inference of non-fraudulent intent.” In support of its holding, the decision noted the sheer magnitude of the financial restatement, the company’s ambitious acquisition strategy, and the company’s alleged false rationalization for the financial restatement.

Quote of note: “To the extent the reason offered to the public [for the financial restatement] was not true, one can infer that the Company had a reason not to delve too deeply in presenting its mea culpa to the public. While fecklessness is not recklessness, when truly falling on your sword, you aim for the heart.”

A couple of notable recent decisions:

(1) In In re Cardinal Health Inc. Sec. Litig., 528 F. Supp. 2d 752 (S.D. Ohio 2007), the court considered a requested attorney fee award of $145 million (24% of the $600 million settlement). The court found that the absence of an ex-ante fee arrangement between the lead plaintiff group and lead counsel required it to “undertake an independent analysis to determine reasonable attorneys’ fees.” The court ultimately awarded an 18% fee award, with a high lodestar multiplier of 6, based on the “excellent recovery, considerable effort and time, and high quality of lawyering.”

Quote of note: “[T]his court would . . . recommend that courts, in addition to the established requirements, look favorably on the presence of an ex-ante fee arrangement in its [sic] decision to approve lead plaintiff and lead counsel. Alternatively, Congress could amend the PSLRA to mandate lead plaintiffs to enter into a fee arrangement with lead counsel before the court formally approves lead counsel. Under this approach, sophisticated parties would be encouraged to negotiate fee arrangements without the bias of hindsight, and they could reach presumptively reasonable results that the court can review.”

(2) In In re Pfizer, Inc. Sec. Litig., 2008 WL 540120 (S.D.N.Y. Feb. 28, 2008), the court considered whether an anonymous blog post could provide reliable factual allegations. The plaintiffs asserted that the blogger was actually a former Pfizer officer. The court found that there was insufficient information about the blogger’s identity and, even accepting that he had been employed at Pfizer, it was unclear whether the blogger “would have been likely to know the relevant facts.”

Quote of note: The blogger’s “allegation does not claim to be based on personal knowledge and lacks detail that might suggest personal knowledge. For example, the blog post does not describe when, how, on what basis, by whom, or to whom the alleged warning was communicated.”

Motive is in the eye of the beholder. Many courts have found that the sale of stock by corporate insiders just before the announcement of bad news is “suspicious” and can contribute to an inference of scienter (i.e., fraudulent intent). In a decision from earlier this summer, however, a federal district court came to the exact opposite conclusion. The court’s apparent theory was that if the defendants had committed a fraud, they surely would have done it better.

In In re Hutchinson Technology Inc. Sec. Litig., 2007 WL 1620805 (D. Minn. June 4, 2007), three of the individual defendants sold stock a month before dramatically lowering the company’s finanical projections. The court found that “it would have been in [the defendants] interests to put off the disclosure of that bad news as long as possible, because the closer the release of the bad news followed on the heels of their stock sales, the more suspicious those sales would have appeared.” The fact that the defendants did not delay the release of the news, according the the court’s reasoning, removed any suspicion from the stock sales.

Holding: Motion to dismiss granted (with prejudice).

There are two prongs to the PSLRA’s safe harbor for forward-looking statements. First, a defendant shall not be liable with respect to any forward-looking statement if it is identified as forward-looking and is accompanied by “meaningful cautionary statements” that alert investors to the factors that could cause actual results to differ. Second, a defendant shall not be liable with respect to any forward-looking statement, even in the absence of meaningful cautionary statements, if the plaintiff cannot establish that the statement was made with “actual knowledge” that it was false or misleading.

Although the two prongs are written in the alternative, courts frequently have rebelled against the plain language of the statute because it appears to provide defendants with a “license to defraud” investors about a company’s future prospects so long as the statement is accompanied by meaningful cautionary language.

In a decision issued this week, In re Nash Finch Co. Sec. Litig., 2007 WL 1266658 (D.Minn. May 1, 2007), the court noted that the Eighth Circuit had not yet addressed the question of “whether allegations of actual knowledge defeat the safe harbor when cautionary language is present.” The defendants argued that their knowledge of the truth or falsity of the forward-looking statements was irrelevant under the first prong of the safe harbor. The court held, however, that “cautionary language can not be ‘meaningful’ when defendants know that the potential risks they have identified have in fact already occurred, and that the positive statements they are making are false.”

If the market were aware during the class period of the allegedly omitted information, could the investors later argue that they were defrauded? Some courts have declined to consider a “truth on the market” defense raised as part of a motion to dismiss because it presents factual issues. Other courts, however, have been willing to examine public documents available to investors and conclude that any failure on the part of the defendants to disclose material information was excused by its availability from other sources. Two recent decisions have taken the latter approach and dismissed securities fraud claims.

In Ley v. Visteon Corp., 2006 WL 2559795 (E.D. Mich. Aug. 31, 2006), the court considered whether claims based on “Visteon’s Ford-related operational issues” should be dismissed because these issues were discussed in analyst reports and newspaper articles during the class period. Although the plaintiffs argued that a truth on the market defense would be premature at the motion to dismiss stage of the case, the court disagreed, finding that it could “consider publications by market analysts in determining if the market had sufficient knowledge of Defendants’ various deficiencies.” The court concluded that it was clear from these publications that the market was aware of “Visteon’s inability to shed unprofitable business lines inherited from Ford, high labor costs, price reductions owed to Ford, and general reliance upon Ford.”

Similarly, in In re Discovery Laboratories Sec. Litig., 2006 WL 3227767 (E.D. Pa. Nov. 1, 2006), the court examined whether certain statements related to the FDA-approval process for a drug product were materially misleading in light of the public information available to the market. The court held that the “‘truth on the market’ defense does not require that any investor should be capable of finding the information and understanding its significance based on a single click for a simple Web search.” Instead, the standard is “reasonable investors, those who we can assume exercise due investment diligence.” Based on public reports of facility problems and the widely known fact that the company would need to comply with FDA regulations to obtain approval for the drug, the court found that the alleged misstatements related to those issues were inactionable.

Courts continue to struggle with the question of how to determine the scienter (i.e., fraudulent intent) of a defendant corporation. Should a court examine the collective knowledge of the corporation’s employees (collective scienter theory) or should it look to the state of mind of the individual corporate official or officials who made the false or misleading statement (which some courts have found is required under the common law of agency)? As The 10b-5 Daily has noted, between these two positions is a weaker version of the collective scienter theory that allows a plaintiff to establish the scienter of a defendant corporation by showing that a management-level employee of the corporation acted with knowledge or recklessness, even if that employee was not an individual defendant and did not make any alleged false statements.

The weaker version of the collective scienter theory, however, suffers from a lack of judicial uniformity as to exactly which employees can have their state of mind imputed to the corporation. One possible definition can be found in a recent decision – Hill v. The Tribune Co., 2006 WL 2861016 (N.D. Ill. Sept. 29, 2006) – dismissing a securities class action. The court found that a “corporation’s scienter is generally limited to being based on knowledge or scienter of a senior officer or director of the corporation, or an employee involved in issuing the alleged misrepresentation.” Because the plaintiffs were unable to “adequately allege that those responsible for [Tribune’s] SEC filings and press releases recklessly relied on the circulation figures that were provided” by lower-level employees, the court held that the defendant corporation’s scienter was not adequately alleged.

Whether a plaintiff can establish the scienter (i.e., fraudulent intent) of a defendant corporation based on the collective knowledge of the corporation’s employees (commonly referred to as the “collective scienter” theory), is a topic that has been simmering in the courts for a number of years. When The 10b-5 Daily last checked in on the status of the issue back in 2004, the Sixth Circuit had issued an opinion in the Bridgestone securities litigation that appeared to apply a collective scienter theory. Although the opinion did not specifically discuss the issue, the court’s holding clearly was incompatible with the Fifth and Ninth Circuits’ previous rulings that a defendant corporation only can be deemed to have acted with scienter if the individual officer making the alleged false statement acted with scienter.

Fast forward a couple of years and the collective scienter theory is gaining traction in certain district courts. There are two distinct versions of the theory being applied.

Under the weaker version, it is sufficient for a plaintiff to establish that a management-level employee of the corporation acted with fraudulent intent, even if that employee is not a defendant and did not make any alleged false statement. Two recent decisions from the D. of Mass. and the S.D.N.Y. have adopted this version. In re Sonus Networks, Inc. Sec. Litig., 2006 WL 1308165 (D. Mass. May 10, 2006) (scienter of former controller attributable to corporation); In re Marsh & McLennan Companies, Inc. Sec. Litig., 2006 WL 2057194 (S.D.N.Y. July 20, 2006) (scienter of “particular management-level employees identified in the Complaint” attributable to corporation).

Under the stronger version, a plaintiff can establish that the corporation acted with fraudulent intent without any reference to a particular employee. Not only has this version been adopted by a court in the S.D.N.Y., but that court has certified the issue for interlocutory appeal to the Second Circuit. In re Dynex Capital, Inc. Sec. Litig., 2006 WL 1517580 (S.D.N.Y. June 2, 2006) (finding that relevant prior decisions from Second Circuit do not clearly decide issue).

So stay tuned. The Second Circuit will have the opportunity to decide a question that The 10b-5 Daily posited years ago: if an officer makes the statement and a janitor knows the statement is false, has the corporation acted with fraudulent intent? If the answer is “yes,” there will be an open circuit split on corporate scienter.

The New York Law Journal has an article (via law.com) in its August 14 edition discussing the dismissal of the federal securities claims in the Salomon Smith Barney mutual fund fees litigation. The plaintiffs had “accused the investment firm of offering undisclosed incentives to brokers and financial advisers, extracting improper fees from investors in its proprietary funds and encouraging its propriety funds to invest in poorly performing companies because of their status as Smith Barney investment banking clients.” In its decision – In re Salomon Smith Barney Mut. Fund Fees Litigation, 2006 WL 2085979 (S.D.N.Y. July 26, 2006) – the court dismissed both the ’34 Act (Rule 10b-5) and ’33 Act (Sections 11 and 12) claims based on the failure to adequately plead loss causation.

Quote of note (opinion): “Here, Plaintiffs have not only not alleged why they lost money on their purchase of the mutual fund stock, they have not alleged even that they in fact lost money on their purchase of the mutual fund stock (i.e., that the mutual fund share price dropped and that it dropped for the precise reason complained of).”