The 10b-5 Daily

In its Tellabs decision, the U.S. Supreme Court held that a court must assess a plaintiff’s scienter (i.e., fraudulent intent) allegations “holistically” in determining whether the plaintiff has met the requisite “strong inference” pleading standard. The 10b-5 Daily noted at the time of the Tellabs decision that this holding “would appear to alter the evaluation of scienter in the Second Circuit and Third Circuit, both of which have held that a court can examine allegations of motive or knowledge/recklessness separately.” The Second Circuit has failed to address this inconsistency, however, leading to decisions that are arguably at odds with binding precedent.

In In re Gentiva Sec. Litig., 2013 WL 5291297 (E.D.N.Y. Sept. 19, 2013), the court addressed allegations that the company violated Medicare rules and artificially inflated the Medicare payments it received. In its first motion to dismiss decision, the court found that the plaintiffs had failed to adequately plead either motive and opportunity to commit fraud or sufficient circumstantial evidence of conscious misbehavior.

As to the amended complaint, the court again concluded that there were insufficient allegations to establish that the “Individual Defendants knew or had access to information showing that Gentiva was pressuring its staff to provide as many therapy visits as possible to receive extra Medicare payments without consideration of patients’ needs.” On the issue of motive, however, the court found that two of the individual defendants had exercised stock options and sold a significant amount of shares during the class period. It also found that corporate scienter could be “inferred from the ‘suspicious’ insider stock sales.” Accordingly, the court denied the motion to dismiss “to the extent the Plaintiff seeks to establish scienter of the Defendants Malone, Potapchuk, and Gentiva based on a theory of ‘motive and opportunity.'”

What does it mean to “holistically” examine the complaint’s scienter allegations if they are divided into two categories? The court offers no explanation, but the responsibility ultimately lies with the Second Circuit, which needs to address this question.

Holding: Motion to dismiss denied, with the court curiously stating the plaintiff would “not be permitted to present . . . at trial” a theory of scienter based on circumstantial evidence of misbehavior or recklessness.

Under the PSLRA’s safe harbor for forward-looking statements, such statements cannot form the basis for securities fraud liability unless (a) the statements were not accompanied by “meaningful cautionary statements” and (b) the defendants had “actual knowledge” of their falsity. A company’s forward-looking statements, however, often contain some reference to present facts. Does that make these statements ineligible for the safe harbor?

In IBEW Local 98 Pension Fund v. Best Buy Co., Inc., 2013 WL 3982629 (D. Minn. Aug. 5, 2013), the court considered this question in evaluating whether the company’s statements that it was “on track to deliver and exceed our annual EPS guidance” and that its earnings were “essentially in line” with expectations were forward-looking. Although the defendants argued that these statements were simply affirmations of the projected guidance, and therefore forward-looking, the court concluded that they really were statements of present condition. Accordingly, the statements were not subject to the safe harbor.

Holding: Motion to dismiss granted in part and denied in part.

Are a company’s ethical guidelines material (i.e., important to the investment decision of a reasonable investor)? In Cement & Concrete Workers District Council Pension Fund v. Hewlett Packard Co., 2013 WL 4082011 (N.D. Cal. Aug. 9, 2013), the plaintiffs alleged that the CEO’s undisclosed relationship with an independent consultant (which lead to his firing and a significant stock price drop) caused the company’s ethical guidelines to be misleading “because in light of [the CEO’s] endorsement of these tenets, there was an implication that [he] was in fact in compliance with them.” In addition, the company’s public filings contained a disclosure about the risk to HP’s operations associated with the need to retain key executives, which the plaintiffs claimed was rendered misleading by the omission of the CEO’s “actual, fraudulent, and noncompliant business practices.”

The court concluded that both sets of statements were immaterial. As to the ethical guidelines, the court found that they were “not specific, nor do they suggest that [the CEO] was in compliance with them at the time they were published.” Indeed, no reasonable investor would “depend on [them] as a guarantee that [HP] would never take a step that might adversely affect its reputation.” Similarly, the plaintiffs’ argument that the risk factor about executive retention was material improperly conflated “the materiality of statements concerning whether [the CEO] would, in fact, remain at HP with the materiality of vague and routine statements concerning the retention of executives in general.”

Holding: Motion to dismiss granted (without prejudice).

The use (and potential abuse) of confidential witnesses continues to be a controversial topic in securities class actions. Some court decisions, particularly in the Boeing securities litigation, have been sharply critical of how the plaintiffs’ bar conducts its pre-filing investigations and decides what statements to include in its complaints. A recent decision from Judge Rakoff (S.D.N.Y), however, suggests that at least some of the problems may arise from witness “indiscretions.”

In City of Pontiac General Employees’ Retirement System v. Lockheed Martin Corp., 2013 WL 3389473 (S.D.N.Y. July 9, 2013), the court denied the defendants’ motion to dismiss. The defendants subsequently deposed the confidential witnesses cited in the complaint and filed a “limited motion for summary judgment” arguing that these witnesses had either recanted their statements or never made them in the first place. The court held an evidentiary hearing, denied the motion, and the parties settled. Nevertheless, the court decided to issue a memorandum on the issue of the confidential witness statements.

In its memorandum, the court noted that the testimony presented by the five confidential witnesses suggested “that some, though not all, of the CWs had been lured by the [plaintiff’s] investigator into stating as ‘facts’ what were often mere surmises, but then, when their indiscretions were revealed, felt pressured into denying outright statements they had actually made.” The court took particular issue with two of the confidential witnesses claiming that they only had short calls with the investigator when the plaintiffs’ phone records revealed that the main calls were both around an hour long. Moreover, two of the witnesses “confirmed the substance of the statements attributed to them in the Amended Complaint, while noting that such snippets did not always convey the nuances of what they had told [the investigator].” The fact that these witnesses testified to the accuracy of what the investigator had reported created an inference that the investigator’s report “was accurate in all material respects.”

Holding: Motion for summary judgment denied.

Quote of note: “It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate ‘private eyes’ who would entice naive or disgruntled employees into gossip sessions that might help support a federal lawsuit. Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate. But, as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.”