August 10, 2012

What Does "Holistic" Mean?

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 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." In the intervening years, however, the Second Circuit has not directly addressed this inconsistency, to the benefit of plaintiffs.

George v. China Automotive Systems, Inc., 2012 WL 3205062 (S.D.N.Y. Aug. 8, 2010) is a "Chinese reverse merger" case alleging that the company engaged in accounting fraud. In their motion to dismiss, the defendants argued that the plaintiffs had failed to adequately plead scienter. The court, citing Second Circuit precedent, noted that the "requisite 'strong inference' of scienter can be established by alleging facts showing (a) defendants' 'motive and opportunity' to commit the alleged fraud, or (b) strong circumstantial evidence of conscious misbehavior or recklessness." After examining the complaint, the court held that the plaintiffs' insider trading allegations, by themselves, were sufficient to establish motive and opportunity. In particular, four of the seven individual defendants "sold over 50% of their CAAS stock during the class period" and the individual defendants collectively made a net profit of nearly $42 million on their class period sales.

The defendants offered two counterarguments, both of which were rejected by the court. First, the defendants noted that the individual defendants had entered into Rule 10b5-1 stock trading plans. As a result "more than two-thirds of [their] sales were made pursuant to the 10b5-1 plans and the remaining sales are too small a fraction of total sales to establish 'unusual' trading." The court held that because the 10b5-1 trading plans were entered into during the class period, they could not be invoked "to disarm any inference of scienter raised by the Individual Defendants' sales of CAAS stock." Second, the defendants asserted that "the alleged accounting errors and misstatements regarding internal controls are insufficient to sustain a securities fraud claim." The court found that this assertion was "immaterial at this stage" because the plaintiffs had "sufficiently plead motive and opportunity."

It is difficult, in the wake of Tellabs, to see how a lower court can engage in the required weighing of competing inferences of scienter if it stops the exercise after finding that there has been "unusual" insider trading. The Second Circuit needs to sort this out.

Holding: Motion to dismiss denied (except as to an auditor defendant).

Posted by Lyle Roberts at August 10, 2012 8:57 PM | TrackBack
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