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).
Summary judgment decisions are usually fact specific and do not provide a lot of insight into how other cases will be decided. The recent decision in In re Federal National Mortgage Association Sec., Derivative, and “ERISA” Lit., 2012 WL 4888506 (D.D.C. Oct. 16, 2012), however, contains some interesting lessons.
The case against Fannie Mae is one of the longest-running securities class actions in the country, with the first complaint having been filed in Sept. 2004. The case arises out of accounting issues that ultimately resulted in a massive restatement. As detailed in the court’s decision, there have been numerous reports and findings of regulators relating to the events in question. During the relevant period, J. Timothy Howard was the CFO of Fannie Mae.
Following prolonged discovery in the case, Howard moved for summary judgment, arguing that the plaintiffs had failed to establish he acted with scienter. The court agreed, finding that despite all of the smoke around Howard’s activities as CFO, there was no evidence of an actual fire. A few key points:
(1) Stretching the Evidence – The court appeared annoyed at what it viewed as the plaintiffs’ attempt to “stich together a patchwork quilt of evidence that they allege presents a disputed issue of material facts as to Howard’s scienter.” The plaintiffs had no direct evidence of Howard’s knowledge of any accounting fraud and, in the court’s view, frequently resorted to overstating the circumstantial evidence.
(2) Outside Reports – The court rejected the plaintiffs’ use of “post-hoc reports and litigation documents, which were uniformly prepared after the relevant events in this case, and some of which were explicitly prepared in preparation for litigation, as ‘evidence’ of Howard’s scienter.” Not only were these materials likely inadmissible, but none of them specifically demonstrated how Howard had acted with scienter.
(3) Relying on Motion to Dismiss Arguments – The plaintiffs argued that the magnitude and duration of the accounting fraud was evidence of Howard’s scienter. The court’s response was (a) “as Shakespeare might have noted: a giant body doth not portend an evil mind,” and (b) “the time for simply presenting allegations that give rise to a strong inference of scienter has long since passed.”
Holding: Individual defendant’s motion for summary judgment granted.
Oral argument took place in the Amgen case in the U.S. Supreme Court this morning. The case involves the issue of whether, to obtain class certification, a plaintiff must prove that an alleged misstatement was material and therefore can support a fraud-on-the-market presumption (reliance by investors on the misstatement is presumed if the misstatement is material and the company's shares were traded on an efficient market that would have incorporated the information into the stock price).
The argument focused heavily on whether it was appropriate to decide the issue of materiality at the class certification stage given that it is both a predicate for the use of the fraud-on-the-market presumption and a substantive element of the securities fraud claim.
A few highlights:
(1) The parties agreed that materiality was a "common issue" for all the class members, but not on whether that fact should preclude it being examined at the class certification stage of the case. Petitioner (Amgen) had some difficulty persuading the Court that a distinction could be drawn between determining materiality at the class certification stage for purposes of the fraud-on-the-market presumption and determining materiality on the merits. A few justices pressed whether it was Petitioner's position, as Justice Kagan put it, "that a judge who has just ruled that a statement is immaterial is going to keep the case in his court litigated by an individual plaintiff, even though he's just ruled that the statement is immaterial?" Petitioner insisted that this was possible, because the judge would not be able to resolve disputed facts at the summary judgment stage of a case brought by an individual plaintiff. Justice Breyer questioned whether this established too much, because why not "try out everything [at class certification], because we could always think of a few examples where, despite the fact that, you know, it's only a common issue 99 percent of the time, we can dream up a situtation where it's not a common issue."
(2) More broadly, Petitioner argued that the purpose of FRCP 23 "is for a court to determine whether all of the preconditions for forcing everyone into a class action are present before you certify." Because materiality is "an essential predicate of the fraud-on-the-market theory" and that theory is necessary to certify a securities fraud class, it follows that the court must determine the existence of materiality at class certification.
(3) In turn, Respondent (investors) was asked numerous questions about why the Court should draw a distinction between market efficiency (another predicate for the fraud-on-the-market presumption that can be rebutted at the class certification stage) and materiality. Justice Scalia noted that market efficiency also is a common issue that, if decided by the judge at class certification, might preclude individual investors from bringing a suit because they could not say "that's why I got cheated, because the market reflected this false statement and I paid more money for the stock than I should have." Respondent - with some assistance from Justice Breyer - argued that the difference was that market efficiency is merely a "gate-keeping function to determine whether or not the answer for indirect reliance on the market is a common question," while materiality is a traditional element of a fraud.
(4) For its part, the government argued in support of Respondent, stating that "materiality in a fraud-on-the-market case serves two purposes . . . . And what Petitioners would have this Court do is isolate the two inquiries when they're really the same question." Justice Scalia's response: "If you have the same question, then maybe we shouldn't have this fraud-on-the-market theory . . . . So maybe we should overrule Basic [the Supreme Court case endorsing the fraud-on-the-market presumption] because it was certainly based upon a theory that simply collapses once you remove the materiality element."
1. Whether, in a misrepresentation case under SEC Rule 10b-5, the district court must require proof of materiality before certifying a plaintiff class based on the fraud-on-the-market theory.
2. Whether, in such a case, the district court must allow the defendant to present evidence rebutting the applicability of the fraud-on-the-market theory before certifying a plaintiff class based on that theory.
The court will be addressing a circuit split on these issues. Three circuit courts (Second, Fifth and, to a lesser extent, the Third) previously have held that materiality is a required part of the fraud-on-the-market analysis when evaluating whether a class should be certified. The Ninth Circuit joined a decision from the Seventh Circuit, however, in rejecting that position and holding that materiality is a merits question that does not affect whether class certification is appropriate.