Yet again, collective scienter is proving to be the unwelcome legal theory that refuses to die.
Collective scienter presumes that a plaintiff can sue a company for fraud without blaming any specific person at the company; instead, plaintiffs argue that various misdeeds and blunders all total up to collective responsibility assigned to the company overall.
As one might expect, companies contest the logic of collective scienter vigorously—and most of the time, federal judges have ruled in their favor. A recent decision in the ever-important 2nd Circuit Court of Appeals, however, has left open a toehold for plaintiffs to use in class-action shareholder lawsuits.
Many observers had hoped the case, Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital, would close the door on arguments of collective scienter for good. But a three-judge appellate panel found that while the plaintiffs in this particular case failed to meet the standard to plead collective scienter, such a standard does exist and can—at least in theory—be met.
McGuirk
It seems to suggest it is possible to claim collective scienter,” says Richard McGuirk, a securities litigation partner at the law firm Nixon Peabody. “But it sets high hurdles to do so.”
The Second Circuit’s decision does underscore the heavy pleading burdens imposed by the Private Securities Litigation Reform Act and recent case law. Enacted in 1995, the PSLRA was intended to force plaintiffs to demonstrate scienter (that is, a knowing intent to commit wrongdoing) when suing a company for securities fraud. Courts have largely interpreted that to mean a plaintiff must show the company’s executives knew they were defrauding investors.
“A lot of commentators expected a black-and-white decision on the so-called collective scienter theory,” says Robert Malionek of the law firm Latham & Watkins. “But you must read between the lines to determine where the Second Circuit is headed. Once you do that, it’s apparent that all or much of the collective scienter theory is dead or dying.”
The case was filed by the Teamsters and other investors who bought mortgage-backed securities issued by Merit Securities Corp., a subsidiary of Dynex Capital. When the housing market tanked and took those securities along with it, the Teamsters sued Merit, Dynex, and the chief executives of both companies, alleging that they knowingly misrepresented the value of the underlying collateral (the mortgages).
The defendants sought to dismiss the complaint, arguing that the Teamsters had failed to plead adequate scienter. A district court quickly agreed for the complaints against the two chief executives. But the court also stated that Dynex as a whole “systematically disregarded various indicia of borrowers’ creditworthiness,” and that lax behavior supported the plaintiffs’ claims of securities fraud. The court let those complaints proceed.
SCIENTER ABSENT
The following excerpt from Teamsters Local 445 v. Dynex Capital contends the Teamsters failed to convince the court of scienter:
Accordingly, we reject appellants’ contention that Teamsters failed as a matter of law
to plead scienter against Dynex and Merit when it failed to plead
scienter against Potts and Benedetti. Congress has imposed
strict requirements on securities fraud pleading, but we do not
believe they have imposed the rule urged by defendants, that in
no case can corporate scienter be pleaded in the absence of
successfully pleading scienter as to an expressly named officer.
Nevertheless, because we review the denial of a motion to
dismiss de novo, we must still determine whether Teamsters has
raised a “strong inference” of scienter against Dynex and Merit.
Teamsters argues that their complaint satisfies the pleading
requirements of the PSLRA, as explained in Novak, in three ways.
First, they claim that they have sufficiently pleaded that Dynex
“knew facts or had access to information suggesting that their
public statements were not accurate,”
because senior executives such as Potts and Benedetti had access
to “collection data” which “reflected the high percentage of Buy
Fair [sic] Loans, First Payment Default delinquencies and failed
or impaired repossessions.”
These
data, Teamsters claims, would reveal “that the true reason” for
the underperforming bond collateral was “the manner in which the
collateral was originated.” Id. But, as we observed in Novak,
“[w]here plaintiffs contend defendants had access to contrary
facts, they must specifically identify the reports or statements
containing this information.” Teamsters’ broad
reference to raw data lacks even an allegation that these data
had been collected into reports that demonstrated that loan
origination practices were undermining the collateral’s
performance. Accordingly, they have not raised an inference of
scienter based on knowledge of or access to information
demonstrating the inaccuracy of Dynex’s public statements.
These
data, Teamsters claims, would reveal “that the true reason” for
the underperforming bond collateral was “the manner in which the
collateral was originated.” Id. But, as we observed in Novak,
“[w]here plaintiffs contend defendants had access to contrary
facts, they must specifically identify the reports or statements
containing this information.” Teamsters’ broad
reference to raw data lacks even an allegation that these data
had been collected into reports that demonstrated that loan
origination practices were undermining the collateral’s
performance. Accordingly, they have not raised an inference of
scienter based on knowledge of or access to information
demonstrating the inaccuracy of Dynex’s public statements.
Teamsters’ second contention fails for much the same reason.
They argue that they have raised an inference of scienter by
alleging that “the defendants failed to review or check
information that they had a duty to monitor.” But
again, they have not specifically identified any reports or
statements that would have come to light in a reasonable
investigation and that would have demonstrated the falsity of the
allegedly misleading statements.
Source
Teamsters Local 445 v. Dynex Capital (June 26, 2008).
In late June, the 2nd Circuit Court of Appeals overturned the district court’s ruling and dismissed the Teamsters’ complaint entirely. But the appeals court stopped short of overturning the idea of collective scienter entirely, and specifically said: “It is possible to raise the required inference with regard to a corporate defendant without doing so with regard to a specific individual defendant.” In other words, a plaintiff can sue a company for securities fraud without naming individual defendants.
The appeals court even referred to the famed Tellabs decision of 2007, where the U.S. Supreme Court set a high standard for proving scienter, asserting: “[I]t is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud.”
McGuirk says the decision is “trying to avoid saying there can never be a collective scienter.”
More Consequences
Latham & Watkins sent out a legal bulletin recently reminding clients that the 2nd Circuit decision draws a distinction between a plaintiff’s burden of proof and its burden of pleading. To prove liability, a plaintiff must still prove that an agent of the corporation committed a culpable act with the necessary scienter. For pleading purposes, however, a plaintiff only need state facts that “create a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter.” Technically, the plaintiff does not need to identify the individual by name at the pleading stage to create the necessary inference, Latham adds.
Greg Ballard, a partner at the Howrey law firm, downplays the significance of that idea. “The way [the court] phrased the point, it is very difficult, if not impossible to craft a complaint and level securities charges against a company without identifying a specific person,” he says.
Malionek
After the Dynex decision, Malionek says, a plaintiff will have to provide more specifics to demonstrate that an individual agent’s actions and state of mind can be imputed to the company. Under one interpretation of the collective scienter theory used in the past, he says, a plaintiff would try to combine the states of mind of various employees, like putting a puzzle together, to allege that the company acted with scienter even if scienter did not exist in any one agent of the company. “You can’t do that anymore,” he says.
The law firm Skadden Arps, meanwhile, says the Dynex ruling will have implications beyond whether a plaintiff can allege “collective scienter.” In a recent bulletin, the firm says the decision could affect whether courts in the future will permit shareholder lawsuits related to the sub-prime crisis—and there is no shortage of such lawsuits these days—to move forward.
In dismissing the Teamsters’ complaint, the appeals court held that the chance that the poor performance of certain mortgage-backed securities was the result of general market weakness was stronger than any chance of fraud on the part of Dynex or Merit. The plaintiffs also failed to allege that anyone at the two companies “had a compelling motive to mislead investors regarding the bonds,” the court said in its decision.
“This latter ruling will be of great significance in the many sub-prime mortgage-related litigations that are making their way through the courts,” the Skadden Arps bulletin noted.
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