Saturday, June 14, 2014

Liability Begins at the Top

Via the 10-5 Daily, I learned of the case In re Maxwell Technologies, Inc. Sec. Litig., 2014 WL 1796694 (S.D. Cal. May 5, 2014), which dismissed the plaintiffs’ securities fraud claims for failure to plead scienter.  The case interests me, because I have actually just written a paper on this very subject, forthcoming in the Washington University Law Review (in April 2015 – it’ll be a while!)

[More under the cut]

In Maxwell Technologies, it was conceded that the company made secret arrangements with distributors to ship goods to them, but without obliging them to pay.  As a result, its reported sales revenues were false.  The revenue reports were signed by the company’s CEO and CFO.  It was essentially undisputed that one of Maxwell’s executives, who reported to the CEO, was involved with the wrongdoing. 

The plaintiffs claimed that even if the CEO himself had not been involved in the fraud, his subordinate’s scienter could be imputed to the company, such that the corporate defendant could be liable for Section 10(b) violations.

The court rejected this argument.  In the court’s view, the company itself could only be held liable if the CEO and CFO – the only officers who attached their names to the false statements – could be shown to have acted with scienter.

In my paper, I argue that this is actually a very common approach to determining corporate scienter under Section 10(b), although courts often try to obscure how limited their conceptions of corporate scienter actually are.  Routinely, courts hold that even in the face of company admissions that lower level employees intentionally filtered up false information through corporate reporting channels, company scienter can only be shown if the person who spoke directly to the public – usually, the CEO or CFO – acted with scienter. 

The reason this is so striking is that it is directly contrary to what at least several courts have claimed is the rule for determining corporate scienter.  Though different courts have had different standards, one common formulation was first announced in the Fifth Circuit’s decision in Southland Sec. Corp. v. INSpire Ins. Solutions Inc., 365 F.3d 353 (5th Cir. 2004), which holds that corporate scienter exists where a behind-the-scenes actor distributes false information to the CEO for public distribution.  As the Fifth Circuit put it, to determine corporate scienter the court must “look to the state of mind of the individual corporate official or officials who make or issue the statement (or order or approve it or its making or issuance, or who furnish information or language for inclusion therein, or the like).”  The Second Circuit has announced a similar type of standard.  Despite lip service to these rules, they are almost never applied.  Even the Fifth Circuit itself dodges its own standard.  See Pipefitters Local No. 636 Defined Benefit Plan v. Zale Corp., 499 Fed. Appx. 345 (5th Cir. 2012)

My paper examines the phenomenon and argues that the corporate liability scheme under Section 10(b) is unlike the most other areas of law, and poses some hypotheses for why Section 10(b) is treated so differently.  But suffice to say, despite the Southland rule and similar formulations, it is in fact a strikingly rare occurrence for courts actually to apply them as written.  As a practical matter, when it comes to Section 10(b), corporate scienter begins and ends at the top.

Ann Lipton | Permalink


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