Saturday, November 25, 2017
The PSLRA requires that complaints alleging Section 10(b) violations plead facts that raise a “strong inference” that the defendant acted with intent or recklessness. 15 U.S.C. § 78u-4. A “strong inference” is one that, taking into account “plausible opposing inferences,” is “at least as compelling as any opposing inference one could draw from the facts alleged.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007).
It has long been an axiom of PSLRA pleading that a strong inference may be raised by alleging that the defendant knew his or her statements were false, or knew facts that contradicted his or her public statements. See, e.g., Novak v. Kasaks, 216 F.3d 300 (2d Cir. 2000); Miss. Pub. Emples. Ret. Sys. v. Boston Sci. Corp., 523 F.3d 75 (1st Cir.2008); Fla. State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645, 665 (8th Cir.2001); Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981 (9th Cir. 2009); Pugh v. Tribune Co., 521 F.3d 686 (7th Cir. 2008). Indeed, allegations of actual knowledge of falsity are sufficient to plead scienter even in the context of forward-looking statements, which are subject to their own special heightened pleading requirements. See 15 U.S.C. §78u-5.
In Maguire Fin. LP v. PowerSecure Int'l Inc., 4th Cir., No. 16-2163, the Fourth Circuit concluded that even when a plaintiff pleads that a CEO had knowledge of the falsity of the statements he issued on an analyst conference call, that is not sufficient to allege scienter under the PSLRA.
The basic claim was that the CEO told analysts that the company was “blessed to announce securing a $49 million three-year contract renewal, both the renewal and expansion with one of the largest investor [owned] utilities in the country,” when, in fact, the referenced contract was a new contract with an existing client, rather than a renewal. As it turned out, the expenses on this new contract caused the corporation to experience losses and, eventually, a dramatic stock price drop.
The Fourth Circuit accepted that the CEO knew the nature of the new contract when he described it to market analysts, but refused to accept the inference that the mischaracterization was intentional or reckless. Instead, the court argued that the CEO had no reason to believe the new contract would be unprofitable – and thus no reason to want to deceive the market about it – and though ordinary persons may have read the CEO’s statement to mean that a contract had been renewed, the CEO might not have realized that this was the common interpretation. The court reasoned that if the CEO had, in fact, intended to deceive investors about whether the contract was new, he would have elaborated on his statement, and offered additional false claims about it. The fact that he had not done so, the court concluded, contributed to an inference that he had not intended to deceive in the first place. The court ultimately opined, “Appellant alleges facts that permit an inference that Hinton knew his statement was false, and then asks us to infer from that inference that Hinton acted with scienter. We decline to do so because stacking inference upon inference in this manner violates the statute’s mandate that the strong inference of scienter be supported by facts, not other inferences.”
Look, I agree that on these facts, it’s very possible that the CEO misspoke. And I personally would like to know whether analysts reacting to the original conference call made their misunderstanding clear (so that the company could not claim to be unaware that the market had misunderstood the CEO’s representations). But this is a complaint. The issue is whether the plaintiffs have identified sufficient facts to get to discovery. The Fourth Circuit seems to have lost sight of this basic function of the pleading requirements, and instead interpreted its mandate to require dismissal so long as there is any nonculpable interpretation of the facts. The Circuit’s eagerness to draw exculpatory inferences from the CEO’s failure to tell an even greater lie bears a resemblance to pre-Tellabs caselaw reasoning that if an executive fails to dump his stock when making allegedly false statements – thus coupling a deceptive statement with a violation of insider trading prohibitions – the executive must not have acted with scienter. Such logic was, of course, rejected by the Supreme Court in Tellabs: not every instance of fraud is part of a carefully-calibrated scheme.
Meanwhile, the Court ignored the very damning fact that the company’s highest officer issued a knowing falsehood and allowed it to stand uncorrected for several months. The Circuit’s extraordinarily technical reason for rejecting the plaintiffs’ inferences – that the plaintiffs asked for an inference based on other inferences, rather than on facts – not only introduces an entirely unnecessary level of technicality into PSLRA pleading, but also contradicts the basic manner in which humans understand the world and attribute motivations and intentionality to other humans. When someone says things he knows are untrue, we infer that there was deceptive intent. Maybe that’s not the case, but the burden’s now on the speaker, not the listener. And if plaintiffs are not entitled to the basic inference that the defendant knew what his own words meant, the pleading standard serves no legitimate screening function; it’s simply an arbitrary barrier to the filing of securities claims.
If nothing else, the case highlights the essential folly at the core of the PSLRA heightened pleading requirements. Whether a complaint raises a “strong inference” of scienter depends entirely on the court’s background assumptions about plausible behavior from corporate officers. To some, it is plausible that a CEO could make such an innocent misstatement and fail to correct it for nearly a year; but surely one could plausibly believe that CEOs carefully prepare before they speak to analysts, and do not often make these kinds of mistakes unintentionally. One could plausibly believe that if the misstatement was innocently made, then the company would have corrected it shortly thereafter, and the fact that it did not do so suggests the statement was not so innocent after all. It might also be plausible that CEOs calibrate just how much they’re willing to lie to analysts, and are willing to be somewhat vague on certain matters in hopes of leaving a false impression, without being willing to go so far as to outright invent new facts to mislead the market. What seems plausible is entirely a function of one’s understanding of, and experience with, the world – and that’s quintessentially the function of the jury.