Still Talking About Corporate Scienter

A couple of weeks ago, I posted about how courts are not terribly precise when evaluating allegations of corporate scienter in Section 10(b) claims.  Since then, a couple of cases were decided that provide some useful examples of the problem.

First up, there’s the Second Circuit’s Plumbers & Steamfitters Local v. Danske Bank, decided earlier this week.  Apparently, the Estonia subsidiary of Danse Bank got into trouble for money laundering, and the plaintiffs alleged this resulted in a number of false statements by Danse Bank itself.  The court dismissed all of the statement claims on various grounds, and then turned to the final allegations that, due to Estonia’s conduct, Danse Bank had engaged in a scheme to defraud.  The court rejected the claim in a few brief sentences:

At no point do [the plaintiffs] articulate with precision the contours of an alleged scheme to defraud investors, or which specific acts were conducted in furtherance of it. Instead, the claim rests upon the incorporation of the previous 140 pages of the pleading paired with the conclusory assertion that “Defendants carried out a common plan, scheme, and unlawful course of conduct that was intended to . . . deceive the investing public” and “artificially inflate the market price of Danske Bank ADRs.” App’x at 160. Money-laundering at a single branch in Estonia cannot alone establish that Danske Bank itself carried out a deceptive scheme to defraud investors. Absent some sort of enumeration of which specific acts constituted an alleged scheme in connection with the purchase or sale of securities, the Funds’ claim does not comply with the applicable heightened pleading standard and cannot go forward.

(emphasis added).

The court did not explain why a Danse Bank subsidiary is being treated as distinct from Danse Bank itself, or how one should assess Danse Bank’s actions and intent distinct from the behavior of its subsidiaries.  I can’t even say the decision was wrong, because I don’t know what standards the court used to reach it.

Next up, there’s Hurst v. Enphase Energy, 2021 WL 3633837 (N.D. Cal. Aug. 17, 2021), where, as relevant here, plaintiffs tried to demonstrate scienter by pointing out that several insiders made unusual sales prior to the end of class period disclosure.  The court rejected the argument by saying:

Defendants correctly highlight that seven of the eight identified insiders are not named in this action, and such sales are irrelevant to scienter.

No further analysis was provided; the court simply cited two other cases, Wozniak v. Align Tech., Inc., 2011 WL 2269418 (N.D. Cal. June 8, 2011) and In re Splash Tech. Holdings, Inc. Sec. Litig., 160 F.Supp.2d 1059 (N.D. Cal. 2001).  Wozniak, like the Enphase court, did not discuss the matter further. 

But let’s unpack this.

Insider trading is often described in 10(b) opinions as a “motive” to commit fraud – for example, in Splash, the court didn’t exactly say that nondefendants’ trades were never relevant, but it did suggest they’d only be relevant if there was evidence the trades were intended to manipulate the stock to assist their colleagues’ fraud.  But that is too broad brush. Insider trading may also be a result rather than a cause.  I.e., imagine a corporation where insiders are committing fraud for some reason – they feel pressure from stockholders or their bosses to get results, they have bonuses on the line, they’re afraid of losing their jobs, whatever it is.  Now they, and possibly other people in the organization, have inside information that the company is not in fact as successful as it pretends to be.  Anyone with this knowledge may decide to sell stock and cash in while they can; the sales, in this scenario, are not the reason for the fraud, but they do evidence someone’s knowledge that something in corporate reporting was amiss.  That knowledge may contribute to an inference of scienter, in the sense that information was known to someone demonstrating that the defendants’ public statements were false and would mislead investors.

Why, then, would nondefendants’ trades be relevant here?

There are a number of possibilities, and they depend on your theory of scienter.

In the simplest example, suppose the selling shareholders worked closely with the individual defendants who spoke publicly.  Or suppose they sat in the surrounding offices.  It might very well be a reasonable inference that if they knew something was amiss, the individual defendants – who worked with them – knew it as well.  Maybe it’s not a strong inference, maybe it doesn’t carry the day, but it’s not an irrational one and it hardly makes sense to dismiss the possibility with a bright line declaration that nondefendants’ sales are irrelevant.

But let’s say we’re talking about corporate scienter rather than individual scienter.  Now, again, nondefendant individual sales may be relevant here, but how they are relevant depends on your theory of how to attribute scienter to a corporation.

Suppose corporate scienter is gleaned from the overall functioning of the organization.  The fact that there is evidence that at least some insiders (maybe highly placed ones) had knowledge of the truth, and yet the company issued false statements despite that knowledge, may give rise to an inference of exactly the kind of communication breakdown that justifies treating the entity as though it behaved recklessly.

Or, suppose corporate scienter is based on the scienter of someone who – as some circuits have held – approved the false statement, or furnished information for inclusion.  These insiders may very well have done that.  Maybe they approved false statements, or supplied false information to someone else.  Their sales indicate knowledge of the truth; their actions permit their own scienter to be attributed to the entity.

Why not just name them as defendants, then?  Simple: Their internal involvement with corporate information flow may not be enough to constitute a false statement under Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), and though they may have participated in a scheme to defraud under Lorenzo v. SEC, 139 S. Ct. 1094 (2019), given how narrowly the Supreme Court has read reliance in the 10(b) context, see Stoneridge Inv. Partners LLC v. Scientific- Atlanta Inc., 552 U.S. 148 (2008), it’s not clear plaintiffs would be able to state a claim against them individually.  Thus, evidence of their knowledge contributes to an inference of scienter against the entity, but they are not proper defendants individually.

And, indeed, in Splash – which was cited by the Enphase court and held that the trades of nondefendants were irrelevant – the actual individuals who traded had been defendants earlier in the case, and were dismissed because plaintiffs could not show they had personally made any false statements.

Or! There is another possibility.  As I discussed in my post two weeks ago, some circuits have held that if truthful information was available to persons who played a role in approving or furnishing false information, etc, plaintiffs may be able to create a pleading stage inference that someone who approved or furnished false information acted with scienter, even if they cannot identify who that person is in their complaint.  And those allegations might create a strong inference of corporate liability for 12(b)(6) purposes, with the specific guilty agent to be identified later.

Insider sales by nondefendants may help contribute to that inference.  Maybe plaintiffs can’t show they were personally involved with generating the false statements, but there may be enough of them – highly placed – that you can infer at least one of them probably was.  Or, going back to the proximity issue, if they are adjacent to power, their knowledge may contribute to an inference that the truth was widely known at least among higher level people, so that, again, it is likely that at least one such person contributed to the false statements while knowing the truth.

I am not saying that any of these inferences were appropriate in Enphase – maybe not.  And how strong they are likely to be is necessarily going to vary case by case.  But the issue deserves more unpacking than a simple maxim that nondefendant sales are irrelevant to to scienter.