A recent precedential decision from the Third Circuit may make it more difficult for putative securities class actions to withstand motions to dismiss and provides useful guidance for district courts in making the often difficult determination whether a complaint adequately pleads the strong inference of scienter necessary to sustain a federal securities fraud claim.
In In re Hertz Global Holdings, Inc., certain pension funds brought a securities fraud class action alleging that Hertz Global Holdings, Inc. and certain of its current and former executives violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5. Plaintiffs’ complaint relied heavily on a financial restatement Hertz issued with its fiscal year 2014 Form 10-K, which corrected errors to Hertz’s 2011, 2012, and 2013 financial statements. According to the restatement, Hertz had overstated its pre-tax income by a total of $215 million and its net income by a total of $132 million during the three-year period. The restatement explained that “an inconsistent and sometimes inappropriate tone at the top was present under then existing senior management” which “resulted in an environment which in some instances may have led to inappropriate accounting decisions and the failure to disclose information critical to . . . effective review.” Plaintiffs alleged that the restatement constituted an admission that Hertz’s financial statements were erroneous and the result of deficient internal controls for which the individual defendants were responsible. Plaintiffs’ allegations in support of scienter included: (i) the size and scope of the restatement; (ii) Hertz’s admission of material weaknesses in its internal controls; (iii) signed Sarbanes Oxley certifications accompanying the materially false SEC filings; (iv) Hertz’s replacement of upper management in and around the time of the restatement; and (v) allegedly suspect trading activity by certain individual defendants (i.e., selling large amounts of their Hertz stock holdings for a significant profit and in a manner inconsistent with those individuals’ prior trading practices).
Judge Madeline C. Arleo of the U.S. District Court for the District of New Jersey found that Plaintiffs failed to adequately plead a strong inference of scienter and dismissed the complaint as a result. The Third Circuit agreed. In affirming the dismissal of Plaintiffs’ complaint, the court explained: (i) while the restatement may have revealed significant financial misstatements, it was not sufficiently drastic on its own to support a strong inference of scienter, and Plaintiffs failed to allege that the individual defendants knowingly caused accounting personnel to engage in fraud or accounting improprieties so obvious that the individual defendants must have known about them; (ii) the admission in the restatement of an “inappropriate tone at the top” was more plausibly interpreted as an admission of mismanagement—which is insufficient to support scienter absent allegations that defendants were aware or recklessly disregarded that such mismanagement created an environment in which fraud was occurring—rather than affirmative misconduct; (iii) SOX certifications did not add to an inference of scienter absent allegations that a defendant knew he was signing a false SEC filing or recklessly disregarded inaccuracies in that filing; (iv) the individual defendants’ resignations did not materially add to an inference of scienter for lack of particularized allegations connecting the departures to the alleged fraud (here, the complaint causally linked the resignations to the release of bad news rather than involvement in any systemic fraud); and (v) although the uncharacteristic nature of the stock sales, percentage of holdings sold, and resulting profit supported an inference of scienter, they added only minimal weight. The strength of any inference that might be drawn from the alleged insider trading is lessened by the timing of the sales (occurring when the stock was not at its highest and not temporally linked with any specific disclosure), the considerable length of the class period (29 months), and that insider trading was alleged as to only two of five individual defendants. Ultimately, the court concluded that the allegations in support of scienter, even when evaluated holistically, were simply not as compelling as the opposing, plausible inference that corporate mismanagement resulted in accounting irregularities and, at most, negligent misstatements.
The opinion serves as an important reminder of the significant hurdles securities fraud plaintiffs face in pleading an inference of scienter sufficient to withstand a motion to dismiss. The opinion is also noteworthy for its reiteration that a district court does not depart from the interpretative framework for assessing scienter set forth by the U.S. Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) simply because it disagrees with a plaintiff’s preferred inferences or analyzes scienter allegations in separate categories prior to making a holistic assessment.