A decision last week from the District of New Jersey is the latest of several recent decisions from the District and the Third Circuit making clear that securities fraud plaintiffs face a high bar in pleading an inference of scienter strong enough to withstand a motion to dismiss.
In In re Electronics For Imaging, Inc. Securities Litigation, Plaintiffs brought a securities fraud class action alleging that Electronics For Imaging, Inc. (EFI), and two of its executives, violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5. According to Plaintiffs, Defendants falsely assured investors in a Form 10-K and Form 10-Q (and accompanying Sarbanes Oxley certifications) that EFI’s internal controls over financial reporting were functional and effective—including by asserting that those controls had been reviewed, evaluated, and improved. A subsequent press release and amendments to the Form 10-K and Form 10-Q identified material weaknesses in EFI’s internal controls. Plaintiffs filed suit in the wake of a drop in EFI stock price that occurred after the press release was issued. Defendants moved to dismiss for failure to sufficiently plead scienter.
In support of scienter, Plaintiffs alleged that Defendants’ record keeping practices so egregiously violated generally accepted accounting principles that Defendants either: (i) lied when they asserted they had previously reviewed and evaluated their internal controls; (ii) knew of the weaknesses and deliberately did not disclose them; or (iii) were culpably reckless in not discovering the weaknesses. The Court rejected each of Plaintiffs’ proffered possibilities. District Judge Madeline Cox Arleo explained that the complaint lacked any corroborative facts that Defendants lied about their previous review of internal controls, and that Plaintiffs had failed to allege weaknesses in the controls sufficiently glaring or obvious to support the inference that Defendants must have known about them. Plaintiffs’ allegations regarding the consequences of the internal control deficiencies—like the drop in stock price and EFI’s poor subsequent financial performance—were also insufficient to support the conclusion that Defendants must have known that the controls were deficient.
The Court also rejected Plaintiffs’ attempt to invoke the “Core Operations Doctrine,” which provides that a plaintiff may sufficiently plead scienter by alleging that a defendant made misstatements concerning core matters of central importance to a company. The Court explained that the doctrine requires additional particularized allegations demonstrating that a defendant knew its statement was false, which the complaint at issue lacked. Plaintiffs’ attempted reliance on Defendants’ SOX certifications was rejected for the same reason. The Court explained that an allegation that a defendant signed a SOX certification in support of an SEC filing does not support an inference of scienter absent other allegations demonstrating that the defendant knew the information in the certification or filing to be false.
Plaintiffs also alleged in support of scienter that EFI’s auditor, Deloitte, had previously issued an unqualified opinion regarding the efficacy of EFI’s internal controls. Plaintiffs argued that Defendants must have furnished false or misleading information to Deloitte or else the internal control deficiencies would have been discovered. The Court rejected the argument for lack of particularized allegations sufficient to support a conclusion that Defendants intentionally withheld any information. The Court also noted that unqualified audit opinions have been found to raise an inference against scienter.
Plaintiffs’ allegations of motive to commit fraud also could not save their complaint. The Court found Plaintiffs’ allegations that the Defendants inflated stock prices for personal financial gain amounted to nothing more than general motives to aid the company that are insufficient to support an inference of scienter.
Finally, the Court rejected Plaintiffs’ argument that all of the allegations, when viewed holistically, are sufficient to support a strong inference of scienter. The Court held that an opposing inference—that the alleged misstatements resulted from mere corporate mismanagement or negligence—was more compelling than any inference of scienter Plaintiffs’ allegations could support. Plaintiffs’ section 20(a) control person claim was dismissed for lack of any derivative underlying section 10(b) violation.
The decision is one of several recent similar opinions from the District of New Jersey dismissing securities class action complaints for deficient scienter allegations, including Judge Arleo’s decision in In re Hertz Global Holdings Inc., which was affirmed by the Third Circuit in September of last year. This latest opinion further confirms that sufficiently pleading scienter in the District of New Jersey remains a significant uphill battle.