Securities Fraud Class Action Properly Dismissed by District Court because Class Action Complaint Failed to Allege Scienter under Heightened Pleadings Requirements of the PSLRA (Private Securities Litigation Reform Act of 1995) Eleventh Circuit Holds
In May 2006, plaintiff John Mizzaro filed a securities fraud class action against Home Depot and six of its officers and directors; the gravamen of the class action complaint was that “(1) Home Depot obtained excessive rebates from its vendors, and (2) violated the securities laws by not informing investors that the financial results it reported for fiscal years 2001-2004 were inflated by these excessive rebates.” Mizzaro v. Home Depot, Inc., ___ F.3d ___ (11th Cir. October 8, 2008) [Slip Opn., at 5-6]. According to the class action, the failure to make this disclosure constituted a violation of § 10(b) of the Exchange Act of 1934 and Rule 10b-5. The class action complaint also sought to hold the individual defendants liable based on the allegation that they were “control persons” under § 20(a) of the Exchange Act. _Id._, at 6. Four identical class action lawsuits followed; the class actions were consolidated and plaintiff Bucks County Retirement Board was appointed lead plaintiff. _Id._, at 5. Defense attorneys moved to dismiss each of the class actions; in response, Bucks County filed a 150-page Amended Class Action Complaint, which became the operative class action complaint in all five cases. _Id._ Defense attorneys again moved to dismiss the class action complaint arguing, in part, that the allegations “failed to create a ‘strong inference’ that [defendants] acted with the requisite scienter” under the Private Securities Litigation Reform Act of 1995 (PSLRA). _Id._, at 6. The district court dismissed the class action and denied plaintiff’s motion for leave to further amend its class action complaint; the court held that the amended class action complaint “failed to adequately plead scienter, and that granting leave would be futile because the additional facts presented in the motion for leave would not change t hat result.” _Id._, at 7. In a 60-page opinion, the Eleventh Circuit affirmed.
The Circuit Court explained that “[t]o survive a motion to dismiss under the [PSLRA], the factual allegations contained in a private securities fraud class action complaint must raise a ‘strong inference,’ one that is ‘cogent and compelling,’ that the named defendants acted with the requisite scienter.” Mizzaro, at 4. This article assumes the reader is familiar with the PSLRA and with the U.S. Supreme Court opinion in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007); the author’s summary of Tellabs may be found here
. Central to the Eleventh Circuit’s analysis was its determination of an issue not addressed in Tellabs – viz., “how courts should go about evaluating allegations based on statements made by unidentified, confidential witnesses.” Id., at 14. As a matter of first impression, the Circuit Court held that a securities fraud complaint need not name a confidential source “so long as the complaint unambiguously provides in a cognizable and detailed way the basis of the whistleblower’s knowledge.” Id., at 16. However, in light of legitimate reasons to be “skeptical of confidential sources cited in securities fraud complaints,” id., the Eleventh Circuit held that “the weight to be afforded to allegations based on statements proffered by a confidential source depends on the particularity of the allegations made in each case, and confidentiality is one factor that courts may consider,” id., at 16-17. The Court clarified its holding at page 17 as follows, “Confidentiality… should not eviscerate the weight given if the complaint otherwise fully describes the foundation or basis of the confidential witness’s knowledge, including the position(s) held, the proximity to the offending conduct, and the relevant time frame.”
Briefly, Home Depot obtains its merchandise from third-party vendors, and these vendors give Home Depot “return-to-vendor” (RTV) credits for defective merchandise. Mizzaro, at 18. After explaining how RTV credits may be used to fraudulent inflate company profits, the Circuit Court explained that class action “alleges that Home Depot stores routinely processed fraudulent RTV chargebacks as part of a ‘companywide scheme’ to boost profits.” _Id._¸ at 19. “The amended complaint relies on five kinds of evidence to demonstrate the scope and duration of the scheme: (1) confidential employee witnesses; (2) newspaper articles; (3) internal Home Depot documents; (4) one whistleblower complaint; and (5) commentary on the SEC’s inquiry into Home Depot’s practices.” Id. The Circuit Court summarized the evidence from each of these sources, see id., at 20-29. It then turned to the “critical question” of “whether the amended complaint, taken as a whole, creates a ‘strong inference’ – one that is ‘cogent and compelling’ – that the individual defendants acted with the required scienter.” Id., at 33.
The Eleventh Circuit agreed that the allegations in the class action complaint, “if accepted as true, establish that Home Depot stores processed improper RTV chargebacks.” Mizzaro, at 33. But the Circuit Court noted that “simply alleging that a widespread fraud may have occurred is not enough” because the allegations in the complaint also “must create a strong inference — again, one that is ‘cogent and compelling’ – that the individual defendants knew about the alleged fraud (or were severely reckless in not knowing about it) when they made the purportedly false or misleading statements.” Id., at 34. The Court found the necessary element scienter missing. The class action complaint “relies exclusively on the widespread nature of the fraud, and the purported amount of the fraud, to draw a strong inference that the individual defendants (all high-ranking officials) acted with the requisite scienter.” Id., at 35. But there is no evidence actually connecting the individual defendants to the alleged fraud, and the confidential witnesses do not even allege to have met any of the individual defendants. Id. And the Court was skeptical of “allegations that hinge entirely on a theory that senior management ‘must have known’ everything that was happening in a company as large as Home Depot, which operates over 2000 stores.” Id., at 43. In short, the complaint “must at least allege some facts showing how knowledge of the fraud would or should have percolated up to senior management.” Id. The Eleventh Circuit found that the complaint failed to make this showing but, instead, rested entirely on speculation. Id.
After a detailed analysis, the Eleventh Circuit held that “the amended complaint contains no allegations directly linking the named defendants to the RTV fraud, and the allegations about the geographic scope, duration, and amount of the alleged fraud are insufficient to create a ‘strong inference’ (meaning a ‘cogent and compelling’ one) that the individual defendants orchestrated the fraud, knew about it, or were severely reckless in not knowing about it.” Mizzaro, at 52. So the district court properly dismissed the § 10(b) and Rule 10(b)(5) claims, id. And because the class action “failed to adequately plead a violation of § 10(b) and Rule 10b-5 by Home Depot,” the control person liability claims against the individual defendants also failed. Id., at 53-54. Finally, the Circuit Court concluded that the district court did not err in denying plaintiff leave to amend the class action complaint. Id., at 54-59. Accordingly, it affirmed the judgment dismissing the class action. Id., at 59-60.
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