The Fourth Circuit Raises the Bar for Plaintiffs Pleading Scienter
POMERANTZ MONITOR | MAY JUNE 2022
A core pillar in many securities’ fraud actions is scienter – i.e., whether a defendant acted with an intent to deceive, manipulate, defraud, or was severely reckless, which is defined as carelessness so unreasonable that it risked misleading shareholders. To make it past the motion to dismiss stage, plaintiffs are required to allege sufficient facts to establish that the likelihood of fraudulent intent – the inference of scienter – is at least as strong as the likelihood of any non-fraudulent explanation for a defendant’s actions. The Court of Appeals for the Fourth Circuit recently addressed the issue of which elements must be pled to establish scienter in a securities fraud case and, in doing so, highlighted the uphill battle that plaintiffs face in sufficiently pleading scienter to survive a motion to dismiss.
As set forth in In re DXC Technology Company Securities Litigation, DXC issued a press release touting its financial success, but months later, the company revised its projected revenue downward by approximately $800 million, causing the company’s share price to drop. Plaintiffs subsequently brought suit against DXC and its executives, alleging that they knew, contrary to DXC’s press release, that cost-cutting measures in 2018 would impede the company’s ability to draw revenue. The District Court for the Eastern District of Virginia dismissed the complaint, and the plaintiffs appealed that decision to the Court of Appeals for the Fourth Circuit.
The Fourth Circuit affirmed the District Court’s dismissal of the stockholders’ claim of securities fraud and, in doing so, analyzed the five different categories of scienter that the plaintiffs relied upon. Specifically, to determine whether the requisite scienter existed, the Fourth Circuit analyzed (1) statements of unnamed former employees, (2) the core-operations theory, (3) allegations by a former executive, (4) stock sales made by the defendants, and (5) the temporal proximity between the defendants’ optimistic statements and the ultimate admission of disappointing revenue. In ruling against the plaintiffs, the Fourth Circuit discounted most of the plaintiffs’ allegations on which they premised scienter and, in doing so, emphasized the high bar that plaintiffs must meet to make it past a defendant’s motion to dismiss.
The Fourth Circuit first reviewed the statements of unnamed former employees to the effect that they were concerned about the cost-cutting measures. There, the Fourth Circuit found that, by and large, the former employees had little or no contact with the defendants and did not pass along their concerns to the defendants. This, combined with the fact that the few times employees did notify the defendants of their concerns were described by the complaint in a vague and conclusory fashion, led the Fourth Circuit to discount this factor. Thus, plaintiffs who rely on statements of former employees in the future will need to make sure that those employees had direct contact with the defendants and describe those interactions with particularity.
Similarly, the Fourth Circuit discounted the plaintiffs’ core operations theory because, as with the statements of former employees, the complaint lacked “particularized allegations” regarding the defendants’ knowledge of the shortcomings due to the cost-cutting measures.
The Fourth Circuit also analyzed the plaintiffs’ claims that a former executive told the defendants that cost-cutting measures could impede revenue. The Fourth Circuit found that the defendants were never alleged to have agreed with the former executive and therefore this could be chalked up to a simple disagreement among executives, negating any inference of scienter. Significantly, the Fourth Circuit’s analysis makes clear that for plaintiffs to effectively plead scienter, they must allege that not only were defendants aware of concerns that their statements to investors were false, but also that they agreed with those concerns.
The Fourth Circuit’s discussion of stock sales by the defendants should similarly raise concern for plaintiffs who are filing a securities fraud action. In its opinion, the Fourth Circuit found that while one defendant sold 77% of his stock during the class period, he also sold more stock before the class period. Thus, according to the Fourth Circuit, despite the massive amount of stock sold during the class period, if a defendant sells less stock during the class period than before it, scienter is unlikely to be found. Concerning the other defendant, while he sold no stock before the class period, the Fourth Circuit found that he only sold 17% of his stock (amounting to approximately $10 million) during the class period, which was de minimis. The Appellate Court also noted that the plaintiffs failed to explain why the defendant selling 17% of his holdings was not de minimis. Thus, due to the plaintiffs’ failure to address the de minimis issue in their briefing, a defendant’s sale of 17% or less of stock during a class period is unlikely to raise the spectrum of scienter.
Even more concerning for potential plaintiffs was the Fourth Circuit’s notice of the defendants’ 10b5-1 trading plans in its analysis. While the Fourth Circuit recognized that the record is silent about when the defendants entered the plans (and thus cannot say whether the plans mitigate a suggestion of motive) and that 10b5-1 trading plans are effectively affirmative defenses that should not be considered at the motion to dismiss stage, the Appellate Court still considered them in its analysis of the defendants’ stock sales and held that the plans “weaken[s] any inference of fraudulent purpose.” Thus, despite itself acknowledging that there is no evidence to show that the defendants entered into the trading plans after the class period began or that it should not be considering the trading plans at all on a motion to dismiss, the Fourth Circuit still used them to discount any inference of scienter from the defendants’ stock sales. The holding of the Fourth Circuit warns potential plaintiffs that they must carefully examine the stock sales of defendants before and during the class period, as well as thoroughly attack any use by defendants of 10b5-1 trading plans to weaken an inference of scienter.
Finally, the Fourth Circuit considered the temporal proximity between the defendants’ allegedly false statements and the subsequent disclosure of truth and found that while the three-month gap between the rosy picture painted by the defendants and the truth of falling revenue was relevant, it alone could not establish a strong inference of scienter. Ultimately, after discounting most of the plaintiffs’ allegations of scienter, the Fourth Circuit held that, under a holistic analysis, the non-fraudulent inference was more compelling than the requisite inference that the defendants knowingly or recklessly misled investors about the company’s financial health.
While the full implications of the Fourth Circuit’s opinion are yet to be seen, the opinion outlines a difficult road ahead for plaintiffs trying to plead scienter. Moving forward, plaintiffs would be wise to learn from the failings of the DXC plaintiffs and plead their complaints with the particularity and detail that the Fourth Circuit found lacking, address both a defendant’s stock sales and any 10b5-1 trading plans – irrespective of whether they should be considered on a motion to dismiss, and work to find evidence that a defendant not only heard evidence that their statements were misleading, but agreed with that evidence.